It’s possible to manage a rental property yourself, and in so doing save a management fee that’s usually around 5 per cent of the rent. But it can be time-consuming and it’s hard to remain emotionally detached when you have tenants ringing up complaining about every little thing, or you personally have to deal with damage to your property. I don’t suppose you’d like to be woken up in the middle of the night to hear that your tenant’s heating system has died, and that they want you to take care of it right away.
The other option is to use the services of a professional property manager. They’ll have up-to-date information on what’s happening in the market and what tenants are prepared to pay. They’ll have prospective tenants on their books, and experience vetting tenants. Because they manage many properties, they’ll have access to reputable trades people at cheaper service fees. And their fees are tax deductible.
Managing your financial risk as a property investor also involves insuring yourself against a myriad of potential hazards.
It’s up to your tenants to take out home contents insurance to cover their possessions, but you’ll need building insurance. Then there’s ‘landlord’ insurance, covering risks such as malicious or accidental damage to your property by a tenant, any legal liability should a tenant injure themselves, and lost rental income should tenants move out without paying.
Be prudent about renovations. The colour palette of the kitchen in your investment unit may offend your sensibilities, but it only makes financial sense to replace it if a better kitchen will stop the unit sitting vacant or lift the rent you can charge. Make a ‘cost-benefit analysis’ of your renovations. If the kitchen is going to cost $10,000, and you’ll have to borrow the money and pay interest, but it will only add $10 a week to the rent, it’s probably better left alone. Don’t ‘overcapitalise’ by spending too much on design, finishes, and fittings.
Whilst we are the first to advocate going to as many inspections as possible to understand how a floorplan appears in real life, and to be able to do a real comparison, we feel very strongly that time spent reading books or on the internet is far more worthwhile than that spent in the car.
We are all busy people, and if you are anything like us, you value your weekends and would like to spend it with family and friends.
Inspections are a MUST, but be selective, and only view properties that meet the profile of what you are looking for – ticking all the boxes relating to location, size, quality and price.
Generally speaking, we feel there are four distinct parts to researching property.
Most people look to invest close to home. Most likely this is because it is something they are comfortable with. They know the suburbs, it’s easy to inspect and easy to manage. All very good reasons, but sometimes a neighbouring town, or something in another city represents a much better opportunity.
The very first thing that we recommend you do is choose the State, City and Suburb(s) you might invest in. You’ll want to benefit from as much capital growth as possible, so the first rule is to buy in a growth area. That might be a suburb located within 10 kilometres of the city centre, or a suburb with special attractions such as a beach or trendy café strip. Proximity to a ‘hot’ suburb could mean your suburb will be next to rise in value. It could even be a regional town supporting a booming industry.
Narrow your search down even further by looking at a property’s access to transport, shops and leisure facilities and its appeal to your market – whether they’re young professionals or blue-collar workers.
Once you know the suburb(s) that you might be interested in, the next thing is to work out which are the best streets in the suburb, and this is where talking to real estate agents, and consulting historical data online is key. You must know the saying about choosing the worst house in the best street – this never dates, and is ALWAYS relevant. The top 5 streets in every suburb will almost always outperform the rest of the suburb. This is perhaps even more important than the choice of suburb itself, and most suburbs have good, and bad qualities. Providing you choose one in a growth area that has good access to public transport, a range of schools, and convenient for people commuting to work then the suburb is likely to be suitable.
Find the streets within that suburb with the best views, close to parks, containing the premium houses in the area and possibly even able to be developed (contact the local council to see if land can be rezoned), and you are onto a winner!
Next you need to decide how much you can afford to borrow, without putting yourself at risk should interest rates rise, or your property remain untenanted for a period.
There are many online calculators (some available on this website) that will help you determine what you can afford. Keep this price in mind when you do your research. Keeping in mind what was said above, you will often find that your best investment will be for a smaller place on the best street, than a larger place on a worse street. A 1 bedroom apartment in the right location will often outperform a large 4 bedroom house on the wrong street, or in the wrong suburb. At first this might not be apparent as the rent received for the house might be equal to, or slightly exceed the smaller place. But give it time, throw compounding capital growth into the equation, along with a dwindling supply of premium land and see the difference that location makes.
