” We know we need to invest and we thought we should buy a positively geared property; can you help us find a good one?”
If only we had a dollar for every time we’d been asked the above question.
It is common for inexperienced investors to have formed opinions of their own which, without some really good professional guidance, they may take several years to realise the shortcomings with those opinions. As the saying goes: “…we don’t know what we don’t know”.
Ah, positively geared property! Each time we peel back the layers and get to the core of the positively geared question, it always comes back to cash flow. Often, the logic is to (simply) find a property which will attract a rental income that will cover the costs associated with holding an investment property so that their household budget will not be affected. Whilst we understand the logic, we firmly believe that it is not an ideal strategy!
Let us say from the outset that no one should invest in anything that they can’t afford!
While rental return is important, we believe that the primary objective for the property selection criteria should be to maximise potential for capital growth – not that anyone can ever give us a guaranteed outcome. At the end of the day though, the greater the future-value of our property portfolio the greater our cash flow will be later in life.
What’s the point of investing in a property primarily for its initial rental income if the property barely grows in value over the next 10-15 years? You’ll probably do better with a term deposit.
All properties don’t increase in value at the similar rate. No, properties don’t always double in value every 7-10 years.
While positively geared properties do exist, they aren’t the norm. The reason which we don’t go specifically seeking positively geared properties for investors is that positively geared properties are generally quite specialised in nature and this specialisation usually equates to a limited resale market. When it comes time to sell, a property which only appeals to a very select market will attract fewer buyers, meaning limited competition and inferior price growth compared to properties which appeal to a much wider market.
The most common examples of positively geared properties are:
Small Country towns
The problem with ‘specialised’ properties is there will always be a much smaller demand for them and that’s why they don’t produce the same amount of price growth as a (well-chosen) residential property which will always appeal to a broader market. We will always need basic housing but the same can’t be said for specialised properties!
Don’t take our word for everything; consider what the banks think about specialised properties. Banks offer the lowest interest rates when the asset is standard residential security. Conversely, banks charge an interest rate premium for specialised securities because they represent a bigger risk. Similarly, banks will lend more money against a standard residential property (sometimes requiring deposits as little as 5% whereas commercial properties need 30%-35% deposit).
Here’s a very general summary of different property types from the last fifteen years:
STANDARD RESIDENTIAL PROPERTY[table “” not found /]
It seems logical to first describe the investment credentials of a standard residential house or apartment. The rental yields, annual capital growth, vacancy rates, and loan-to-value ratios (LVR) above are indicative of what we might have expected in a normal year over the last fifteen years.
Rental yield formulae:
Weekly rent x 52 weeks x 100 / property value = rental yield (%)
COMMERCIAL / INDUSTRIAL PROPERTY[table “” not found /]
The main attraction to commercial property is usually the potential for higher rental returns and lower turnover of tenants. It is a substantial disruption to a business to relocate so they usually rent for longer periods than residential tenants. On the flip side, when a business does relocate (or go bust, as is often the case, especially during an economic downturn) it can take 6-12 months to find a replacement tenant. Suddenly, the positively geared property you thought you had has no income at all, so the tenancy risk as higher than residential. Vacancy rates in ‘good’ commercial property market at least 10%; several capital cities currently experience vacancy rates of over 15%.
Commercial property valuations (an influencer of capital growth) can be quite volatile, reflected in the Resale Demand rating above. Valuations are largely based on the quality of the tenant, best use of the property, and a multiplier of the anticipated rental return (whereas residential valuations are determined by comparative sales). No wonder banks charge higher interest rates and require greater equity for commercial property!
RETAIL PROPERTY[table “” not found /]
Retail properties have similar investment credentials to commercial properties. Exposure to the public and parking are often vitally important for retailers and you’ll often find several retailers located in clusters to attract the extra foot traffic. The quality of neighboring tenants often has a big bearing on other occupants in a complex so there is a third party vulnerability factor.
NATIONAL RENTAL AFFORDIBILITY SCHEMES (NRAS)[table “” not found /]
NRAS is a property scheme which attracted considerable interest for several years. Introduced in July 2008, NRAS was part of the Federal Government’s (GFC) building industry stimulus package. It was designed to give the building industry a boost and address the growing shortfall of affordable accommodation across Australia. There were tax incentives for developers who met criteria within development projects. Similarly, there are tax incentives of up to $9,140 pa to property investors who elect to buy one of the NRAS properties.
On face value the rental returns and tax incentives are great. But… investors need to really think through this. Propertyology gives NRAS properties a big “Buyer Beware”!
Whether it’s a new housing estate or a large apartment block, owners of NRAS properties must have their property managed by NRAS agents and the properties can only be rented to NRAS eligible tenants. Property management fees are in the order of 13% (compared to 8.5% for standard residential), rents must be charged to the tenant at a 20% discount, and lease documents are quite involved. This dilutes the extra tax incentives.
NRAS properties are located within large (mass-produced) complexes or large master-planned housing estates which places an additional ‘ceiling’ on capital growth potential.
A number of banks are not comfortable lending money against NRAS properties. The banks which are comfortable with them require bigger deposits because of perceived lower resale and mortgage insurers will not accept the properties.
Again, think this through….The property owner is constrained by the size of deposit they need, the bank that can fund the loan, who the property can be managed by, and who it can be rented to. These constraints will limit the number of interested buyers (initially and also if the investor wants to sell at any time inside 10 years). Lower demand equals less buyer competition equals lower capital growth!
