Investing in Real Estate
Australians love property - about 70% of us live in a home we
are either buying or have paid off completely. This is one of the highest owner
occupancy rates in the world.
Australians know the value of owning property, yet fewer than
10% of us have invested in a residential property to provide income or future
capital gains. Does that seem strange to you? After all, some 40% of the adult
population invest in shares, with varying results. So what's stopping people
from investing in property? We think it has something do with feeling
comfortable.
People sometimes feel they do not know enough to ask sensible
questions of the "experts". That's why we have put together this Guide to
Investing in Residential Property.
Why Invest In Residential Property?
Residential property has consistently proven to be one of
the best ways of building wealth over the years. For example, in
Sydney the median price of houses more than doubled in the ten years to 1996.
This long term growth in the value of residential property in
most major cities in Australia has occurred even though some years showed a
decline in price. And in recession times it is less severely affected than most
other forms of investment.
While all investments have some element of risk, history and
the track record of successful investors show that residential real estate is
an essential part of any balanced investment portfolio.
There are two main reasons why it is so successful. First, there is a continued
demand for good rental housing as around 30% of Australians rent their homes.
Second, banks and other lenders are so convinced of the long term value of
residential property that they lend up to 95% of its value.
In the case of owner occupiers they often offer 100% on investment, providing
equity in your own home.
That means that if you borrow effectively, you can "leverage"
your money and have a bigger investment to work with.
This mix of security, predictability and growth is why residential property is
considered such a good investment.
What Should You Expect From Your Investment?
If you are thinking about investing in residential property,
perhaps the first question to ask yourself is .Why am I doing this? You might
find that you come up with one or all of these reasons when you ask the
question.
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You want long term capital growth for your investment
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You want to use the equity in your home to start a property portfolio.
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You want a reliable income - for now or as an extra superannuation; or
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You want to make a good investment that helps reduce your taxes
Once you have answered the question, you will be better able to
consult your financial adviser or accountant. This will help ensure that your
reasons fit in with your overall situation and are in your best financial
interests.
If you have a clear idea in your mind of why you are investing in residential
property other than your own home, you will be better able to decide on such
vital issues as the type and location of property to buy, how to finance it and
how to manage it over the years.
What Should Your Investment Expect From You?
A rental property represents a significant investment, and it brings
responsibilities as well as benefits.
To make the most of your investment, you will need to look after it. That means
maintaining the property - keeping it in good condition at all times. This will
allow you to get the best possible rental return, while preserving the long
term value of the property.
And remember, maintenance is a tax deduction, so you get tax relief while doing
the right thing for yourself and the future of your property.
Some Points to Consider When Buying an Investment Property
Buying an investment property is a serious financial decision.
To make the decisions as informed as possible, you might want to consider and
discuss with your advisers some important points. What follows is a kind of
check list which you can use at any time as a basis for discussion when you are
looking at a property.
These are some of the questions a smart investor will ask before buying - and
answer. Your EAC agent, Accountant and your Solicitor can all help you make
your decision more informed and appropriate for you and your future.
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Is it the kind of property I feel comfortable with?
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Is the location good
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Is it close to services like transport, shops, schools?
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Is there a high level of traffic
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How is the parking?
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Is the area noisy?
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Is the price within the range I am interested in?
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What rental returns are normal in this area?
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How will I structure the financing for it?
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Furnished or unfurnished?
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What's the vacancy record in the area?
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What will be the effect of the property being vacant for a while?
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Can I insure for periods of vacancy?
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What condition is it in? A building survey and pest inspection will set your
mind at rest before you buy
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What maintenance will it need now or in the future?
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If I decide to do some renovations, are they going to add real value?
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Or would they over capitalise the property and so reduce my returns?
Tax and Investment Properties
The Good News
Most people who are thinking of investing in rental property have heard of
"Negative Gearing" and how good it is for tax effective investment. And it's
all true - the example below shows how it works.
There is other good news on the tax front when you buy a
residential property to earn income. For instance, there is" depreciation"
which works in your favour by allowing you to "write off" as an expense a
percentage of the value of the property each year against taxes, even though
you did not pay out any cash for it. For some investments, depreciation can
make the difference between a marginal investment and a profitable one. On most
property built after 1985, the rate is 2 ½ % or $5,000 a year depreciation on a
$200,000 unit. Properties built before 1985 are not usually eligible for
depreciation.
