Plant and Associates Accountants Beenleigh and Nerang specialise in property investments.
Cash flow properties:
These are properties with a low capital growth profile of 4–6% and high rental yield (return) profile of around 6–10%. Occasionally though the capital growth achieved for these types of properties can be very high. But typically this is only for a short while.
The main advantage with cash flow properties is the positive or neutral cash flow that they generate. You can’t lose having money in your pocket (unless you get in too late). Typically these properties are located in regional areas and so they tend to have lower entry prices (as well as lower stamp duty and land tax) – so for investors who don’t have much equity or income it is easy to get started. Moreover, you can use the surplus cash flow to pay down principal to get more equity for future investment. Because of the popularity of these types of properties it is not uncommon to occasionally achieve strong capital growth gains due to the demand for high yield properties. Regional areas tend to have slower capital growth over periods of time unless there is an economic change in the area. For example, North Queensland is experiencing growth in property values at the moment due to mining. Traditionally properties in regional North Queensland have been strong cash flow properties. The increase in population has driven a demand for homes and rental accommodation, which in turn has pushed the price up for existing properties. These properties would now be giving you good growth. Buying into the area now, however, would give you a higher entry cost and would reduce your ongoing cash flow. Should the mining boom cease or slow down, the demand for properties would drop, which in turn would have an impact on values.
Because you are generating an income from the positive cash flow, you pay tax along the way. You get taxed on this extra income and the money going in the tax man’s pocket is going to make it hard for you to create serious wealth. Because these properties are usually in regional or outer areas they can be quite sensitive to economic cycles. Therefore compared to properties located closer to the centre of our major cities these properties will generate lower capital growth over the longer term. There are also potential higher costs associated with maintenance and more tenancy problems due to socioeconomic factors. From a finance perspective it is harder to get low-doc loans for some regional properties due to postcode restrictions imposed by lenders, mostly due to their smaller populations. The result is lower leverage which will reduce your return.
These are properties with a higher capital growth profile of 7–10% (and occasionally over 12% for a short while) and a lower rental yield (return) profile of 3–5% rent (occasionally below 2.5%).
The main advantage of these types of properties is the fact that these areas are usually inner areas and high population areas which are not affected as much by economic cycles and interest rates. Therefore they usually have higher and consistent capital growth over the longer term. This means investors can generate more equity in a quicker period of time which can allow them to invest further. The government also makes it attractive for investors to purchase these types of properties by offering tax benefits via negative gearing and delayed capital gains tax (CGT).
Most lenders view these types of properties as less ‘risky’ than regional properties, mainly because of the larger populations in these areas. Therefore there is less risk of tenancy problems due to better socio-economic conditions and the fact that there are more buyers in these areas, in case the property ever needs to be sold quickly.
The big disadvantage with these properties is the negative cash flow if you take on a normal mortgage at a high leverage level. Added to this is the fact that these properties are usually more expensive than cash flow properties, in terms of purchase price, stamp duty and land tax. It is harder for beginners to enter the market, simply because there is greater demand for these types of properties than the supply. Furthermore, in the short term there is no guarantee for capital growth every year – you may bet on the wrong horse. The main disadvantage from a finance perspective is that it gets harder to get full-doc loans to access cheaper interest rate mortgages as your portfolio gets bigger.
Houses have typically shown more consistent growth long term in established areas. Therefore purchasing property with high land content is a way to increase your chances of securing good future growth if in an established area. You usually own the land and so therefore you also have greater control over what you want to do with it. This means there are more options open to you (depending on council regulations in the area you are purchasing) to modify the property and add value. Because of the above, houses are typically more sought after and therefore it is usually easier to get finance. However, townhouses are now getting popular as family sizes decrease and the number of retirees increases.
Houses offer lower rental returns as a percentage of their value. There can also be higher maintenance costs.
One of the main advantages with apartments (or units) is they tend to have higher rental as a percentage of their value. Moreover, apartments often achieve just as good returns as houses in areas that are fully built up with height limit restrictions on further development. Over the last decade we have seen these types of assets start to become popular with the younger generation and empty nesters. They meet the needs of these demographics as lifestyle trends change. Partly because they typically are less labour intensive in terms of maintenance so there is generally less time involvement, and they also have potential advantages over houses because of the shared benefits of many apartment complexes from community/group services, eg pool, tennis court, gym, activities, etc.
