Real estate - Financing aspects

In part 1, I concluded that a real estate investment cannot be separated from its financing aspects.

In order to dig deeper into this matter and put some hard facts behind my reasoning, I calculated some annuity schedules at a 3.25% p.a. interest rate and an annuity of EUR 1,400 for different debt levels in a range from EUR 150,000 to EUR 425,000. For simplicity, I chose an annuity of EUR 1,400 as this is my current rental expense per month.

Then I drew a chart of the results with loan life (final repayment date of the loan) on the x-axis and loan balance on the y-axis. The result is shown below:

An annuity always consists of a repayment amount and an interest portion which, of course, is bigger in the beginning of the repayment phase as the borrower is paying interest on the fully-drawn loan.

The chart shows very well how the interest compounding effect works:

Although debt is raised by the same amount of EUR 25,000 for each curve, the distance between the curves on the x-axis (i.e. loan life) is continuously increasing. The difference in years between the curves is displayed in the colored scale to the right of the chart.

The described effect is similar to a dividend growth strategy only that it works in the opposite direction. To be more clearly, the interest compounding effect works against the borrower and it works even stronger against the borrower, the more debt he borrows.  

That said, I colored the various curves on a scale varying from dark green (healthy financing) to dark red (unhealthy financing) to indicate which loan amount, in my view, is affordable given a monthly annuity of EUR 1,400.

My conclusion is that the compounding effect becomes critical at a repayment horizon of ca. 30 years. But even at shorter horizons, the interest portion as part of total debt service is already significant. It actually makes you kind of sad to see the huge amounts paid in form of interest expense during the loan life. The chart below shows the exact proportions of the interest and repayment components:

Given the figures above, it becomes clear that a loan life of 30 years is acceptable, but carries already a significant interest burden on the borrower’s side. If possible, it is therefore advisable to use shorter repayment horizons for loans. Personally, I deem a loan life of ca. 20 years (ca. 75% repayment and 25% interest portion) as balanced and therefore appropriate for my own considerations.

Based on this result and an annuity of EUR 1,400 it is apparent that my maximum loan amount is capped at EUR 250,000-275,000. If I assume and equity portion of EUR 150,000 to be accumulated by my mid-thirties this adds up to a total investment of EUR 400,000-425,000. Unfortunately, these prices are not achievable for a terrace house in the Munich area in the foreseeable future. 

Of course, at the age of 30 I have some more room for financial leverage as there should be a few salary increases ahead. But on the other side, this additional income will probably be directly consumed by my future kids and family :-). So I am on the safe side staying with my EUR 1,400.

Getting back to my colleague’s investment, it is rather clear that with an acquisition price of EUR 550,000 and a EUR 125,000 of equity, he is pretty much damned to repay his loan for the next 35 years. What that means in terms of interest burden should be clear by now. Even if his financial strength, represented by the amount of his annuity, is higher than mine by some hundred Euro this is still not enough to repay below 35 years. Tables below show some sensitivity analysis in this respect:

In addition, he has a 3.50% p.a. fixed interest rate agreement while I am assuming 3.25% p.a.. This indicates that his loan life might be even higher than 35 years.

So, what are the conclusions from the calculations and arguments explained above?

- I will not buy any real estate in the Munich area at current prices (moving away from Munich to a more favorably priced city could make sense in the mid-term).

- I still have a long way to go to reach my goal of EUR 150,000 of required equity
- I will stick to my dividend income strategy and hopefully this strategy will help contributing towards achieving this goal