Negative Gearing
If you finance the property by borrowing a large portion of the total purchase
cost, and if you are in a higher tax bracket, you may be able to save on the
taxes you pay each year. Negative gearing happens when the net rental income
for the year, after deducting other expenses, is less than the interest on
borrowings. Here's how it can work.
Rental income from tenants $12,000
Less: Expenses, including depreciation and interest $17,000
Difference is available for offset against other income - $5,000
Tax Saving if you are on a marginal rate of 48.25% $ 2,412.50
At the same time, negative gearing is not for everyone. As it reduces cash
flow, it depends for its success on a combination of long term capital
appreciation and regular tax advantages. And it is best for people who are
comfortable with borrowing.
The Bad News
If you own your own home, you know that under current laws you will not pay any
taxes even if you sell it for more than you paid for it. That's what makes the
family home the most tax effective and single best investment for most
Australians. But the Capital Gains Tax introduced in 1987 may affect any other
property bought after 1985 - if you sell it for more than the purchase price
"indeed" for inflation over the years. Further, the State Governments
introduction of the vendor "exit tax" has also affected investment property.
So there is good news and bad news on taxes. So what's new? Talk to your
accountant and see how they affect you.
Establishing the Net Return
One question every investor needs to ask is "What returns can I get on my
investment?" The answer will help you decide if the investment is suitable or
not. Will it meet your investment goals as you have agreed to them with your
financial adviser or accountant?
A reasonably simple calculation is all that is required to give you a clear
picture of what return on investment (or ROI) the property will provide.
Effectively, the net return is the net income or profit from the property
expressed as a percentage of the capital tied up in the property.
Let's take an example of a Unit that costs $160,000, including all fees and
taxes on purchase. We'll assume that the rental for the first year is expected
to be $10,000.This gives a gross return - or Initial Yield as it is called - of
6.25% ($10,000 / 160,000 x 100 = 6.25%). But a more important figure for most
investors is the Net Return.
The basic calculation for this is first to deduct all expenses from the net
income expressed as a percentage of capital employed gives a net rate of ROI.
So if we have expenses of $4,000 the net ROI will be 3.75% ($6,000 / 160,000 x
100). However, for accounting and tax purposes, "expenses" include depreciation
- which doesn't come out of your pocket, although it can help reduce your
taxes. This is just one more reason to make sure you consult your accountant or
adviser about how your finances will be affected at all stages of this
important investment process.
Capital Growth
According to many investment analysts and commentators, the long term growth in
the value of residential property has been better than shares, commercial
property, or bonds, cash or fixed term investments.
Residential property is also much less volatile than the stock market. That
makes it easier to live with for many people. And it is much easier for the
ordinary person to understand. So you can quickly become comfortable with
making your own decisions and looking after your own investment.
The key to investing in residential property is do it for the long term. Some
advisers suggest a minimum of seven to ten years. Others suggest a range of 14
to 21 years to gain the maximum advantage of the long term cycle. All agree
that property is not a get rich quick investment. It repays patience, and it
rewards good preparation and careful management.
What kind of capital growth? That depends on a variety of factors. Some areas
will be better than others. Some types of properties are more in demand which
is bought for a sensible price with intelligent financing is likely to produce
a substantial capital growth over the long term.
There is also the different expectations people have of what capital growth
really is. Say, for example (this is over simplifying it to make the point) you
sell a $200,000 unit for $300,000 ten years later. That's a 50% profit on the
capital. But if you had borrowed 90% of the money, you had only $20,000 of your
own money invested. So you have a 500% profit on your investment!
This example ignores such important matters as inflation and expenses, but it
shows that capital growth entails more than just buying and selling. It also
reinforces the need to have a clear ideal in your own mind as to what you want
from your investment before you make any buying decision. That way you are more
likely to be happy when you get there.
How to Finance an Investment Property
Types of loan available for property investment
Some people do not like to borrow, even if it makes economic sense to do so.
That's a valid choice for them.
But if you want to make the most of your investment in residential property,
most advisers will suggest that you borrow some or all of the purchase cost.
They call it leverage. Borrowing is like using a lever to lift a heavy boulder,
you can't do it using just your own strength, but with the right kind of level
you can. The example below shows the difference that can make to the returns on
your own available cash.
