Tuesday, May 2, 2017

Would a loan-to-rent limit for home investment work?

What if the rules about lending for housing investment limited the size of a loan to an amount based on the rental income of the property rather than its market value? Could such rules constrain wasteful lending growth that simply fuels speculation, and instead encourage lending that fosters long run investment in housing?

Let me take you through one possible version of such rule that I think could ensure that the enormous economic power of new money creation that lies at the heart of our banking system is used for productive purposes.

My proposed loan-to-rent-ratio (LRR) rule is this:
Loans can be made at 80% of the amount where the gross rent of a property covers the interest repayments at an interest rate 2% points above the offered rate.
How would this work?
Imagine a home that rents for $400 per week, or, say $20,000 per year. Mortgage interest rates are 4.5%.

The loan limit calculation starts by asking what size loan can be serviced with $20,000 a year at a 6.5% interest rate (4.5% plus the 2% buffer). This is $308,000. Using this as a benchmark value, 80% of this value can be created as a new loan, which is $246,000.

It is possible to beef up this rule further with a requirement that any remaining payment for the home must come from savings accrued from incomes, not from home equity lending secured against another property asset.

With this rule in mind, we can look at its effect through the property market cycle compared to a rule that restricts lending to a proportion of home values, say 80%, rather than tying it to rental income.

For simplicity, let us start at a point where the market value of our example home is $308,000. Here, an 80% loan-to-value-ratio (LVR) limit would allow lending of $246,000 against this property, which is the same as my proposed LRR rule.

But then the market begins to rise in the property up-cycle.

A year later
Now, the property's market value has increased 15% to $354,000, but the rent is unchanged. Under an LVR limit, a new buyer could now borrow $283,000 (or 15% more). But since the rent has not grown, under the LRR rule, a new buyer could still only borrow the same $246,000. The LRR rule would thus reduce the amount of new funding available during a speculative upswing, where the rise in market value is not matched by a rise in rental income, and therefore dampen the price swing by not increased borrowing and new demand.

During a downturn
The reverse effect happens during a property market downturn. If the 15% price gains reverse, the LVR rule effectively restricts new lending by the same 15% during this market downturn. The LRR rule does not. Again, a dampening effect.

Any downsides to this plan?
The main one is that benefit of lower demand for housing mainly comes in the form of lower prices, which most current homeowners won’t be especially happy about. Banks won’t be happy that their cash cow of new lending is brought under control. Nor will the vested interests of the land-banking property development lobby be happy that their massive stocks of empty land will become worth far less than they thought.

But these are the downsides of any reforms that make housing more affordable. That’s why no effective reforms have been enacted in the past 20 years.


  1. Your suggestion is a very good one and has a long pedigree in the accounting liturature, financial analysis, and evaluation of borrowers.

    Check out "Interest coverage ratio" in accounting books and Benjamin Grahm wirtes about it in a short book of his.

    If I remember ritght it shows a degree of abvailability of funds to pay interst on a loan. Interst coverage ratio = Net income before taxes and interst/interst to pay with the loans.

    Grahm used this to evalutae how safe it was to buy bonds; (loan ing money) to a company. Grahm wants a moat of safety for flucuations not to effect repayment of bonds purchased. For some businesses he wanted a ratio greator or equal to 3.

    At the beginning of a mortgage it is almost all interst. But in your suggestion you use rent revenue instead of profit or net income.

    The ratio is part of a bunch of "accounting ratios" that are used to analyse the financial statements, once the accounting is done.

    Prerequisit knowledges are basics of double entry bookkeeping.


    Text from two accounting books:



  2. If you have not please consider dabbling in accounting basics or dobuld entry bookkeeping.

    Since, you teach MBA students, you can easily visit accounting professors and ask them the best way to learn. And, ask them to explain debit and credit clearly and quickly. It is the learning curve hump of accounting.

    You could even take a class for free.

    1. I understand your point. However, the main point of this short post is not about accounting measures themselves, but about the effect of different regulatory constraints on new lending during an asset price cycle.

  3. Your suggestion of a regulatory constraint is a good one. And, the measure to base it on is both simple and easy to measure.

    The banks and the borrowers should have been doing some thing like that them sleves but did not as a group.