How to win the battle of control with the banks

Investment selection and duplication come down to control. Control stems from knowledge of (a) finance structure and (b) the valuation process.

Once you grasp these two critical elements, you can duplicate much faster, with little ‘braking’ in between buying your second, third and fourth properties.

While we can't control how banks value properties, we can make sure we stay fully informed. Thus, we gain control by ensuring we get full disclosure of the process.

We can dig deep to understand the best combination of lender and valuer in each market and location based on valuer expertise. This is detailed, but necessary to build your portfolio.

Risky business

Most banks are great at setting up a home loan. If you’re looking at one investment property, they’ll offer you fee and interest rate discounts. This sounds fantastic, but your own home is the security. This cross-collateralisation means using a current asset to secure another one.

Say you want to use equity in your home for deposit and costs on an investment property. Your bank will typically value the property but not tell you what they think it’s worth. Based on their estimation, they offer to lend you money for the investment property, provided your own home secures that investment.

That’s good and bad.

It’s good you’re using equity to build your portfolio (and not letting it become “lazy”). But it’s bad from a risk perspective. If anything happens to you or your investment property, the easiest way for the bank to recoup their cash is to quickly flog your own home for $50,000+ less than its true worth.

Crossfire

Cross-collateralisation is to be avoided for two key reasons. Obviously from a security perspective, we want to keep our home out of the bank’s reach. And secondly, because going down this path means we place all the control with the bank. This is not good. We want the decision making to remain with us, not the banks.

Unfortunately, since the global financial crisis (GFC), banks now love control even more than ever!

Let’s go a bit deeper on the process of valuation.

These days, most Australian lending institutions utilise the valuation exchange (ValEx) platform to conduct valuations.

Before the GFC, you could pick and choose between valuers to ensure you got the best valuation and borrow against it. But this opened a dark side to the industry.

Property sales sharks would give some valuers the old “wink wink, paper bag”. The valuer would then provide a valuation that was above market price. The industry shark would then sell the over-inflated property to unsuspecting buyers.

In this type of scam alone, one company sold over 3,500 Australians over-inflated property and those people lost collectively around $60 million. Not anymore. The banks finally caught onto this, and then the GFC smashed the lending pot from $7 trillion to around $1 trillion. The banks were therefore more cautious of who they handed their money out to. So, the banks upped their control by adding an intermediary, ValEx, to the valuation process.

ValEx randomly assigns valuation requests to a panel of valuers. Your assigned valuer may have lived in your suburb all their life, or never set foot in it. They may have decades of experience or be two weeks out of uni. You don't know what you’re going to get, there’s so much variability.

Crunch time

Say the contract price of your investment property is $500,000 and you have enough equity in your own home to use as deposit and costs.

At best, a bank will agree with this valuation and lend you 90 per cent ($450,000). When you add that to the equity you’ve used for deposit and costs, you’ve got finance.

Unfortunately, this dream scene is rare.

Banks and their insurers are conservative. Like investors, they want buffers in place for peace of mind.

Worst -ase scenario, a bank will discount a valuation by 10 per cent of the contract price.

So, the numbers now look like this:

$500,000 - 10 per cent = $450,000. And when they lend 90 per cent against that, you get just $405,000.

In other words: $450,000 - $405,000 = $45,000. A shortfall you must make up.

How? By using more equity from your own home. Ugh!

This is crucial. You’re still borrowing $450,000 in total. But under this scenario, the bank lends you $404,000 and you effectively borrow the other $45,000 from ... the Bank of You! This is not a smart way to finance your property investment.

When once I was blind, now I can see if you use the same bank that you have your home loan with and cross-collateralise, your bank won’t disclose the valuation on your own home. You’ll be left in the dark.

So, how do you avoid cross-collateralisation and find out the bank’s valuation of your home and investment property? Use a different bank.

By using different banks, both will need to disclose the valuation. Firstly, when you set up an equity loan against your own home, you will need a valuation. In this case you get to see the valuation. Then by having your investment property with another bank, they too will have to disclose the valuation.

Full transparency is achieved.

Based on that, you can work out how much the bank will lend you and what, if any, shortfall you must cover. The process is the same, but you get to make the decisions, not the bank.

First blood

Buying your first investment property is easy. But without full knowledge of the valuation process, you come unstuck 18 months later when you go to buy your second investment property. Only then do you realise the bank spent $45,000 more of your money the first time round.

Suddenly, you have less equity than you estimated and your grand plan is on its way to being derailed.

I've seen this saga unfold time and time again. And it really matters, because real wealth doesn’t come from one investment property. It's a process you must repeat time and time again. And you can only do that if you know what your bank thinks a property is worth at that time.

If you and the bank have different ideas, you’re stranded until you bridge the gap. It’s important to get your head around these two terms:

A ‘fair market valuation’ is what a property could sell for in 2-3 months with a full marketing campaign. It's a realistic appraisal that a real estate agent might give you or the figure you might find from comparable sales data from a data house like CoreLogic.

A ‘bank valuation’ is merely what a bank is willing to lend against (i.e. use as security). It’s not necessarily a true reflection of a property’s worth. The instruction to the valuer is more like ‘provide a valuation on this property if we were to have to sell it at 9am next Monday’.

Valuers will generally value 5-10 per cent below market value. Anything more and you should investigate further.

True tale

Let’s see what this looks like in the real world. A valuer valued an investor’s property I know (my brother) at contract price (a best-case scenario). Three weeks later, the same valuer valued an identical property down the road at $30,000 less.

My bewildered brother asked the valuer to please explain. The valuer said he got so much grief from the bank’s insurer for valuing the first property at contract price that he decided to avoid all the drama by valuing the second property at $30,000 under.

You see, valuers are paid a very small fee per valuation. They pump ‘em out like a sausage factory. If they have to waste time fielding questions from the bank or their insurer, they’re not out there earning cash. Therefore, in most cases, they go conservative.

Moral of the story

None of this is rocket science. But ignore it at your peril.

Information is power and, when it comes to property investment, that means control.

So, make sure to stay in control and use information to your advantage when dealing with the banks.

By Cam McLellan, director, OpenCorp