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Your Introduction and Guide to Property Investment

  • There are a number of reasons to consider investing in property, including a long history of sound returns, the potential benefits of leveraging to invest and improved tax outcomes for some investors.
  • Property also has potential disadvantages, including an inherent illiquidity and high entry and exit costs.
  • Property should be considered as a long-term investment due to the costs involved, and the potential impact of volatility on short-term returns.
  • Investor Assist believes there are three elements to a property investment: land, build and finance. It is a successful combination of these three elements that can lead to sound outcomes.

 

Property investment is a popular and proven method of building wealth in Australia. This introductory guide to property investment explains the ins and outs, to help aspiring investors start off on the right foot. If you’re new to property investment, this guide is for you.

WHY PROPERTY?

There are several sound reasons supporting the idea of investing in residential property; Australia’s continual population growth, a well-reported housing undersupply, and ongoing infrastructure development all underpins long-term house price increases.

Perhaps the biggest reason property is so popular as a form of investment is that it is relatively easy to understand, especially when compared to shares and other financial assets. Property is tangible; it can be touched, renovated and customized. Yet tangibility doesn’t equate to simplicity and, depending on your personal situation, property may or may not be ideal for you. Below is a guide to property investment advantages and statistics that will show you why you should invest.

  • Australian residential investment property has produced sound returns over the past 25 years

Comparing property with other types of investments is difficult, because the performance of property varies widely by location and property type. Investors should note that the performance of one or several investment properties would generally be different to the performance of a national property index, which might be based on thousands of properties nation-wide. Furthermore, after-tax returns will vary widely depending on each individual’s personal situation.

However, comparisons do exist, and one of the most comprehensive is the Russell Investments/ASX Long-Term Investing Report. The June 2011 report[1] (the most recent at time of writing) shows that residential investment property achieved the highest return of 10.1% p.a. and 11.6% p.a. respectively over ten and twenty-five year periods. This compared favourably with Australian shares, which returned 8.4% p.a. and 10.8% p.a. over the same periods. Over a period of 20 years, Australian shares returned 11%, while residential investment property returned 10.2%.

  • Property can be less volatile than shares or other investments

Research has shown property to be less volatile than shares (volatility is a measure of how much a price moves over time). Less volatility in an investment is typically good, since returns will likely be more stable. The benefit of low volatility for property investors is that, while shares can rise and fall by the minute (and even alter in price drastically overnight), property typically rises or falls in value gradually.

You can leverage property to borrow up to 90% (or possibly more) of the investment value

Banks will typically lend much more to someone purchasing a property than shares. Investment properties can be purchased at 80% LVR (loan to valuation ratio), or up to 90% LVR with mortgage insurance (note that mortgage insurance is an added cost). And if you already own your own home, and have a reasonable amount of equity in it, you may not even need a deposit. For example, if you have a house worth $400,000 and you have a $100,000 mortgage on it, you have $300,000 of equity in the property.  You could use that equity to obtain finance to buy other properties, rather than having to provide the deposit from your own money.

  • You can earn rental income as well as capital growth

Ongoing rent from tenants can help you service your loan repayments, while capital growth (where the property increases in value) can provide gains when you sell the property.

  • Property can provide tax advantages

Property can provide tax advantages where the cost of owning the investment exceeds the income you receive. When this occurs it is referred to as negative gearing (see more on this topic under ‘Finance’). If you take out a loan to purchase an investment property the interest on the loan is tax deductible, and you can deduct such expenses as property management fees, loan costs and repairs. Depreciation also provides advantages on newer or renovated properties. Homes are depreciable over 40 years, and capital improvements such as a new kitchen or hot water system are also counted. Of course, tax benefits alone are not a good enough reason to invest in anything, yet they can provide advantages as part of an overall investment portfolio.

  • Improvements to increase value

You can exert direct control over the value of your investment by making improvements to your property.

  • Property is illiquid

This means it can be difficult to sell property quickly, particularly when compared to more liquid assets such as shares. And while you could sell a portion of a share portfolio to provide short-term cash flow, it goes without saying that you can’t sell a bedroom to raise cash from your property investment. In this regard, property is suited to a long investment timeframe.

  • High entry and exit costs

The minimum price for a property investment is well above the minimum for other types of investments. While you can borrow to invest in property, there are other costs you will need to pay up front, such as stamp duty. Ongoing costs are another consideration, and these include building insurance, landlord insurance, property management fees, council and water rates and any building maintenance. In addition, while you can receive rental income from tenants, in many cases this will not be enough to cover your mortgage repayments. Taking account of all of the costs up front is therefore vital.

  • Interest rates

If you have borrowed on a standard variable rate loan and interest rates rise, you will be required to pay more. It is important to take possible rate rises into consideration when working out your finances.