Using other people's money (the banks') you can leverage your own investment
capital and have their money working for you too. That's how most wealthy
people got that way.
If you decide to take out a mortgage loan, there are two main types to choose
from: Principal & Interest Loans or Interest Only Loans. Principal &
Interest Loans are the norm for most home purchasers. You pay the whole loan
off over (say) 25 years. The regular payment includes both the current interest
and some capital repayment as well. This method reduced the "Principal" off the
loan to zero after 25 years.
Some investors in residential property also use this form of loan, often
because they feel more comfortable that they are reducing the debt over time.
This is a perfectly valid reason, and you may decide this way is best for you.
However, there are financial benefits to taking out an Interest Only Loan when
you are buying for investment. For example, if you pay part of the Principal,
that amount is not tax deducible. Instead, it has to be paid out of after tax
dollars from other activities. Also, you could use this extra money as interest
on a loan to buy another property - start your own property portfolio.
Finally, there is also the option of borrowing against the equity you have
built up in your own home. Have you thought about using some of that as a basis
for building your long term wealth?
It's your choice. However, if you choose to finance a major long term
investment like a residential property, borrowing is likely to be part of it.
Selecting Your Property
Where do you start? Probably where you are. Most successful
property investors buy in areas they know, close to where they live.
Many advisers suggest that the best way to start is by looking at houses or
units that are:
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well built
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median priced properties
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in a good location
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in a major city that has
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good long term employment and growth prospects
Of course, you must buy it at a reasonable price - one that
fits your investment goals and cash projections. For example, if you buy at the
top of the market in a fashionable area where panic buying has driven up the
prices, it may take a lot longer to show a positive return.
That's why we suggest that you consider the lower end of the market rather than
the top end. They are usually easier to rent, easier to finance and easier to
sell.
Ask your local EAC agent to show you some properties - they know the area, and
they understand the need to find the right kind of property to fit your needs.
What Can I Afford?
You must feel comfortable with any property you buy. A unit? A townhouse? A
villa? A terrace house? All have their special advantages and disadvantages.
Is there a body corporate which puts restrictions on tenancies, for example? Or
will the windows of the cottage have to be painted more often because it's
close to the sea?
Work out with your advisers what the best mix is for you to meet your goals
over the years and to be comfortable in the meantime with your investment.
Making an Offer
Now you have found the right property, it's time to make an offer to buy it.
But first, make sure you have done all the necessary preparations, such as
arranging finance and deciding on your plan of action in discussion with your
investment and financial advisers.
Making an offer on an investment property is exactly the same as you own home.
However, just to remind you of the details involved, we suggest you take a look
at our EAC Guide to Buying. This gives a complete picture of the process of
acquiring a property in New South Wales.
For now, it is probably enough to remember a few important items. One is that
dealing with an agent can give you more flexibility in making an offer than
dealing directly with a vendor. Another is to make sure you know exactly what
the price actually includes.
The Legal Details
Valuation, exchange of contracts, settlement etc.
The Guide mentioned previously also sets out in some detail the legal aspects
of buying a property - from offer and acceptance to completion of the purchase.
It covers such issues as the deposit, how a lender will often insist on a
valuation of the property before lending, and how the contract procedure is
carried out from making the offer through exchange of contracts and final
settlement.
In general, these are standard and straight forward activities. At the same
time, you would be well advised to make yourself comfortable with the details
of the process, so you can ask searching questions of your advisers and other
parties.
We also suggest that you read some of the excellent books now available on
investing in real estate in Australia. After all, it's your money - and the
more you know about what you are doing with it, the better your decisions will
be.
In the meantime - we wish you every success and satisfaction in investing in
residential property.
Managing Your Investment Property
Once you have bought your investment property, you will want to manage it to
maximize your return and protect the value of your asset for the future.
Looking after a property takes time and expertise if it is to be done properly.
That's why we suggest you consider engaging an EAC agent to manage your
investment property. Our agents are experienced in all the many facets of
property management, from finding the right tenants to keeping you informed of
all relevant details.
Consider what can be involved:-
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Choosing and dealing with tenants regularly
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Drawing up and interpreting leases
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Collecting rent and bond money
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Inspecting and maintaining your property
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Advising you of any problems and
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Ensuring the best possible return on your investment
That's why so many successful investors rely on EACagents to
manage their residential rental properties.
We invite you to join them.
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