The main disadvantage is that apartments typically show less consistent growth in areas that are not fully built up. Owners of apartments also typically have less control over their asset as any changes they want to make to their property usually requires approval from a body corporate. So the opportunity to add value is restricted. Owners have to contribute to the running of the body corporate, so compulsory fees are generally higher. It’s also hard to get good finance for some types of apartments, mainly company title properties and very small apartments (under 40m2). So watch out for these!
New vs old properties strategy
New properties are attractive to passive investors who are time-poor and would like to have a property that requires little effort on their behalf. There is usually lower maintenance, and if there happens to be any defects after completion, the builder or builder’s insurance should cover any cost involved. New properties have an appeal to tenants as they usually have lots of light and space, and may also come with other amenities such as a swimming pool and gym (new apartment complexes). Tenantswith good incomes are often prepared to pay higher rent for new properties, particularly if they are situated close to their work. From a tax point of view, new properties usually offer higher or longer depreciation benefits, not only from the fixtures and fittings but also from capital works. It is possible for investors to use these tax benefits to assist with monthly cash flow.
The main disadvantage of purchasing new properties is that the cost to purchase may be higher than an old property in the same area, as developers have to cover their costs and profit margins. Many people who purchase new properties may make emotional rather than business decisions, as they may have fallen in love with the look of the place and how it makes them feel. If they have paid an inflated price for the property, it may take longer to realise capital growth. Another reason that growth may be affected is because there may be a few properties that are very similar being sold at the same time, such as in a brand new development. A few hasty re-sales can affect the values of all the properties in the immediate area. This can have an impact both if you are trying to sell a property or are trying to release equity from your own property. If properties have been sold for lower prices, it will reduce the market value of your own property. As a general rule, brand new properties don’t allow much room to add value by renovating as all the work has already been done by the developer, so unless an investor has purchased at well under market value they will need to wait for natural capital growth to occur.
One of the biggest advantages of old properties is the fact that you get less price fluctuation than new properties in the same area, plus you gain the ability to add instant value through renovations, subdivision and development. Some investors have even managed to get their property for ‘free’ by subdividing a large block and selling off a portion of the land. It has been proven that land, and the scarcity of it, is what drives property value upwards, and older properties generally have a bigger land component. Investors can be more certain that the property they are purchasing has a ‘true’ market value, with no profit margin set by the seller. They are usually found in well established suburbs which can demonstrate consistent growth.
High maintenance costs are probably the biggest disadvantage of old properties. There may be a loss of rental income if renovations need to be done. It may also be harder to attract good quality tenants to an old property, unless it has had some renovations done to it to modernise it. Also, tax benefits are not as good with old properties due to lower depreciation values. Rental may not be as high if the property is very run down, which could impact on your monthly cash flow as the rental yield you can command will be lower than could be achieved with a new property.
Off-the-plan purchases have a lot of the advantages I have already touched on with new properties. An off-the-plan purchase is a brand new property which has higher depreciation benefits. The stamp duty payable on the purchase is reduced because the property is not yet completed.
The Foreign Investment Review Board will allow an overseas investor to purchase an off-the-plan property, whereas they can’t purchase an established property. Perhaps one of the biggest advantages is that there is the potential to secure the property without putting any of your money down. Some developers accept Deposit Bonds to cover the deposit instead of you having to use your own cash. If the property is not completed for a couple of years, this is a much cheaper option and allows you the flexibility of using your cash for something else. So there is a potential equity gain for the investor to be had, even before settlement. But only if you get it right.
There have been occasions where properties purchased off-the plan may have dropped in value by the time the property is completed and ready to settle; therefore investors may find themselves out of pocket. These developments tend to be heavily marketed by skilled project marketers and you have to be careful to see through the spin and focus on the underlying fundamentals of the project itself. With some new developments the area and type of product that is being developed may not have been tested before. This is a warning sign. Past performance is the best indication of future performance; without past performance the future performance is unknown. Therefore there is more scope for the purchase price to be set artificially as there is no precedent. You need to factor this risk into your decision making process. Paying the upfront deposit prior to any valuations being completed commits you to the property before you have a true ‘value’ on the property. Remember you haven’t actually ‘seen’ the property you are purchasing. If there are a number of large developments going on in the same area, it can reduce the value of the property you have purchased even before it’s completed because there is an over supply. With large developments, if a certain percentage of the properties are not sold before construction, there is no guarantee the project will commence, which means you may have lost valuable time and missed out on other property opportunities.
