Financial Review Smart Investor, Nov 1 2008
By Karin Derkley

It may not be as easy to make money from property as it used to be when prospects were brighter. But, as Karin Derkley reports, savvy investors can still find good deals in a softer market if they know where to look.

The South-East Queensland market was as flat as a tack in 1998 when Brenda and Leslie Irwin started looking at investing. “The market had been devoid of capital growth for years and had dropped to rock-bottom prices,” Brenda says. To the Irwins, pictured right, that meant opportunity.

“There was nothing wrong with the properties, it was just that no one was buying them,” Brenda says. Doing their spreadsheet calculations, the Irwins figured their property investment would not only deliver good rental yield, but as long as they were patient, strong capital growth further down the track.

In fact, as the Brisbane market gathered strength by the early years of this decade, the capital growth came quicker and stronger than they had anticipated. Over the next 10 years they bought and sold 27 properties, piggybacking off the capital growth in each one to buy yet more real estate.

Today they have managed to retire on the proceeds of those investments, whittling their holdings down to the “best of the four investment properties”, Brenda says, as well as the family home and a beach-house – both paid off.

When the real estate market is off the boil, as it is in many parts of Australia, rather than worrying whether it’s a good time to buy, it’s worth following the example of the Irwins and calmly considering the numbers on how to make your next property investment stack up.

How much should you pay initially? How can you contain costs? And how can you make sure you buy a property that will be easy to rent out and sell later for a solid profit? These are the kinds of questions you should be asking before leaping into real estate.

After all, like any investment, property is a numbers game – and the people who win out in the long run are those who do their sums at the outset.

To help you decide whether the numbers stack up, we’ve pulled apart the three main aspects of property investment: negotiating the best deal, containing your ongoing costs and maximising earnings on your investment.

Do the best deal

It’s said that you make money when you buy a property, not when you sell it. Minimise your costs at the beginning and you’ll have a bigger share of profits further down the line.

Monique Wakelin, director at Wakelin Property Advisory, says it’s not necessarily about buying property at fire-sale prices but about paying no more for real estate than it’s worth.

To pay the right price, do your research on a property’s value in relation to similar properties nearby, and be prepared to walk away if the price rises beyond the level that you know it’s worth.

Jacque Parker, a property investor and director of House Search Australia, says it’s easier to negotiate if you know the seller’s motivation and how long the property has been on the market.

Avoid property that requires structural work or “invisible” improvements such as rewiring or replumbing, she says. The ideal properties require only cosmetic makeover work.

Parker’s rule of thumb is that it should take only four years of increased rent to recoup the price of any improvements.

In other words, if you spend $8000, those improvements must let you add about $40 a week to the original rent.

What about other initial transaction costs? There’s not much you can do about stamp duty, and Wakelin says it’s unwise to skimp on building inspection fees and legal and conveyancing fees.

“That’s your due diligence on what is a very significant investment,” she says.

But costs associated with establishing a mortgage can vary widely. Some loans come free of establishment fees – although the head of research at InfoChoice, Steven Anderson, warns that this may be at the cost of a deferred establishment fee if you decide to wind up the loan early.

If you’re an existing customer, your lender may be happy to waive establishment fees, he says. “Be upfront and say, ‘I want to borrow another few hundred thousand, what can you do for me?’,” he stresses.

One big cost you should be able to avoid is lenders mortgage insurance, which covers the lender, rather than you, for the risk that you’ll default on the loan. This insurance is charged on loans with a loan-to-value ratio of more than 80 per cent.

If you have equity in your family home, you should be able to borrow the 20 per cent deposit against that, saving you thousands of dollars in LMI.

Remember that any of these initial costs, including loan-establishment fees and any improvements you make to the property, can be added to the cost base of your property, which will reduce your capital gains tax bill when it comes time for you to sell.

Minimise ongoing costs

The costs of holding a property can be substantial. They include borrowing costs, expenses incurred in renting out the property, and anything you fork out for maintenance and repairs.

Given that you’re likely to hold a property for several years, reducing these ongoing costs by even a few hundred dollars a year can add up to a significant sum over the life of the investment.

