Real estate can be an excellent investment, but choosing the wrong property can be disastrous. When it’s done correctly, investing in real estate can help in building wealth for the future. Property is a popular form of investment in Australia and a lot of people are jumping into the market. However, it takes careful and meticulous planning for your property investment to be a resounding success. So, without further ado, here are the eight key factors to consider before buying an investment property.
Location, location, location!
Location will always be the main determinant of demand, prices and property values. When people think of location, the first thing that comes to mind is proximity to public transportation, school, market, church, among others. Bear in mind that an individual searching for a place to live takes into account and puts a premium on these considerations. Hence, you also need to consider location in such terms, because majority of your prospective buyers or tenants will care about these things too.
Moreover, as a property investor, you need to look into location on a more strategic level. When it comes to investing in residential property, location matters with regard to what a prospective property means to the market. So what does this mean? If you are contemplating on purchasing an investment property, it’s imperative to consider location because real estate markets are geographically defined.
When house prices in your chosen area rise, so does the value of your property. Gains in real estate investment boil down to what the specific market you’re in is doing. You must understand that the ‘Australian property market’ consists of hundreds of sub-markets. The media just finds it’s easier to define it as though it is a single entity, but to an investor it is irrelevant. There is no such thing as a huge Australian market that follows a specific path.
There is no New South Wales property market, or Victorian market, or Western Australian market. Having such notion is flawed because there are a multitude of markets within each of these areas, and each market behaves differently. If you look at recent trends, you’ll realise that there is no Sydney market either. Instead, there’s a Parramatta market and there’s an Eastern suburbs market, and within each of these suburbs there are significant discrepancies in terms of market behavior. In fact, you can zoom in to street level and find out that certain streets tend to perform very differently.
As an investor, the important thing to do is to ensure that the market that you’re in is healthy and vibrant because if it rises, the value of your property will also rise even if you made some erroneous decisions along the way. The overall market rises in unison. If you purchased ‘junk’ in the Eastern Suburbs ten years ago, now you’d be the proud owner of some very expensive ‘junk’. Don’t get us wrong, we are not advocating buying junky property; what we are trying to say is that the first consideration should be the specific market where your property is located.
So, whether you plan to invest in Brisbane or Sydney is simply the start of the decision-making process. When you invest in a specific location, you are essentially investing in a specific market. Ideally, your prospective investment must be located close to basic amenities, but more importantly, look carefully on the market where the property is located and how the market is performing in terms of its potential for growth.
Time and Timing
As the adage goes, timing is everything. It also holds true for real estate, but it all depends on your specific objective. To most real estate ‘entrepreneurs’, timing is of utmost importance because it dictates when to buy and when to sell. It becomes even more important if you only plan to stay in the market for a brief period. Why is that? Because if you overpay even so slightly for a property and the market misbehaves, you’re in big trouble.
However, as an investor, your primary focus must be on buying in the right market (which refers to the first consideration, location) and paying fair value for a property. Investing at the right time is only a secondary consideration. Timing actually becomes much less of a concern if you pay a fair price for a property in a promising market and you are holding it for the long term.
An investment strategy that involves time in terms of duration, and one that focuses on purchasing a fair value property is actually a lot more crucial to the success of the investment than trying to get the timing right.
If you have made up your mind and opted to invest long term, and pay a fair price for a property in a market where you believe there is potential for growth, timing becomes a secondary consideration. The rationale behind this is that an inverse correlation exists between the term of the investment and the need to get the timing right. Timing becomes less and less important if you hold a property for the long term, say 10 or 20 years.
A classic example of this is your parents who purchased a property 25 years ago for $25,000. Even if they overpaid by 10 percent, and the property’s worth was really $22,500, today its value is close to $700,000 – so the fact that they overpaid becomes immaterial because time has diminished the importance of timing.
Timing comes to play when you consider the duration for which you intend to hold onto a property. As long as you are paying fair value for a quality asset, in a good location, time will take care of everything. If you overpay, then it would take a lot longer to compensate for that mistake. The bottom line is that your focus should be on fair value and not on getting the timing right.
One of the drawbacks of excessively focusing on getting the timing right is developing the so-called bargain-hunting mentality, because it frequently leads to inaction and an unnecessary delay of a purchase. A bargain-hunter wastes a lot of time and energy searching for the cheapest deal, and a couple of years later no property has been bought yet, because of futile efforts to avail the cheapest possible price every time a property comes up. Meanwhile, the market has risen by 10 percent and the unfortunate bargain hunter has missed out on this growth.
We are not telling you to disregard everything we’ve said about holding a property for the long term. What we are trying to say is that no amount of time can save you if you’ve ventured into a market that you haven’t thoroughly researched. No-frills real estate investment is about buying fair value and holding for the long term, but what’s more important is being aware of the conditions prevailing in the market you’re entering into.
Arm yourself with as much information as possible in order to make a wise decision. If you don’t have time to conduct the necessary research, then find a professional who can provide a sound advice. Holding for the long term is a good strategy for an investment as volatile as real estate, but it’s not always going to save you if you’ve picked the wrong market to invest in.
When it comes to timing, investors must not expend a lot of time and energy trying to predict the peaks and troughs of the real estate waves. A long-term investor is well aware that on average, the value of real estate increases at or faster than the rate of inflation, and that paying fair value for a property in a carefully chosen market is what truly matters.
Rental Yield
The traditional notion is that the higher the yield the better. Sure, it’s the conventional view on yield, or ‘return’ as it is commonly referred to in the share market, where the concept originated and where it is readily discussed.
