Amid rising rates, tight borrowing limits a blessing for Reits, homebuyers

WHEN cost of debt is low, loading up on debt to buy a property is compelling.

For a property with an annual entry yield of 3 per cent, the yield on equity rises to 3.4 per cent and 4.5 per cent based on funding the purchase 30 per cent and 60 per cent by debt respectively, assuming cost of debt of 2 per cent per annum.

If the cost of debt is 3.5 per cent per annum, the yield on equity in the above example falls to 2.8 per cent and 2.3 per cent respectively.

The simulation shows that using debt to fund a property purchase is much less compelling when interest rates rise. The three-month compounded Singapore Overnight Rate Average (Sora) was around 0.2 per cent or less per annum for much of mid-2020 through early 2021. As at value date Sep 30, 2022, the three-month Sora was 2.07 per cent per annum.

Property owners such as real estate investment trusts (Reits) and individuals are grappling with rising debt costs. In such a climate, managers of Reits and homeowners may be happy not to be overly leveraged due to regulatory limits.

Regulatory limits

For Reits, the total borrowings and deferred payments should not exceed 45 per cent of the fund’s deposited property. A property fund’s aggregate leverage may exceed 45 per cent of the fund’s deposited property, up to a maximum of 50 per cent, only if the fund has a minimum adjusted interest coverage ratio of 2.5 times after taking into account the interest payment obligations arising from the new borrowings.

The loan-to-value (LTV) that limits what an individual can borrow from a financial institution for a housing loan is 75 per cent for those with no outstanding housing loan, and 45 per cent and 35 per cent for those with one outstanding housing loan and two or more outstanding housing loans respectively. Lower LTV limits apply if the loan tenure exceeds 30 years (or 25 years for HDB flats), or the loan period extends beyond the borrower’s age of 65 years. Separately, the LTV limit for HDB housing loans is 80 per cent.

Another regulation governing extension of credit by financial institutions caps the total debt servicing ratio (TDSR), which refers to the portion of a borrower’s gross monthly income that goes towards repaying the monthly debt obligations, including the loan being applied for, at 55 per cent.

Also, buyers of HDB flats and executive condominium (EC) units, where the EC’s minimum occupancy period has not expired, are subject to a mortgage servicing ratio (MSR) cap of 30 per cent on the gross monthly income that goes towards repaying all property loans, including the loan being applied for.

Effective Sep 30, 2022, a 0.5 percentage point higher medium-term interest rate floor is used to compute the TDSR and MSR. A floor of 4 per cent per annum is now used to compute TDSR and MSR for home loans. Separately, for HDB flats buyers, an interest rate floor of 3 per cent per annum is now used to compute the eligible loan amount available to borrowers seeking HDB loans.

Flexibility

Applying strict limits on what a Reit or homeowner can borrow has downsides.

A Reit manager may like to push the amount of borrowing beyond the regulatory limit temporarily due to a timing difference between the completion of a new property purchase and the sale of an existing property.

Also, a Reit manager may want to push the debt level up temporarily as more borrowing is incurred to fund capital expenditure on asset enhancement work, which can result in higher asset valuation.

At times, the ability of Reits to grow via acquisitions is hampered as the trusts cannot compete with asset buyers who are able to gear up more.

For homebuyers, having more generous LTV, TDSR and MSR limits can help less cash-rich buyers. Tough borrowing limits could disadvantage a young homebuyer who needs to rely on using credit, versus a peer who can get financial support from parents.

An individual with strong earnings prospects may want to take on a large home loan because he expects to make a partial capital repayment in a few years’ time.

Also, banks may want to lend to some individuals who have high debt liabilities because such a situation is temporary, or the said borrowers have minimal other expenditure.

But events such as the outbreak of the Covid pandemic and the war in Ukraine remind us that the world is an uncertain place.

Individuals may see their ability to repay loans change dramatically due to a job loss. A Reit manager, who is expecting to receive cash proceeds from an asset sale, may see cash flow projections messed up should such a sale fall through.

It can be tricky setting the level of a property fund’s aggregate leverage limit, or the LTV, TDSR and MSR limits applicable to homebuyers.

Even as interest rates rise, debt has a useful role to play in funding purchases of chunky physical properties, which can generate recurring income and capital gains.

Robust markets

Nonetheless, the Reit and homes markets are more robust due to tight borrowing limits.

The risk to the banking system from overly leveraged homebuyers defaulting on mortgage payments, which can be catastrophic, is mitigated.

Many individuals invest in Reits to earn passive income to help fund retirement needs. The success of the Reit market and value of retirement investment portfolios can be jeopardised should overly-leveraged Reits face refinancing difficulties.

Being clever with using debt in buying property helps. Some Reits can better deal with rising interest rates because they have locked in borrowings with longer durations, spread out debt maturities and have a higher proportion of fixed rate debt.

Some homeowners may have locked in fixed rate home loans some time back, albeit these owners could face higher mortgage bills as fixed rate periods of say two or three years expire.

Individuals and businesses are seeing costs of goods and services increase. The goods and services tax will go up from 2023. Businesses and individuals need to be vigilant on costs, including rising debt cost.

The Singapore Reit and residential property markets can face rising interest rates and slowing economic growth with some confidence, because of prudent levels of borrowings.