So you now may have an idea of where to look, and what you can afford. Now onto the details
3) Desktop analysis
Having worked through the financial considerations, and bearing in mind that you’re not actually going to live in the property, you should be able to make a fairly rational decision about where and what to buy.
There are a lot of tools online that can be used to inspect property that you may be interested in. There are mapping tools which allow you to zoom in on each property on a street to view the shape of the land, the neighbours, easements (electrical, sewerage), slope, land value etc. Make use of these, and skip right over any advertised properties that for some reason don’t make the grade.
When looking at houses it can be useful to look for opportunities to manufacture equity at a future date. This can be by subdividing, or redeveloping land, or opportunities to extend and add extra rooms.
With apartments, what can be useful is to find locations that cannot be built out. It’s no good buying into a place that has a fantastic view, if a few years down the line a new, taller building blocks that view. Similarly, you want some level of uniqueness. Find a block of apartments that is well located, but doesn’t have to compete for tenants with loads of other apartment blocks right next door.
There are so many ways to use your computer and the internet to do your research. Many of the Links on this site are for listings which show photos, floorplans and inspection reports for a property. Make good use of these.
So you have shortlisted a few places on the best streets of a suburb you are interested in. Now you need to inspect them. You need to remember that it is not you that will live there. Take all emotion out of the decision. Find something that will appeal to a large number of potential tenants and will not cost a lot to maintain.
Properties with a view are always more desirable than those without. Tenants like facilities such as balconies, internal laundries, undercover parking and security. These sorts of facilities may not be available in an older property, which may have to compete with a new apartment building down the road with all the mod-cons. But, if the property is well located and offers other things that a tenant would want then it could still be a great buy – especially if it is likely to benefit from a higher capital growth.
If the property you’re interested in is already rented, ask about its history of tenancy. Have there been periods when it hasn’t been occupied? If so, find out why. You don’t want to inherit those problems.
Try and ignore the small things though. Should you decide to buy a property, you can always paint the walls, change carpets and light fittings at little cost.
The bottom line: balance what you can afford to buy with the rent you’ll be able to charge. There’s no point buying a waterfront property if you can’t find tenants happy to pay the sort of rent you’ll need to make the exercise worthwhile.
Capital growth is the increase in the value of your property over time and is one of the main reasons people invest in residential real estate. The nature of the property cycle means real estate should probably be thought of as an investment with a 10-year horizon.
Take the experience in recent years. In 2003, Australian house prices were rising at a rate of about 20 per cent, but since then prices have come to a virtual standstill in many areas and have gone backwards fast in some of the hot spots. Your best chance of achieving capital growth is buying the right property, in the right place, and – most importantly – at the right price.
Research current house prices. Keep an eye on sale and auction results in the papers, or buy reports on specific suburbs from researchers like Australian Property Monitors’ Home Price Guide. Talk to real estate agents and observe at auctions.
Rental income and yield, You should apply the same standards to property investment as to any other investment, ‘benchmarking’ the potential return against what you might achieve elsewhere.
An important measure is a property’s yield. That can be calculated by dividing the annual rent it generates by the price you paid for the property and multiplying that by 100 to get a percentage figure. Let’s say you bought a unit for $400,000 and rented it out for $350 a week (or $18,200 a year). That’s a yield of 4.5 per cent. That might compare with a dividend yield of, say, 7 per cent had you invested in a particular company’s stock.
But let’s say you bought a worker’s cottage in a mining town where prices are low but the rental income as good as in the big city. Pay $350,000 and rent the property out for $600 a week and you’ll achieve a yield of 9 per cent. Remember, yields fall as house prices rise (if rent doesn’t rise commensurably). Keep an eye on vacancy rates – the proportion of properties sitting empty out of the total rental supply.If landlords have to fight for tenants, they won’t have much ‘pricing power’ with regard to rent. However, if the rental market is tight, and tenants are competing for properties, they’ll be prepared to pay a bit more to get in the door.
