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Chapter 14:
Selecting the best
property
Out of 1.3 million residential dwellings in Sydney around 340,000 are owned by investors. The majority of those were presumably acquired as an investment medium to generate capital growth and, or, rental income, as part of an overall strategy to enhance wealth and beyond that to secure an acceptable lifestyle in retirement.
Assuming the average value of an investment property in Sydney is half way between the current median house and unit price, then the value of all residential investment property in Sydney is around $61.2 billion. Total rent payable on these properties is estimated at $3.5 billion per annum. A huge market, involving massive amounts of capital and resources - serious money indeed.
Why is so little serious attention given to residential property investment in either the popular or financial press? Why is it so few "experts" understand the principles of successful residential property investment?
One of the main reasons is also the main advantage of residential property as an investment. Around 70% of the residential market are people owning or paying off their own homes. As investors, this is our secret ingredient. The majority of those in the market in which we invest do not act according to normal investment criteria or motivation. If times get tough the majority of those home owners do not panic and rush to sell as can happen in virtually every other medium where we invest our hard-earned funds. It is a benefit of residential investment which is absolutely unique.
It is also the reason that commentators seem to find residential investment unexciting. Other markets that can and do fluctuate by double digit percentages overnight are obviously much more newsworthy. Consequently, the main qualities to look for in a good investment property are often overlooked or glossed over with the well-worn adage of location, location, location. Clearly it is not that simple. When assessing the worthiness of any property for investment, we check no less than twenty five key points.
THE 25 KEY POINTS
Let us consider some of these points.
Design and Utility
Thirty years ago home units were specifically built for the rental market and were called flats. The flats of yesteryear are typically on the small side, of very basic design and often with open car spaces and shared laundries. Times change. These days it has been estimated around 30% of people choose medium density type accommodation as a first preference. People with busy lifestyles who do not want lawns to mow or houses to paint.
With 70% of the market being home owners, developers concluded during the eighties that perhaps it might be a good idea to design and build dwellings which met this market demand. At the same time we were all becoming a little more discriminating about our lifestyles.
Typically a home unit in the nineties is 25% larger than its predecessors, includes security systems and often features en-suite bathrooms, defined entry lobbies (remember opening the front door of an old flat to be immediately standing in the middle of the living area?), lock up garages, interesting balconies or courtyards, and intensive landscaping.
We constantly find both purchasers and tenants, given the choice, prefer to own or live in a dwelling that "feels good", generally meaning spacious and inviting. The practical use of the available space, or utility, has also become increasingly important. It is no longer possible to call a wide corridor a living area. The demands of electronic appliances for space, power and communication connections must be met. Open kitchens are preferred ... and the list goes on.
Finance
The most critical aspect of finance is making the distinction between borrowing for home ownership and for investment purposes.
When buying a home, a principal and interest loan, usually at a variable rate, which we seek to reduce as quickly as possible, is the right approach. Using this type of borrowing on an investment reduces the financial efficiency of the investment dramatically. When we use our available cash flow to reduce the principal on an investment property loan two things happen.
Firstly, the overall tax saving we enjoy and which allows us to hold property at relatively low cost starts to diminish. Secondly, the same funds we are using to reduce principal, could potentially be used to own and subsidise a second investment property, thereby increasing potential capital growth.
The golden rules of investment include two important points, protecting what we already have, and minimising risk by knowing as much as possible in advance, thereby avoiding future surprises.
In finance terms this means keeping borrowings to overall comfortable levels and locking finance into fixed term, fixed interest rate loans.
Investment property should meet criteria which ensures all financial considerations work well. This includes ensuring rents are in line with market, building allowances are applicable to the property, and future growth prospects are market average or better.
Building Allowance
Every residential property in Australia, held as an investment, which commenced construction after 17 July 1985, qualifies for a major tax deductible allowance of at least 2.5% of the original construction cost - every year for forty years. For example, a $200,000 property purchased today may have cost $100,000 to build (the balance being the land value). A building allowance of 2.5% would generate a tax deduction of $2,500 per annum. At the highest marginal tax rate this is equivalent to a tax saving, or cash back in an investors pocket of $1,210 every year.
The building allowance was introduced at the same time as Capital Gains Tax. If an investor purchases property today which is more than twelve years old, the investor pays Capital Gains Tax, when and if the property is sold, but does not receive the building allowance as a trade off benefit.
We recently discovered a property where the original construction cost actually exceeded the amount we could buy the property for. The original developer had overcapitalised. The annual allowance this generated turned an average investment into an extraordinary investment.
Value
Considerable capital gain can be achieved at point of purchase. Buying at less than market value translates into capital gain. However, saying it and doing it can be entirely different matters. No vendor sets out to sell property at a bargain price.
Bargains do appear for a variety of reasons. Forced sales through financial stress or family problems account for the major proportion of bargains.
But often a bargain is more perceived than real. We have instances where an investor has told us of a great deal they made. How they negotiated hard to achieve a less than market value purchase only to be told by the vendor of the same property what a great price they sold their property for. What is a bargain for one is often a killing to another.
One of our investment criteria in regards to value is to ensure that the price we buy or sell for is fair. To always look for a bargain is often not to buy at all, and to always maximise selling price often means remaining the owner.
If throughout your lifetime you bought and sold every property at fair value you would have little to complain about. The objective then is to be sure that the consideration paid or received represents fair market value.
The simple definition of market value is the price paid for a property when exposed to the open market for a reasonable time by an informed purchaser assuming both parties are willing but not over anxious.
