You don’t need to look far to see that property investor loan interest rates have increased significantly above owner-occupier home loans in the last year. Investor loans currently have interest rates 0.3% higher than owner-occupier rates.
Before APRA took initial action to limit year-on-year investor loan growth in 2014, investors and owner-occupiers were paying the same interest rate and with some bank preference to even charge investors less. This is at odds with overseas, where buy-to-let mortgage (investors loan) interest rates are approximately 1% higher per annum.
Part of this Australian market attribute is driven by the perception that investor loans have less risk: if the renter loses their job then you can replace them with someone else. If an owner-occupier loses their job, they might default on the loan. No recessions helps reinforce this.
From my perspective, this is the wrong assessment and overseas banks clearly agree with me – hence the higher interest rate for buy-to-let mortgages.
For owner-occupiers, the 4 Major banks hold approximately 2.5% credit risk capital on home loans (APRA average). When offering home loans at 3.8% they make around a 30% return on regulatory capital.
The 2.5% credit risk capital is driven by the probability of default (PD) and loss given default (LGD). This falls into the ranges of 0.2% to 0.3% for PD and 10% to 25% for LGD. I expect the Major banks are on the aggressive end here.
For investor loans, there is a similar analysis with similar PD and LGD assessment. I also expect that the price increases are more of a supply/demand consideration given that the year-on-year limit is within sight – so there is a little else a bank can do except raise prices.
The Credit Risk Assessment is Potentially Wrong:
Key Question: Should investor loan credit risk be measured by Basel 2’s PD & LGD formula? Possibly not.
The main risk I see in these portfolios is the assumption that new renters will be available rather than the property investors’ ability to service the loan. So the 99% downside financial stress needs to be driven by 2 things:
- What will the renter vacancy rate increase to in a 99% downside scenario
- If there is rental income contraction, does that influence the likelihood of investor default.
These 2 items should be additive. Note: for credit risk capital we assume a fully diversified portfolio, so can use broad averages.
Renter Vacancy Rate:
As a broad estimate, the vacancy rate could increase by 10%. This will be driven by renters losing their jobs and/or downsizing and/or moving in with others for an interim during a deep recession. Unemployment rates could potentially rise by 10%, so I have mimicked this for the increase in rental vacancy rate.
I make no judgment on in investors themselves lose their jobs – but I would presume this would could to default. I will assume everyone who loses their job is a renter. If a property is not rented out for 6+ months, I assume the investor will default as property price declines will not bail them out (they will be in negative equity, on average). As unemployment rates will rise for more than 6 months, the vacancy and hence default rate will hit the 10% level.
This one is harder as it is a sensitive supply & demand problem and the serviceability is a 2nd order impact. I will simply assume that there is not impact at this stage.
99% Stressed PD
Based on this, the 1-Year 99% downside Stressed PD (SPD) could be 5%-10%, depending on the increase in jobless rate, with a preference to selecting 10% and assuming a severe stress to the mining or financial sector.
The 10% SPD in this instance is also the stressed PD required for capital calculations. Using this in a loan capital & pricing model, I obtain an investor mortgage rate of 4.4%, which is 0.6% higher than owner-occupier.
Why is the UK 1% higher?
The calibration of loss-given-default might be important. Whilst broad market LGD could be assumed to be 20% (derived from a 35% decline in property prices plus 10% collection costs on an 75% LVR property), specific property investment stressed house prices could be considered to fall much further. If this is in the 50% to 70% range then the LGD is 40%+. If we then revisit our pricing, we can get a difference between owner-occupier and investors to match that 1%.
So What Happens Next?
Australia has a lack of recession-based data, so cannot really make an assessment of investor loan risk based on observed defaults and losses. The main concern is the divergence from countries and banks that have better data sets that have led to higher pricing for higher risk in investor loan markets. This higher pricing is also driven by stricter regulatory intervention which is also derived from a view on risk.
Given the regulatory hurdles in place, increasing risks for high rise apartments and the above analysis, we are forecasting that most Australian banks will have investor loans with interest rates 0.6% higher than equivalent owner-occupier. This is a further 0.3% increase on the current situation. Shame investors didn’t get a FlexiFix loan.
Watch this space!