A vacancy rate above 3 per cent is a warning sign, and it may pay to be wary of areas where there’s going to be a big increase in the supply of apartments.
In any case, build into your calculations of your likely return periods when you’ll be in between tenants. TaxNegative gearing Gearing basically means borrowing to invest. Negative gearing is when the costs of investing are higher than the return you
achieve. With an investment property, that’s when the annual net rental income is less than the loan interest plus the deductible expenses associated with maintaining the property (such as property management fees and repairs). When you’re negatively geared you can deduct the costs of owning your investment property from your overall income – reducing your tax bill. High-income earners benefit the most, because they’re in the top tax bracket. In addition, while you record a loss on the income from the property, in theory capital gains in the value of your property should make the investment worthwhile. But don’t over-commit to property just to get a tax deduction. Those tax benefits generally don’t come until the end of the financial year and you have to make your mortgage payments in the meantime. That said, you can apply to have less tax deducted from your pay to take into account the impact on your overall income of
expected losses on an investment property.
Say you earn $45,000 a year, gross, in your day job but you can reliably estimate that you’ll make a $15,000 loss on an investment property. You can apply to have your tax payments calculated on an income of $30,000 rather than $45,000 – giving you more cash in hand now, rather than a refund at the end of the year. Get your sums wrong, though, and you’ll owe the tax man money at the end of the year.
See www.ato.gov.au for information about pay-as-you-go (PAYG) withholding payments.
Remember, too, that a capital gain – which will be taxed – is never assured. What’s more, the benefits of negative gearing are smaller when interest rates and inflation are low and can be offset by charges such as the land tax levied in NSW
The owners of investment properties can also claim depreciation of items such as stoves, refrigerators and furniture. That involves writing off the cost of the item over a set number of years – the ‘effective life’ of the asset. The ATO sets out what it considers to be appropriate periods. The cost of a cooktop, for instance, is generally written off over 12
years – you claim one-twelfth of its cost as an expense each year.
There are two different types of depreciation – an allowance for assets such as the cooktop, and an allowance for capital works, such as the cost of construction.
It’s a good idea to talk to a quantity surveyor or other depreciation specialist right from the start, so you make full and correct use of the available depreciation allowances.
The higher the depreciation bill, the higher the amount to offset against income when you’re negative gearing.
Capital gains tax
Capital gains tax (CGT) is the tax charged on capital gains that arise from the disposal of an asset – including investment property, but not your place of residence – acquired after September 19, 1985.
You’re liable for CGT if your capital gains exceed your capital losses in an income year. (If you’re smart, you’ll time asset disposals so that if you really must take a capital loss it’ll be at a time when it can offset a capital gain). The capital gain on an investment property acquired on or after October 1, 1999, and held for at least a year, is taxed at only
half the rate otherwise. This means a maximum rate of 24.25 per cent if you’re in the highest tax bracket. The capital gain is the profit you’ve made over and above the ‘cost base’ – the purchase price plus capital expenses such as subsequent renovations. Make sure you keep good records of these sorts of expenses.
Capital gains tax is a complex area, so it pays to get specific advice about how it applies in your individual circumstances.
Making your investment pay
If you hold your investment property for long enough, hopefully you’ll reach the stage where losses start turning into gains. The rent you’re charging should have risen over time, and you’ll be steadily whittling away at the mortgage. Once your rental income exceeds your mortgage repayments you’ll no longer be negatively geared, however. And no negative gearing means no tax advantages – but that doesn’t mean you should rush to sell. Yes, you’ll have to pay more tax because the income you’re making is more than your losses – but the fact is you’re making money, which is why you invested in the first place.
The temptation may be to take your profits and plough them into another property – and that can be a perfectly reasonable strategy – but don’t lose track of the costs involved in selling. Stamp duty alone is a big disincentive.
Cashflow vs Capital Growth
When discussing property investment there are two somewhat conflicting philosophies of property investment. Some suggest you should invest in property for high rental return while others feel you should invest for capital growth (the increase in value of the property.) We would all like to buy properties that have both great capital growth and a high rental yield. But if you buy good property, that’s just not the way it works. In general in regional centres and many secondary locations investors can achieve a higher rental returns but get poor long term capital growth. However in the major capital cities of Australia strong capital growth usually goes with a lower rental yield (the income earned over a year represented as a percentage of the value of the property.) From the above definition alone one can see why this inverse relationship exists.
