Buying a property as an investment allows you to take the emotion out of the purchase and weigh up the property more on the financial metrics.
Taylors Strategic Partner, Michael Sik - Financial Adviser and Owner of FinPeak Advisers - shares his strategy for buying property as an investment.
If You Are Buying This Property As An Investment
Faced with escalating real estate prices in most of our capital cities you may decide to buy a property as an investment instead of living in the property. Or you may have some equity in your current property and may want to utilise it and purchase a second property. Perhaps you would like to use some of your funds in your superannuation to own direct property. Whatever the reason, buying a property as an investment allows you to take the emotion out of the purchase and weigh up the property more on the financial metrics that it will either grow in value and allow you to cash in on the capital gains in the future or it will provide a steady income stream to fund your future needs. In this second part, we will discuss owning property directly in your name or via your superannuation fund.
1. Pros Vs Cons
Direct property investment is like any investment in that it will have some sort of risk, there is no free lunch when it comes to investing. There are some pitfalls that you need to be aware of:
- Less volatility – owning direct property can be less volatile than other investments as the asset is not priced on a daily basis;
- Income – it can provide an income stream if the property has a tenant;
- Capital growth – If the property grows in value over time you can benefit from this growth when you realise (sell property) the gain and covert the value to cash;
- Tax deductions – you can offset most of the ongoing expenses of the property against the income it generates and in some cases, you may be able to offset your other income in the same name;
- Real asset – you are investing in an asset that you can see and touch;
- Leverage – you may be able to multiply your capital gains by borrowing to purchase the asset (however, as noted below this can also multiply your losses as well).
- High costs – property investment has high entry and exit costs (eg stamp duty, legal fees, mortgage settlement costs, agent fees) and in most cases, the value of the property needs to grow by more than 5% before you show a profit. There are also ongoing costs such as council fees, strata, water rates, interest expense, repairs and maintenance, property management fees and insurance;
- Interest rate movements – in many cases debt is used to acquire the property. Were experiencing historically low rates at the moment, however, as you can see from the graph below, up until recently the average mortgage rate has been north of 6% pa. You can mitigate this risk by increasing your tenant’s rent, however, given that most tenants would have a lease for 6 to 12 months there will be a period of time, which you as the landlord, you will need to absorb the costs. Banks are also highly regulated and as we saw a few years ago, changes to capital requirements for banks meant that investment loans carried a higher interest rate than owner-occupied loans.
- Capital losses – in circumstances where debt is used and the value of the property falls, you could end up owing the bank more than what the property is actually worth. If there was a situation where you were forced to sell, you would walk away owing a large sum of money to the bank and putting your other personal assets at risk;
- Vacancy – there is always a risk for some period of time where you do not have a tenant and will have to fund the ongoing expenses from your back pocket;
- Liquidity risk – if you needed funds from this property it may take some time to sell the asset at the price you were expecting and in the cases of retirement you couldn’t just sell part of the property to fund your lifestyle;
- Low/no diversification – there’s a saying ‘don’t put your eggs in the one basket’, for most people, investing in direct property will mean owning only a few properties as property investing is usually requires significant capital. We will discuss ways to reduce liquidity risk and diversification in a later article.
- No reinvesting of income – Benjamin Frankin once said 'Money makes money. And the money that money makes, makes money'. Unlike some other assets, the income generated from this direct property investment is generally unable to be reinvested. You may, however, be able to fund a renovation but this does not guarantee an increase in the overall value of the property.
2. Cashflow Case Study
Consider an investor who is looking at buying an investment property in NSW, we have assumed that this investor earns $90,000 pa and has no other income or deductible expenses. We’ve assumed that interest rates are at 3% pa for the first three years and 4% pa in later years to reflect the current economic environment.
Based on our assumptions, and if you sold this investment after 10yrs, this represents an after-tax rate of return of 6.93% pa with a net yield (income) or 2.22% pa. By comparison, if no debt was used then the after-tax rate of return would be 3.6% pa. This just goes to show how debt can enhance returns, however, it could easily work in the opposite direction if the investment were to lose value at the end of the period. Debt (or ‘gearing’ as otherwise referred) is not unique to property investing and can also be used with other investments, such as shares, the main difference is the amount you can borrow on your capital with property is generally higher as opposed to shares.
(You can contact Michael Sik directly on 0404 446 766 if you'd like to learn more about the source of FinPeak's assumptions).
3. Investing Through A Self-Managed Super Fund (SMSF)
You may decide to use the capital to purchase an investment property but to do so you must we aware of certain ‘rules’:
The property must:
- meet the sole purpose test of solely providing a retirement benefit to the members;
- not be acquired from a related party of a member;
- not be lived in by a fund member or any fund members’ related parties;
- not be rented by a fund member or any fund members’ related parties.
If your SMSF purchases a commercial premise, it can be leased to a fund member for their business. However, it must be leased at the market rate and follow specific rules.
There are essentially four ways you can invest in property through your SMSF, we discuss this in an early article here.
You need to weigh up the pros vs cons of investing through an SMSF to determine if holding the asset inside super will produce an outcome that is right for you as the costs of setting up and ongoing will be higher than holding the asset in your own name. However, the benefits could be that it may provide significant after-tax benefits in the long run due to the tax effective nature of the super/pension environment.
Buying property at the end of the day is just a means to an end, it can be exciting and rewarding but at the same time can be costly and frustrating.
Like To Learn More?
Seeking advice can help take the headache out of your investment property journey. For more information, please contact Michael Sik on 0404 446 766.