  • Vacancies and bad tenants

Your property may not always have tenants (if a tenant leaves or if demand is low), and not all tenants are well behaved. Having an expert help you source a good, long-term tenant can help alleviate these issues.

INVEST FOR THE LONG TERM

One of the most important lessons you can learn from a guide to property investment is that property should be considered a long-term investment. Investor Assist considers a minimum of five years, and preferably seven to ten, to be a suitable timeframe. There are some good reasons for this.

Buying an investment property involves substantial upfront, ongoing and exit costs (discussed above). Therefore in order to make a profit, the value of an investment property needs to grow by more than the value of these costs, and the after-tax costs associated with holding onto the property.

Most investors target capital growth from their property investments, yet it can take time for a property to increase in value and it doesn’t happen in a straight line. You may need to endure occasional years of low or even negative growth throughout the course of your investment.

Property is often described as a stable investment, which can bring about the notion that it is a ‘low risk’ option. This is not technically true. The fact that property occasionally goes down in value is a reflection of its inherent risk. All investments have an element of risk, but risk is reduced when you have a long investment timeframe, as you are giving yourself time to ride out any short-term volatility in returns.

In fact the potential for volatile short-term returns are a normal part of investing in higher risk asset classes (such as property), and investors with long-term horizons should not view these periods as alarming. For example, if you had purchased a property in Perth two years ago, based on the performance of the wider Perth market, the value of that property may not have grown, or may even have gone down. However, history shows that markets recover – and investors with patience tend to be rewarded.

CAPITAL GROWTH VS. RENTAL YIELD

No guide to property investment would be complete without a discussion on this issue. Property investors have long debated the merits of capital growth vs. rental yield. It is rare to find a property that delivers both high rental yield and high capital growth, as they generally have an inverse relationship, which means high yield may be achieved at the expense of capital growth, and vice versa. This presents opportunities to the investor since different properties can deliver different types of benefits.

High yields from cash-flow positive properties may be tempting in the short term, particularly when interest rates are rising. However, it is generally accepted that capital growth should be the primary objective of property investment as this is where the major gains are made.

The balance between rental yield and capital growth may change over time as property goes through cycles. Though the market doesn’t follow a rule, when property prices are rising as a result of demand, a related increased supply of rental properties may reduce rental yield. Conversely, when capital growth slows, rents may increase.

The best result is a combination of yield and capital growth that suits your personal situation. And it is important to invest in a viable way. Seeking capital growth from your property investment may mean you earn less weekly rent, thereby resulting in a shortfall (where the rent you receive does not cover your regular mortgage payment). Working out whether you can afford this shortfall over the long term should be one of the first steps to your investment planning.

Even though achieving capital growth may mean forgoing short term rental yield, as the following example shows, this can pay off significantly in the long run.

The importance of capital growth to long-term returns

The below example is a guide to property investment terminology in action. It shows after 15 years, Property A has achieved a net position (capital growth plus rent) of $791, while Property B has achieved a net position of $944,000. Despite sacrificing rental yield, Property B achieves a much better overall outcome.

 

 

Property A

High Y Lower G

Property B

LowerY High G

 

Cost of Investment

Capital Growth over 15 years

15 years @ 5% per year

$400,000

$431,571

15 years @ 5% per year

$400,000

$431,571

Total value after 15 years $831,571 $1,104,000

 

Pental Income Per Year

Total Rental Income over 15 years

Rental Yield @ 6%

$24,000

$360,000

Rental Yield @ 4%

$16,000

$240,000

Financial Position after 15 yrs

(Capital Growth + Rental Income)

 

$791,571

 

$944,000

 

Property A costs $400,000 and achieves capital growth of 5% on average. This property also achieves 6% rental yield on average (roughly $460 per week). After 15 years, the property is worth $831,571, while total rent yield over that period is $360,000 (assuming rent stays the same).

Property B also costs $400,000, yet achieves average capital growth of 7% per annum. However, the rental yield is lower (4%). After 15 years, the property is worth $1,103,613, while total rent yield is $240,000.

After 15 years, Property A has achieved a net position (capital growth plus rent) of $791,571, while Property B has achieved a net position of $943,613. Despite sacrificing rental yield, Property B achieves a much better overall outcome. 

 

[1] Russell Investments/ASX Long-Term Investing Report, June 2011.

Property investment can be an intimidating and confusing business. We hope you refer back to our guide to property investment as you work your way towards your goals. Or contact one of Property Investment Specialists to discuss any questions you may have.
 
DISCLAIMER:This information is of a general nature only and does not constitute professional advice. We strongly recommend that you seek your own professional advice in relation to your particular circumstances.
 
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