As the value of a property increases, then it follows that its rental return decreases. This is of course unless the rent increases by the same proportion, which does not normally happen. Rents eventually go up but these increases lag capital increases by a number of years. (This is clearly evident in Melbourne Sydney and Brisbane at present.)
So the situation during any extended period of high capital growth as happens during property booms is that rental returns fall. This is just the way the property market works.
And now in the slower phases of the property cycle as we are experiencing on the east coast of Australia, when interest rates are rising and affordability of properties are decreasing, more potential home owners are turning to renting properties. This is the stage of the property cycle that rental growth starts to catch up, as is clearly happening in all our capital cities at present.
I understand why investors would prefer a higher yield. They feel they need the higher rental returns to pay their mortgage. They also believe they cannot buy many properties because they can’t afford to service additional loans.I guess that is why many beginning investors make the mistake of viewing their property investments as income driven.
Yet I still believe that is strong capital growth that will be the key to a successful property investment. Even though the first year or two of holding an investment property can be challenging, remember that capital growth builds your equity much faster than loan re-payments and rental income will.
So I suggest you seek a balance between growth and income and view your investment as medium to long-term and be prepared to ride out the cycles. The rental income needs to be high enough to help with your holding costs such as loan repayments,
insurance and rates. But it should not be the main reason for investing, unless you are retired and are just looking for income to maintain your lifestyle.
If you have any doubt about the importance of capital growth, the calculations in the table below may change your mind, Imagine you bought a property worth $400,000 in a poor growth area delivering 5% capital growth and 10% gross rental return;
in 20 years your property will be worth just over half a million dollars.
On the other hand, if you had purchased a property for $400,000 in a high capital growth area showing 10% per annum capital growth and only 5% rental return the property this property will be worth $2,691,000 at the end of the same period.
That is a massive difference in the final value of your investment property.
In the meantime the rentals on your property would have grown substantially in line with its capital growth and they would catch up to the rentals you would achieve on the first (high return) property.
The real bonus for the investor who bought the high growth property is that he will be able to access the extra equity in this property and borrow against it to buy further properties.
It is very hard to do this with properties that have high rental return but poor capital growth. It is very difficult
to save that deposit to buy your next property?
Let’s look at a real example of David who bought an investment property in a regional town in NSW a few years ago.
When he bought the property for $90,000 it returned $135 per week rental. David was thrilled with this; he has money in his pocket every week.
Over the last few years he had over $1,000 per year positive cash flow from his property. But after tax, he didn’t have much to put aside and he hasn’t been able to save for another deposit for his second property. And as interest rates have increased recently, he has been getting less positive cash flow. He understands the benefits of investment property but just can’t get sufficient money together for his next investment.
Each year David asked the local agents what his property was worth hoping it has gone up in value enough that he can borrow against the extra equity.
But unfortunately each year he gets much the same answer. “It’s gone up 2%or 3%”.
So over the last 5 years, his property has only gone up slightly in value. It had not increased in value enough for David to borrow further funds for a deposit on a second investment property.
Imagine if David had bought a property that cost him $20-$25 per week, which he could easily have afforded from his salary. If he purchased in a good area with strong capital growth, his property would have gone up on average 50-60% in value over the
last 5 years. If he had bought it in some of the stronger growth suburbs in Melbourne or Brisbane it might even have doubled in value.
David would easily have had sufficient equity to purchase another investment property as was the case for his friends who bought properties in suburban Melbourne and Brisbane. Instead he has gone through most of a property cycle, had a small amount of surplus rental income but minimal growth. He is still stuck with one investment property.
Let’s look at it another way.
How much positive cash flow could David ever hope to achieve from one investment property? $20 or $25 per week? Let’s be generous and say $30. This would give you him positive cash flow on your property of say $1,500 each year or less than $1,000 after tax.