Understanding Property Options

A Useful Guide to Understand Property Options

Investment: bricks and mortar

brick-and-mortar

Buying a property to rent out is a popular form of investment. Houses and units are easier to understand than many other types of investments, yet they do have some issues you need to be aware of.

Before you enter the property market, check if this type of long-term investment suits you.

Pros and cons of property investment

The benefits

  • Property can be less volatile than shares or other investments
  • You can earn rental income and benefit from capital growth (if your property increases in value over time)
  • If you take out a loan to purchase an investment property, interest on the loan and most property expenses can be offset against rental income, for tax purposes
  • You are investing in something you can see and touch

The pitfalls

  • Rental income may not cover your mortgage payments or other expenses so you may have to use other money to cover these costs
  • An increase in interest rates will increase your repayments and decrease your disposable income
  • There may be periods of time where you don’t have a tenant and will have to cover all costs yourself
  • You can’t sell off a bedroom if you need to access some cash in a hurry
  • If property investment is your major investment you may have little or no diversification
  • If the value of the property goes down you could end up owing more than the property is worth, this is known as negative equity
  • There are very high entry and exit costs such as stamp duty, legal fees and real estate agent’s fees

Don’t invest only in property

If you invest exclusively in property, you will have a lot of money riding on one small market sector, for example the North Sydney apartment market. If you also own your home, you will have all of your wealth concentrated in the residential property market.

This is poor diversification and increases your risk. Investments such as managed funds and Exchange Traded Funds allow you to invest in a broader range of assets, which will reduce your overall risk.

Important

There are restrictions on buying property with SMSF monies. There are strict compliance rules to invest via a self-managed superannuation fund.

Buying an investment property

Where and what you buy will affect your return on investment. The following tips will help you develop your own criteria for a good property investment.

Where to buy

  • Think twice about investing in property markets you are not familiar with
  • Look for areas where high growth is expected, in other words where there is potential for capital gains. Property experts regularly provide tips on up and coming suburbs, just make sure you are aware of any biases they may have
  • Look for areas where rental income is high compared to the property value
  • Research recent sale prices to give you an idea of what you can expect to pay for property in the same area
  • Find out about the vacancy rates in the neighbourhood. A high vacancy rate may indicate a less desirable area. This may make it harder to rent the property and may make it difficult to sell in the future
  • Research proposed changes in the suburb that may affect future prices. Things like planned developments or zoning changes can affect the future value of a property. Don’t assume that last year’s boom will continue this year.

What to buy

  • Look for properties with features that will appeal to as many people as possible, such as a second bathroom, lock up garage or somewhere close to shops, schools and transport
  • Look for a property that will attract more than one segment of the rental market such as singles, couples, young families or retirees
  • Low maintenance costs are important
  • Units can be easier to maintain than houses, although you will have to pay body corporate fees

Property prices can fluctuate

When deciding if a property investment is right for you, remember that property prices can go up and down.

For example, the value of Gold Coast units, which have been recommended by property developers, fell by 17.9% between February 2008 and March 2013.

Value of Gold Coast units 1997-2013

value-of-gold-graph

Source: rpdata – Rismark 2013

Investment property advisers

Think carefully before using the services of groups of professionals such as property developers, accountants, lawyers and mortgage brokers who work together and recommend each other’s services.
Be particularly wary if they recommend that you invest in a property market you are not familiar with. Do you own research and choose your own service providers.

Costs

Buying, selling and managing an investment property can be costly and will affect your overall return. When you buy a property, you will have to pay costs such as:

Costs of buying a property

  • Stamp duty
  • Conveyancing fees
  • Legal costs
  • Search fees
  • Pest and building reports

Costs of owning a property

  • Council rates
  • Water rates
  • Insurance
  • Body corporate fees
  • Land tax
  • Property management fees
  • Repairs and maintenance costs

Costs of selling a property

  • Agent’s fees
  • Advertising costs
  • Legal fees

If you borrowed to invest you will have interest repayments and if your investment is positively geared you may pay tax on your rental income.

If you sell the property you may also have to pay capital gains tax if the property has increased in value. See our separate article about this.

Work out your income and expenses

Once you have a property in mind, think about the income you expect to receive from it and what your regular expenses will be. If there is a shortfall, think about whether you can cover it long-term. Also consider whether you could cover all expenses short-term if you had no tenants for a while.

Case study: Juhyan and Jennifer consider an investment property

juhyan-and-jenniferJuhyan and Jennifer, are in their 40s and are considering buying an investment property in Sydney. They spot a unit that ticks all of their boxes: it’s close to a train station and is a 10 minute walk to an area filled with restaurants and shops.

The property price is $550,000 with buying costs of $23,000. They have a deposit of $150,000 so they will need to borrow $423,000 to complete the purchase. Their monthly income and expenses are expected to be as follows:

Income and Expenses $
Rental income  $2,250
Less loan repayment -$2,725
Less allowance for expenses -$   225
Monthly shortfall -$   700

Juhyan and Jennifer can easily cover the monthly shortfall with Jennifer’s salary, which they currently save, and they have an emergency fund they can draw on if they were suddenly without tenants for a while.

Positive or negative gearing

Most people will borrow to invest in property. This is called ‘gearing’. The more you borrow, the more you will pay in interest.