Arriving at market value is the task of an expert and a qualified valuer can be engaged for the purpose.
When buying a family home the expense of a valuer is probably not warranted. If borrowings are required the lending authority will have a valuation carried out, at your expense of course, and this will act as a safety net for the inexperienced purchaser.
During the process of property inspections the buyer uses one of the most effective methods of valuation, that is comparisons. Inspecting available property on the market gives most a good feel for value.
We do not propose to outline in these pages the principle of valuation although we are well experienced to do so. We believe our clients benefit from that experience as part of the twenty five points we cover before we include any property on our recommended list.
We have one more advantage. Many vendors and developers know that we have a large list of investor clients and this represents buying power. We use it by offering to introduce purchasers to projects as long as our clients receive a discounted purchase price.
This system works for everyone. The vendor receives volume sales more quickly, often before completion, saving holding charges and interest, our clients get a "bargain" and we make lots of sales, who could ask for anything more.
Income
Buying value also means producing sufficient income to service capital and provide a net yield. Extensive research needs to be done to prove a rental value for the investment property. Systematic analysis of other rental properties of a similar nature and location needs to be completed for each property we recommend so that the total analysis represents an achievable yield and proper assessment of before and after tax returns. Within our staff, both investment and property management, we have the resources to carry out this research saving our clients time, cost and hassles.
Borrowing Capacity
Every investor has a potential to borrow. Keeping those borrowings to manageable levels that also provide maximum returns and tax benefits requires special consideration as well as extensive consultation with the client. We use our exclusive Property Optimizer computer program to initially assist our clients in assessing their borrowing capacity at prudent risk levels. A Property Optimizer application is provided in Chapter 23. You are welcome to complete it and return it to our office to have your borrowing capacity for investment purposes assessed, obligation free.
Capital Growth
It cannot be taken for granted that all property will grow in value in unison. Whilst it can be assumed that all sectors of property markets ultimately increase in value at fairly consistent rates, regard for growth potential has to be shown. We use our experience gathered over forty four years to test the growth prospects of all our recommended properties. It is not possible to foresee all the pluses and minuses but it is as well to carry out as much research as possible to expose as much as possible, in advance.
This requires extensive investigation into transport, retail, and public services available as well as major development activity in the area that may enhance or detract from value growth in the future.
Inflation
In projecting future cashflows for any property an assumption must be made of the effect of inflation on costs and expenses. Even though inflation may be low today, if we are projecting cash flows over say a ten year period, an average inflation rate for that future period has to be assessed based on a reasonable view of likely future economic events.
Interest Rates
Interest rates impact on total return. They are important although not the most important aspect of the investment decision. Remember interest is a tax deduction. Minimising interest rates at time of purchase is important. Although we are not mortgage brokers, we constantly monitor the lending market, as the amount of loan interest has a substantial bearing on the after tax result so must take an important place in our twenty five point check list.
Property Expenses
Accurately assessing the holding costs on property requires effort and experience. Carrying out calculations on the back of an envelope is not satisfactory. Guessing or approximating is not acceptable. All outgoings must be established and checked for correctness and none overlooked.
We have in an earlier chapter entitled "Establishing a Net Yield" outlined the process in assessing proper property expenses.
Depreciation on fixtures, fittings and furnishings
Not to be confused with the building depreciation allowance already included in this check list, depreciation on these items can provide excellent tax benefits, especially in the early years of the investment. Where possible, the value of the items needs to be clearly established in advance in order to provide maximum benefits and an accurate after tax cost.
Tax Credits
All allowable tax deductions at the appropriate rate of tax are applied to the investment analysis for each individual client. As part of the computer analysis process, frank discussion with individual clients is required to determine the true tax effectiveness of each investment decision.
After Tax Cashflow
Knowing how much per week an investment will cost to hold is intrinsic to appraisal of the property purchase decision. This is critical in negative gearing. Proper budgeting will prevent problems down the line.
Internal Rate of Return
The internal rate of return is the profit from all sources, earned on capital invested, including purchase costs, over time. It takes into account meeting any cash shortfalls and is the only figure that reveals the total picture and should be accurately assessed. It is a complicated calculation which makes a computer spreadsheet or specialist programme essential.
Purchase Costs
No investment analysis can be completed unless purchase costs are established. Approximate figures are not good enough. These include stamp duty, legal costs and total borrowing expenses.
Renovation Costs
Renovations carried out in certain time spans attract depreciation allowances, even though a building may not comply for depreciation because of its construction date. Any renovations since 17 July 1985 will provide depreciation benefits at rates relative to the date the renovations were commenced. Proper assessment of those costs needs to be established.
Yield
The realisation of rent provides gross income. The gross yield is calculated by expressing the income to total capital cost as a percentage. Net yield is income less all operating costs expressed as a percentage of total capital cost and is part of the assessment process.
NOT TO BE TREATED LIGHTLY
Investment in property is not to be treated lightly. Thorough research and assessment is imperative and needs to be carried out by those who have the experience to do so. The principles of residential real estate are not difficult to understand, but all must concede that the check list we have just outlined is better researched by experienced hands, if the right investment decision is to be made.
Most potential investors lack the time to carry out the research and, when you consider that this type of investment assessment is available, why wouldn’t you wish to be armed with such information. In any decision making process you need all the available data first. It takes all the hassles out of the decision. In fact, the decision makes itself if you are properly informed.
In the chapter "Finding The Property" we provide a copy of one of our investment reports that includes assessment of all the elements outlined in this chapter. Read it and judge for yourself how much easier your decision would be when provided with such detailed and extensive data and projections.
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