Borrowing costs are your biggest expense, and it certainly pays to shop around for the best possible deal.

Stuart Wemyss, a mortgage broker and the author of Smart Borrower’s Handbook, says even half a percentage point can make a big difference to your eventual interest bill. On a $400,000 mortgage with an interest rate of 8.25 per cent, for instance, you’ll pay a total of $681,824 in interest alone over 30 years. A rate of 8.75 per cent boosts the interest bill to $732,849.

That’s $51,025 less in your pocket.

As with establishment fees, it’s possible to shop around for a better interest rate, especially if you already have a home loan. Generally, the fewer the features, the lower the interest rate. The rate on a no-frills loan is often half a percentage point below the standard variable rate. (See page 115 for the best deals on the market.)

Account-keeping fees are another ongoing cost Anderson says you can negotiate. These can be as much as $300 a year, adding up to several thousand dollars over time. However, Wemyss says you may be better off paying account fees if that means a lower interest rate.

Property management fees range from 6 per cent to 9 per cent of the gross income from the property (so, if you rent the property out at $400 a week the manager gets $1248 to $1872 a year). But cutting back too hard on those costs can be counterproductive, Wakelin says. “If you negotiate too hard they may not give you the service you require.”

One option is to manage the property yourself. Parker says self-management works best when the property is nearby, when you’re able to maintain a business-like relationship with the tenant and as long as you comply with tenancy laws.

Council and water rates can’t be avoided; repairs and maintenance shouldn’t be. A neglected problem is only likely to become bigger and more expensive to repair. What’s more, it will annoy your tenants and the cost of finding new tenants and having your property sit empty could be far greater than the cost of undertaking the work.

Consider, also, the impact of strata title costs, which can add up over a year.

Another cost that shouldn’t be avoided is landlord’s insurance. This covers you for damage to the building and for lost rental income in the event your property lies vacant for an extended period (usually no more than one year).

All these ongoing costs, as well as depreciation on fittings and fixtures like stoves, carpets and lights, can be offset against tax payable. Then there’s the magic of negative gearing, which softens the out-of-pocket difference between what you pay out each year to hold the property and the income from rent.

However, be aware that the effect of negative gearing is greatest when you’re in a higher tax bracket.

Take a property worth $450,000 that you rent out at $450 a week. If you have a $400,000 loan at 8.5 per cent and are paying 8 per cent in property-management fees, you’ll have a shortfall of about $16,000 a year before tax. On the highest marginal tax rate, you’ll get a tax credit of $7567, taking those out-of-pocket expenses down to $8706 in the first year. If you’re in the middle bracket, the tax credit will bring your out-of-pocket expenses down to only $11,147.

But as Wemyss points out, that difference is neutralised when you come to sell, and have to pay capital gains tax. If you’re on the top tax rate, you’ll pay more CGT than someone on the middle tax rate. And he says in the end, you should never invest in any asset purely because of the tax savings. “If it’s a good-quality investment asset, you should buy it regardless of the potential tax benefits,” he says. “You must look at it as a whole – including capital growth, holding costs and exit costs.”

Maximise your income

Don’t expect rental income to cover the ongoing costs of holding a property, at least in the early years. A positively geared property, where you earn more from the rent than you pay out in holding costs, is a rare creature – unless of course you have a huge cash deposit and, as a result, plenty of equity in the property.

Just compare mortgage rates, at about 8.75 per cent, with the yield on an average Sydney property of about 3 per cent. That’s a shortfall of more than 5 percentage points a year before you take into account other holding costs.

Negative gearing can help soften the blow, but you should also make sure you maximise your rental income with the right combination of property and location. As House Search Australia’s Parker says, it’s all about demand and supply.

“In an area with a low vacancy rate [such as Sydney’s inner suburbs], tenant demand is naturally going to push rents up,” she says

A two-bedroom unit in Sydney, for instance, might command $380 a week in rent. The same unit in Adelaide will bring in only $230 a week. A property that’s close to workplaces, schools and universities, as well as parks and good public transport, is always going to be in higher demand than one that is cut off from everything.