Now, picture this… You purchased a NRAS property a few years ago and an investor within the same complex or estate as yours now wants to sell. The extra red tape and constraints imposed on owners will result in less interested buyers for the property. They certainly will not be in a position to attract a premium sale price and will probably have to discount the price substantially in order to move on. The minute this sale occurs a benchmark has been set for valuers and potential buyers of your property.
If this housing scheme was so good, why wouldn’t governments (federal, state or local) fund the properties themselves? The government tries to lure investors by offering tax deductions and developers were aggressively marketing the properties using the “positively geared” tag. Spot the magazine advertisement or radio campaign!
STUDIO &/OR SERVICED APARTMENTS[table “” not found /]
Investors who buy studio apartments typically fall for the low purchase price, central location, and potentially higher rental returns. Studio apartments are small, one-bedroom, with a very basic kitchen facility, and a bathroom / toilet. Very similar to a standard hotel room, they are usually less than 50m2 in total size.
The market for renting these types of properties is usually short-term business trips, holiday letting, or a single person wanting to pay really cheap rent for a place to sleep (not a home). The limited rental market, high turnover of tenants, and high property management fees are not appealing at all. There can often be body corporate restraints / covenants surrounding who manages the property and who it can be rented to. Vacancy rates can be seasonal.
We did quite a bit of research in to buying a studio apartment a few years ago. For around $200,000 we could buy a one-bedroom apartment in trendy suburbs like Carlton (inner-Melbourne) and Toowong (inner-Brisbane). They were renting for around $250pw (6.5% yields, wowee!). We investigated how much the owner paid for them several years earlier and the average annual capital growth results were appalling – between 1.5% and 2% capital growth over a period when more standard properties in the same location saw price growth of 7% to 10%.
Don’t touch them!
DEFENCE HOUSING[table “” not found /]
Defence housing properties are regular houses and apartments which investors can purchase from the Defence Housing Authority (DHA) but must lease them back to DHA for the provision of accommodation to defence personnel. There is nothing ‘specialised’ about the property itself however, the tripartite relationship between property owner, property manager (DHA), and the tenant makes it a specialised investment.
There’s quite a bit to like about what the DHA scheme offers investors. The lease is actually between the owner and DHA themselves so your rent is guaranteed and there are no vacancy periods! Generally speaking, DHA will lease the property for 12 years from the time it is built. DHA are fully responsible for keeping a good tenant in the property and they are required to hand the property back to the owner at the end of the lease in good repair and with a bit of a cosmetic spruce up (repaint, new floor coverings, etc). DHA properties are generally in central locations with amenities for families nearby.
On the downside, investors can’t use the property for anything other than defence accommodation until the 12 year period expires. The same constraints apply if you want to sell a DHA property – buyers must be happy with the DHA conditions so there will be less willing buyers (again, restraining your capital growth). DHA charge a whopping 16.5% (houses) and 13% (apartments) to manage the property. Mortgage insurers don’t support DHA properties so investors must use at least 20% of their capital to buy one.
All DHA homes are initially built by DHA in locations chosen by DHA because they meet requirements for DHA personnel. This is a completely different process to the search which Propertyology conducts on behalf of investors to pin point growth drivers. A “central location” is far from a comprehensive list of criteria for investment potential.
COUNTRY TOWNS[table “” not found /]
So, you’re a keen property investor, you have plenty of equity but not the cash flow to invest again right now. Then you figure out that properties with cheap purchase prices usually have better rental yields. So, you think you’ve uncovered a property investment secret and set about finding locations with cheap properties and high yields. Don’t bother – I’ve completed the exercise for you. Check out these massive rental yields from locations around Australia:[table “” not found /]
Other than good rental yields, the thing which all of these locations have in common is their very low population and remote location. Questions ought to be asked about economic diversity, employment opportunities, infrastructure, and voting power to attract government spending.
RECONFIGURED RESIDENTIAL PROPERTIES[table “” not found /]
By “reconfigured” we are referring to a property which was initially built to provide a standard residential accommodation purpose but it has subsequently been redeveloped with the intention of creating accommodation for multiple users. Examples include building a granny flat on the property or converting a bigger home in to share accommodation with separate lockable rooms.
The logic of the owner is to create extra income streams from one property. One really needs to think about who would really want to live in a place like this and for how long. The problems with it include reducing the pool of interested tenants, it will not receive the same bank support, and you will most definitely have a limited demand (and therefore less buyer competition) when you go to sell.
Strategies To Better Manage The Investor’s Cash Flow…
While we maintain that potential for capital growth is the primary consideration for selecting a property, we acknowledge that the rental return is still important. The thing with a lot of investors however, is that they make decisions upside down. That is, they focus on selecting properties with a rental income that meets their budget while neglecting the most important thing of all – is it a good investment?
This is where working with a (tertiary qualified) property investment advisor (QPIA’s) can add enormous value. QPIA’s within our business have a structured process whereby they will evaluate a client’s available capital and cash flow to then strategically calculate the best way to invest. Quite often, the QPIA will come up with initiatives to better manage cash flow in ways that the investor has the confidence to (safely) invest in multiple properties.
There’s a whole range of things which a skilled QPIA might consider in regards to helping investors maintain a comfortable cash flow, including:
- gearing levels
- the name on title
- setting aside contingency funds (buffers help people sleep at night)
- innovative debt structuring, including the possibility of consolidating some existing personal debts
- strategies to reduce non-deductible debt
- strategic combinations of fixed and variable interest rates within a liability portfolio
- where and how to use offset accounts
- rent versus buy scenarios
- reviewing the performance of any existing investment properties
Over time, it’s reasonable to anticipate that all properties will eventually become cash flow positive as rental incomes increase.