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

Real estate - Basic considerations

A couple of days ago a colleague of mine proudly reported that acquiring his own property was one of his best investment decisions in life. In 2010, he paid EUR 550,000 for a rather basic terrace house in the outskirts of Munich. He financed the acquisition through EUR 125,000 of equity and the remainder through a mortgage loan at a 3.50% p.a. fixed rate. He was very proud of his investment. To me paying off a loan for the rest of my life appears not so promising. Who knows what will happen during such a long period of time!?

I have been asking myself for some time now whether my dividend income strategy is really superior to a regular real estate investment. The reasons for not having considered such an investment so far were rather practical in nature:

First of all, with 4 years of professional experience I still consider myself to be a job starter. Being flexible and not put on the chain has been very important for me in today's fast-paced work environment. Secondly, prices for real estate in German cities (and particularly in the Munich area) dramatically increased in the past years. They swiftly reacted to the ECB monetary policy of low interest rates. As a consequence, it takes more time to build up the equity required to be granted any mortgage loans. Of course it might also be possible to pursue a real estate investment without any equity at all. Whether this is a good and sustainable way forward is, however, another thing.

When I turned 30 last month, I felt that it is time to reconsider my personal situation and review my investment goals. Lets give more thought into this.

What are the pros and cons of either strategy?

1. Dividend income

+ continously growing return on investment if long-term dividend growth rate is positive

+ diversification across various sectors and geographies

+ investment amounts can be randomly split across assets

+ real estate exposure can also be achieved via investment in REITs

+ moderate risk concentration

+ hedge against inflation

- considerable tax impact (25% witholding tax (Abgeltungssteuer) on interest and dividend income)

- regulatory risk / risk of financial repression (higher taxes, extra duty)

- high variation in market value during stock market turmoil

2. Real estate

+ appreciation of property value if asset location has a positive long-term outlook

+ saving of monthly rental expenses

+ interest on loan is tax deductible if asset is rent to 3rd party

+ hedge against inflation

- no diversification across sectors and geographies

- high risk concentration

- difficult to split up the investment

- interest burden (paying interest on any loans which is not payable when renting)

- considerable tax impact (3.5% land transfer tax (Grunderwerbsteuer))

- regulatory risk / risk of financial repression (higher taxes, extra duty)

- limited mobility

I am sure I missed out some aspects of each investment strategy. Nonetheless, it seems that given my current personal circumstances a dividend income strategy has more advantages compared to a real estate investment.

However, there is one aspect which is worth to highlight: My girl-friend and I currently pay EUR 1,400 per month of rental expenses for our 3-room apartment. I consider this as money thrown out of the window. Wouldn't it be better to buy a property, really own something, and pay-off a mortgage loan instead? In my view, saving the rental expense is a real advantage of real estate even though I would have to invest all equity into such a new project at once. I could still start all over again with my dividend income strategy in parallel once this investment is made.

You might be asking 'why is he still hesitating then?' Well, main reason is the following: As I wrote in the beginning, prices in the market have exploded since 2009. I would even say that prices in Munich increased faster than my personal savings rate throughout the last years. This does not mean that I did not save enough, but rather that there was a run into real estate due to the low interest environment.

Experts believe that there is no real estate bubble in German cities, but I deem real estate prices of 30-35x of annual rental income in the Munich area as over-priced. At this price levels, I would have to finance a very large portion of the acquisition price through loans.

This is the critical point here: While the interest compounding effect in a dividend income strategy works for me, it works against me when I take on a loan.

Now, what does that mean in detail? How can I make sure that the financing is still bearable? Of course, I do not want to drown in financial indebtedness.

Lets have a closer look into this in part 2.