Wakelin says it’s always worthwhile checking out how much comparable properties in the area are being advertised for. “Even if you’ve had a tenant in your property, don’t assume you’ll get the same rate when you re-lease it,” she says. (For a guide to what you should be charging, see the median rents table on page 46.)

To get the going rate, you’ll need to ensure your property provides accommodation and facilities to the standard of comparable properties close by.

That doesn’t mean putting in granite benchtops. What you want is a liveable, fresh package. Storage, even wardrobes, is essential, as is a revamped kitchen and bathroom.

A fresh coat of paint will add appeal.

If you want to boost the rent by a few dollars, Parker says the most sought-after features are off-street parking, an extra bedroom or study, access to public transport, north-facing, sunny yards or courtyards and updated kitchens and bathrooms.

Tenants will also pay a bit more if they are allowed to keep pets, she says.

Avoid money pits

Finally, the best way to ensure consistent income over the years is to treat your tenants well. The most profitable investment properties are those occupied by tenants who look after your property as you would, and who keep renewing their leases year after year. Properties left vacant – or worse, damaged – by disaffected tenants are the biggest money pits.

As Wakelin says, if you’re a property investor, you’re in the people business, not just the property business.

Should you go interest-only?

You can cut borrowing costs by opting for an interest-only loan, allowing you to pay only interest and saving several thousand dollars a year in repayments.

But it means you never reduce the loan; when you sell, you’ll have to pay back the entire amount from the sale proceeds.

Andrew Gardiner, spokesman for the National Tax & Accountants’ Association, says that over 10 years, principal and interest loans win out over interest-only because you pay down the principal.

Here’s how the out-of-pocket costs compare after 10 years, including the outstanding principal, assuming a 30-year loan of $400,000, at 8.5 per cent, on a $450,000 property. Calculations take into account the tax deductions received.

Out-of-pocket costs on 31.5 per cent marginal tax rate (MTR):
Interest-only loan – $632,900
Principal-and-interest loan – $621,590
So interest-only costs $11,310 more
Out-of-pockets costs on 38.5 per cent MTR
Interest-only loan – $609,100
Principal-and-interest loan – $598,946
So interest-only costs $10,154 more
Out-of-pocket costs on 46.5 per cent MTR
Interest-only loan – $581,900
Principal-and-interest loan – $573,067
So interest-only costs $8833 more

But remember this additional cost is offset by having the benefit of money in your hands now. Mortgage broker and author Stuart Wemyss says that if you also have a home loan you should apply any extra money to reducing that non-deductible debt. Otherwise, make extra interest-only repayments, giving you lower repayments and a redraw facility.

*Tax rates are for 2010 income year, including Medicare levy. Figures ignore rent, which would not change relative results. Source: NTAA


As an accountant by profession, property investor David Allen, 22, was probably never going to go into any investment without having done the numbers first.

He says number crunching is an essential part of all property investing.

“You’ve got to be realistic and take into account all the upfront and the holding costs,” he says. “You can’t go into it just hoping that the market will go up.”

That’s probably a sensible approach in the Sydney property market right now.

Although David did factor in capital gain to his calculations before buying his one-bedroom apartment with study in Sydney’s Rockdale, a suburb within the magic 15 to 20 minutes travelling time to the CBD, his analysis included a modest growth rate of 6.5 per cent a year.

“In fact, it needs to go up only 3.5 per cent a year to break even by offsetting the negative gearing costs each week,” he says.

Given the current market conditions, what David found more important in making the numbers stack up was the depreciation schedule.

“I worked out that because of depreciation, I could afford to buy a new property for $350,000, whereas I could only spend $280,000 on an older apartment,” he says.

With the higher price, he figures his capital gain will also be higher.

He bought the apartment at a discount from a builder in financial distress, which reduced his overall upfront costs. He also decided he was better off taking a loan with an annual, tax-deductible account-keeping fee in exchange for no establishment costs and a lower interest rate.

David is renting the property out for $380 a week, giving him a comfortable 5.8 per cent yield which, after property management fees, borrowing costs and other holding expenses leaves him $150 out of pocket a week. “It’s pretty easy to find that amount,” he says.

David plans to hold on to the property for at least six to seven years ? or longer if it doesn’t show the expected capital gain in that period.

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