Rental guarantees are attractive to property investors because they offer the promise of secure, ongoing rental income from an investment property. There are several scenarios where an investor might be offered a guaranteed rental return: ?Department of Housing (Housing commission) rentals ?Defence Housing Australia (DHA) rentals ?Off-the-plan units with a developer’s rental guarantee ?Display homes sold to an investor then rented back to the builder until the rest of the houses in the development are sold DHA has put together the most comprehensive rental guarantee system in Australia, with over 18,000 properties under management; over 11,000 of these are managed on behalf of investors. They are able to do this by building and selling properties close to Department of Defence installations to house Defence Force personnel and their families.
You get guaranteed rent so you won’t have to worry about your property becoming vacant. It ensures steady cash flow and peace of mind that your property is well-tenanted during the duration of the lease. The upside of a rental guarantee with an
organisation like DHA is thatit’s unlikely to run into financial difficulty because of its size and government backing. The other positive is that a rental guarantee in a market where vacancy is high and rents are stagnant is not a bad thing.
The offer of a rental guarantee is only as good as the company giving the guarantee, its commitment to the offer, continued operation and having sufficient financial resources, including a positive cash flow, to fund rental shortfalls for property investors. In the case of most developer’s guarantees, the developer will guarantee the rent for a period of time on properties they have built and are trying to sell. Very often these rental guarantees are higher than the current market rate to make the investment more attractive. In the case of Defence Housing Australia, the rental guarantee is based on independent valuations and is reviewed annually. DHA’s standard lease terms are nine or 12 years, and sometimes include an option for DHA to extend the lease by a further three years.
There are many advantages to renovating, the main being the ability to instantly create additional equity that you can access for further investment or to create an equity ‘buffer’ to manage your risk better. Spending money on a renovation, if done right, is a very efficient use of your money.
Renovations don’t have to be major to add instant value. Cosmetic renovations have lower town planning requirements and don’t carry the risk inherent in building. They can be as simple as a new kitchen or bathroom, fresh paint and floor coverings. This increased value can assist by also enabling a higher rental return, not just creating more equity. It can also lead to higher tax advantages due to higher deprecation. Sometimes you can buy properties under market value that need renovation. However, these properties are highly sought after so competing parties frequently bid this benefit away. Another positive is that if you are purchasing these types of properties, most of the money you pay is going to the ‘land component’. It’s the land which appreciates, while the building on the land depreciates. So with a higher land component you are ensuring solid future growth.
Inexperience, however, could cost you more money if you don’t anticipate structural, engineering or council permits. You may not see trouble spots until half way through a renovation (electrical, plumbing or structural issues). It’s very easy to underestimate the time, cost and work involved in a renovation; you would have to ensure that the money spent is going to give you the increased value in the property and that you haven’t over-capitalised. You have to ask yourself, will you be able to create enough equity on the sale or revaluation to make it worth your investment in time and money? Can you increase the rent sufficiently in the area to make the exercise worthwhile? Doing a renovation requires a lot of work if you do it yourself. Even if you don’t do it yourself, it requires a lot of management if done by others. It also takes a lot of time to find the property that can make the numbers work.
The main benefit of developing is the potential for you to make a good profit above your costs by creating the equity instead of waiting for it over time with capital growth. It also allows you to express your creativity. There is no question about it, developments are exciting projects to work on and there is a certain amount of pride that goes with completing a project. You also get to call yourself a developer! From a finance perspective the main benefit with development is that you have the potential to get finance and capital based on the strength of the deal, instead of your own personal equity or income capacity. While there are multiple exit strategies to make money, depending on how quickly and how much profit you want, ie subdivide and sell, sell with plans and permits, secure plans and permits construct, subdivide and keep, secure plans and permits construct, subdivide and sell etc…
Like anything, where the potential return is higher, so is the risk. Developing is a complex business. It’s easy to make a loss if you don’t know your craft. It requires high commercial skills and people skills if it is to be done successfully. It also requires good timing. You have to be able to read the property market extremely well. And from a money perspective it might not be the most efficient use of your money due to long lead times. There are potential delays in every step of the development process; planning, permits, finance and construction. Therefore it frequently requires a larger capital commitment (than originally estimated) from the developer, as these delays cost money. So you have to factor in that you will have a lower income while holding the site. Which one is the best? Each of the above strategies has its own unique characteristics and none any better than the other. You can make good money out of all of these strategies or just focus on one and become very efficient at doing just that.
Bill Zheng is the CEO of Investors Direct.