Negative gearing

Negative gearing is when your income from an investment is less than your expenses. In the case of property this means the rental income you receive is less than the interest and other expenses you pay. Your investment is making a loss which most investors hope they will make up with a capital gain when the value of the property increases.

A loss can be used to reduce your taxable income which will reduce the amount of tax you pay. See the Australian Taxation Office’s section on residential rental properties for details of income you must declare and expenses you can claim.

Remember, you are only reducing your tax payable because the income from your investment isn’t covering your expenses.

Positive gearing

Positive gearing is where your income from an investment is higher than your interest and/or other expenses. This means you will have extra money in your budget but you will have to pay tax on the additional net income.

Positive vs negative gearing

Many investors focus on the tax benefits of negative gearing without considering the loss in after tax income. The following example shows the difference between buying an investment property that is negatively geared and buying a property that is positively geared.

Case study: Comparing negatively and positively geared properties

rodRod gets a $400,000 loan to buy an apartment as an investment property. The loan is initially payable on an interest-only basis. The  current interest rate is 6% pa. Interest on the loan is $2,000 a month, which is tax deductable.

Karen, his sister, has some money saved so she only needed to borrow $100,000 to pay for a similar apartment in the same block.  Karen’s loan is also an interest only loan at 6% pa. Karen’s interest payment is $500 a month, which is also tax deductible.

Rental income on both properties is $500 a week with property expenses of $5,000 a year.

Both Rod and Karen earn $70,000 per year.

  Rod and Karen’s income before buying an investment property Rod’s negatively geared investment property Karen’s positively geared investment property
Salary $70,000 $70,000 $70,000
Plus rental income $26,000 $26,000
Less interest – $24,000 – $  6,000
Less property expenses – $  5,000 – $  5,000
Taxable income $70,000 $67,000 $85,000
Tax + Medicare levy – $15,697 – $14,662 – $21,097
NET INCOME  $54,303 $52,338 $63,903

Assumptions:

  • Example reflects the interest payable in the first year. Over time this will decrease but so will the tax benefits
  • It does not take into account inflation, increases in rental income or changes to interest rates or income tax rates over time
  • Capital growth is not taken into account as it does not affect income calculations. The same capital gain would be applicable under either scenario

Karen’s income is considerably higher than Rod’s, she is getting a good return on her investment. If Karen had left her money in a savings account earning 5% interest, her after tax income would be the same as when she buys a property, however she has no potential for capital gain with a savings account.

Rod actually has less money in his pocket as most of his rental income is being paid to a bank in interest. He will be hoping a future capital gain will recoup his short-term income loss.

Managing an investment property

You have two options when it comes to managing your property, you can do it yourself, or engage a managing agent to do it for you.

If you manage the property, you can avoid paying management costs. This means that you will have to do everything, from showing the property to tenants to collecting rent and organising repairs. You also need to comply with landlord regulations.

If you decide that it is a lot easier to have a managing agent to look after the property, the management fees you’ll pay are tax deductible.

Insurance

While you don’t need to pay for home contents insurance, you will need to organise building insurance. This covers you for full building replacement if, say, the house burns down. If you buy a unit, building insurance will be paid from your strata levies.

You should also consider taking out landlord insurance. This protects you if your tenant damages the property or if they run off without paying the rent. The cost of landlord insurance is tax deductible.

If you are relying on part of your employment income to cover the interest cost and expenses, make sure you have adequate income protection insurance. Your ability to earn an income may be the most important asset you have.

Renovations and repairs

You need to factor repairs and maintenance into your property budget. If your tenant complains that the oven is not working or the shower starts leaking, you need to fix it straight away.

You should only renovate your property if you think it will increase the amount of rent you can get, or if it will make the house or unit easier to rent. Property improvements are not tax deductible.

Risks with overseas property investing

Investing in overseas property is more risky than investing in property in Australia. It is much more difficult to make sure the investment suits your needs if you don’t have local knowledge and you can’t regularly inspect the property.

ASIC has received complaints about promoters who are encouraging Australians to invest in the United States property market. If you’ve been ‘invited’ to invest in a supposedly ‘cheap’ overseas property, ask yourself why they need someone in Australia to invest? Why aren’t savvy locals investing? Chances are it’s a dud investment.

Here are some things to consider if you’re thinking about investing in property overseas:

  • Distance – Good tenants and good property managers are hard to find, especially when you’re so far away from the property.
  • Renovations and repairs – Expensive renovations and repairs may be needed, especially if the property is in a location prone to squatters and vandalism. Buying property sight unseen is a big risk.
  • Hidden costs – You must factor in Australian tax laws, local property taxes, insurance, management costs, and ongoing repairs. There are lots of hidden costs that the promoter may not tell you about.
  • Exchange rate – Changes in the exchange rate could affect the amount of income you receive

See the Barefoot Investor’s article on an Australian woman who bought US property and ended up losing around $300,000: Some home truths about US property. www.barefootinvestor.com

Investing in property may be a good way to grow your assets, however, as with other types of investments, it’s important to do your research and seek professional advice if you’re unsure about any aspect of the investment.

For further information, go to the Government site about Property Investment.

 

Reproduced with permission of ASIC – Source: ASIC’s MoneySmart website, moneysmart.gov.au, 23 January 2015