So you’ve been thinking about getting into property?
Great. But before you start hitting the open houses, read through this guide for an overview of what you ought to know when you’re just getting started.
Why property
Let’s start with the positives and negatives of investing in property:
Positives:
- Property value can rise significantly (capital growth)
- You can generate passive income by renting your property
- You can reduce your tax bill by offsetting property expenses and loan repayments
- You are putting your money into something real, bricks and mortar, which you can live in
Negatives:
- Repayments can go up with interest rate hikes
- Property isn’t a very liquid asset i.e. no quick access to cash
- You may be ought of pocket at the start until your property becomes positively geared (more on this later)
- Vacant periods where you have no rental income
- Hidden costs which you might not be prepared for
Property investment strategies
There’s many investment strategies out there, some more risky than others. The most common ones for beginners are buy and hold, and property development.
Buy and hold
This is the most common beginner strategy. You “buy” a property and then “hold” it. You can profit from capital growth, and you can also generate rental income.
Property development
Property development involves making improvements to an existing house or piece of land. The most typical methods are:
- Renovating – Upgrading an existing property e.g. adding another level, or a new bathroom
- Purchasing land and then building a new house
- Demolishing property and rebuilding a new house
- Adding a granny flat or similar
What can you afford?
What you can afford depends on just 2 things:
- The size of your deposit
- The repayments you can afford to service
Deposit
In Australia, banks are typically only approving loans with a maximum 80% LVR.
LVR (Loan to Value Ratio) is your (Total Loan Value / Property Value) x 100%
Say you wanted to purchase a property for $400,000. You would need an $80,000 (20%) deposit to take out a loan of $320,000 (80%).
Coming up with 20% is no easy task, even with an investment partner.
But you needn’t wait, if you use one of these 2 options:
- Purchase lenders mortgage insurance (LMI). This insures the bank if you default on your loan.
- Using a A close relative guarantors the portion of your loan that is above the 80% LVR, usually against their own property. Again, extra insurance for the bank.
The guarantor method saves you an additional expense, but it may not be possible in your situation or you may not have a willing guarantor. Either way, there’s no need to wait for a 20% deposit before entering the market.
Repayments
Following on from the example above, let’s look at your repayments if you had a modest 15% deposit (85% LVR). The loan amount is then $340,000, and we can assume an interest rate of say 5.00%. We will assume also that you are using the guarantor method to avoid paying LMI.
For a 30 year loan term, the monthly principle + interest repayments would be $1,825.
A rule of thumb some experts advise is that repayments shouldn’t be more than one third of your before tax salary.
Using this rule for our example, your recommended minimum before tax salary is $66,000 (or combined salary with your investment partner).
Note this is a rough guide only; you should assess your own unique financial situation to determine your debt servicing capability and always allow for some contingency.
One way to help pay off the mortgage is with rental income. But you shouldn’t depend on it. Consider the following scenarios:
- You decide you want to move in to your place
- You live there short term for tax or other purposes
- Vacant periods where you’re looking for tenants
Also think about if you were to lose your job, or if interest rates suddenly spiked, if you have enough contingency to still service your loan.
Positive and negative gearing
You’ve probably heard of negative gearing before. But do you understand what it is?
First of all, negative gearing only applies when you’re renting out your property.
Gearing is borrowing to invest, and positive gearing is when your rental income exceeds your expenses incurred e.g. interest repayments.
Negative gearing then is when your investment costs are higher than your rental income.
Yep. You’re losing money. So why all the hype?
Because when negatively geared, you can deduct the costs of owning your investment property from your overall income – thus reducing your taxable income.
I always recommend to view negative gearing as a tool for reducing your losses. That way people never lose sight of the fact that they are actually losing money.
Continuing the previous example, we had a $320,000 loan. For a $400,000 property we can estimate a rental income of $400/week x 48 weeks (4 week contingency) = $19,200.
You can then calculate the yearly interest by multiplying the loan value by the interest rate, which gives us $340,000 x 5% = $17,000.
You also need to allow for property expenses such as water, rates and taxes. If you can’t find them online, it should be on the handout at the open house, and if not then just ask the agent. For this example let’s assume a conservative $4,000.
Now you can calculate the Total loss = rental income – interest – expenses
= 19,200 – 17,000 – 4,000
= -$1,800
This is how much money the investment has lost in the first year.
Because your investment is effectively losing money, it is negatively geared. This loss can then be claimed against your taxable income.
For someone in Australia earning between $37,000 and $80,000 the tax rate is 32.5%. The negative gearing saving therefor is $1,800 x 32.5% = $585.
Your effective loss has now been reduced from $1,800 to just $1,215.
Why property is so powerful
The property market long term national average growth is around 7% in the major Australian capital cities of Sydney and Melbourne.
The advantage of property over shares or other investments is that when you invest your deposit of $60,000 for a $400,000 property, you are making that 7% return on the property value as opposed to the deposit amount.
A 7% capital gain on $400,000 is $28,000. That’s a 47% return on your deposit. It’s very powerful. That is, as long as you bought within your means and can safely service your loan.
The first years are always the hardest. As the rent goes up and you steadily pay off your mortgage, your property should quickly go from cash flow negative to cash flow positive.
That’s the aim of the game. Finding a property with the ideal combination of good rental yield to improve your cash flow and high capital growth to achieve profit.
Properties delivering higher capital growth tend to cost more initially to maintain, i.e. they are cash flow negative. Essentially you are speculating that the temporary loss will soon be offset by significant future gains. This is typical of the capital city markets.
One important caveat is that capital gains aren’t physical cash profits like with what you would get from a positively geared property. You can only access this money by either selling or revaluing the property and refinancing your loan. But that’s beyond the scope of this beginner’s guide.
Adam Sweeny
About the author
Adam Sweeny is the founder of www.diypropertyinvestment.com, a site where new home buyers and property investors can learn the ropes in real estate without being bombarded with sales pitches.