To calculate yield, add all the income you’ll get from a property for a given year and divide the total by the sale price. Then multiply by 100 and you’ll get the yield in the form of a percentage. This is merely a basic analysis and does not take into account all the factors involved including the cost of your mortgage, property taxes, and other accompanying expenses including depreciation.
So even though it is a rough estimate, the computation does serve as a means to gauge how much your investment will return annually as a percentage of its value. In terms of residential property, yields are usually between 2% and 6%.
Just as a high returning share may entail increased volatility, in real estate, it’s important to understand the dynamics behind high yield, because ‘the higher the yield the better’ does not hold true in all cases. A good example of a scenario where high yield alone does not make for a sound property investment is in the recent trends observed in some mining towns.
For instance, when BHP Billiton Ltd. puts up a local division of its operations in a small town, the company brings with it an army of new workers. These new temporary residents will need a place to live, so BHP leases some 200 houses in the town. The company pays $500 per week to rent the houses that are worth about $250,000, for example. This translates to approximately 10% yield, which is fairly high for residential property. In this case, does high yield alone make the property a sound investment? Not necessarily, because as the yield increases significantly, house prices begin to follow, as other investors try to take advantage and purchase houses in town. This inflates the market unnaturally.
The problem arises when BHP opts to slow down or terminate its operations, say five years down the line. The rents will return to normal rate in the town and house prices follow again, but this time their value depreciates.
If you were ‘unfortunate’ enough to purchase a property in the town at the peak of the price increase, and then wanted to sell shortly after BHP packed up and left town, the odds of either high yield over the long term, or high capital growth would be both very unlikely.
Always treat high yield with caution because it can come at a huge expense to growth. As a smart investor, you ought to have a clear understanding of the dynamics behind unusually high yield. In order to do this, you’ll need to conduct some research, have local knowledge and determine what specific trends are prevailing in the relevant market.
For instance, yield has been rising in Sydney. Rent has tightened and the market has softened, and yields are currently close to 3-4%. This is spurred by several factors, including an influx of new immigrants, majority of whom will likely stay, and which should be beneficial for long term capital growth.
Striking a balance between yield and capital growth is the objective. Bear in mind that markets are geographically determined, with yield varying from area to area. Generalisations like ‘high yields are always good’ and ‘low yield means overpriced real estate’ are risky. You’ll need an experienced and educated mind to see through it.
For instance, waterfront properties have a long history of low yield, but that doesn’t prevent them from being sound investments, because the potential for capital growth is so significant that it can outweigh the deficit in yield. Again, the objective is to strike a balance.
Capital Growth
Capital growth refers to the increase in value of an investment over time. It is measured based on the current value of the property in relation to the amount that was originally invested in it. It is where money is mostly made in residential real estate. As previously discussed, yield is part of the property investment equation but in residential real estate, capital growth is equally (if not more) important.
When taking into account the growth potential of a property, it helps to start by determining what drives property growth in general. First in the list are the forces of demand and supply, which involve the people wanting to buy houses and the availability of such investment property. Supply includes both existing houses and the new ones being built. Demand includes the existing population as well as the new population arriving or departing.
Demographics is a big factor in the supply and demand equation, and capital growth potential. For instance in Tasmania, the lack of population growth has a negative effect on property prices. Statistics revealed that from June 1992 to September 2002, the population of Tasmania witnessed steady quarterly net migration losses. In four years – from 1997 to 2000 – the losses resulted in absolute decline, as the net outflow of migrants surpassed even the gain from natural increase.
Unlike other capital cities in Australia, property prices in Hobart saw minimal growth. If you had purchased a house in 1986 and held onto it for 15 years, it would have been worth approximately the same in 2001. That’s far from being a sound investment.
There is certainly a strong demand for housing, but as smart investors, we won’t stop our analysis of the region because supply needs to be taken into account as well. There is a profusion of developers in the Gold Coast area, but how this plays out will still depend on how the market behaves. If you are considering an investment, you’d want to know how prices are being affected by supply. Whenever the scale is tipped, you’ll have either a positive or negative change in prices.
Inflation in the construction industry is another factor that can exert upward pressure on house prices and spur capital growth. Supply and demand can be static, but if the cost of building a house increases, then so do house prices in general. As the salaries of builders increase and as the cost of construction materials rises, the price of building a house also goes up, making the property more expensive. This price increase spreads to other houses in the area, even if they were constructed at a lower cost.
Another factor that affects property prices and capital growth is money supply. Interest rates have a profound effect on money supply because the more they drop, banks tend to lend more based on how their formulas work internally. Money supply is also affected by the invention and development of financial products. Generally, If you have a loan to valuation ratio of under 80% you avoid having to pay Lenders Mortgage Insurance (LMI). Borrowing limits have tightening across the board, especially in areas that the lenders deem to be ‘high risk’ of a capital loss or extended rental vacancies such as regional mining towns who rely of cyclical industries to fund the local economy. Banks are less aggressive in allowing people to refinance existing loans and use equity to fund the purchase of the next investment property and we believe this is a trend that will continue into the future.
All facets of capital growth can be explained by supply and demand, inflation, and/or money supply. So if you’re eyeing a property that has doubled in value, it’s doubled because of one, two or all three of these factors.
Choosing Between a New versus Existing Dwelling
Purchasing a new property, holding to it with minimal capital expenditure and forgetting all about it for a decade does not make for a great dinner party conversation. What’s better is to purchase a renovator’s delight, pay for land value, demolish the structure, build a new house, and make tons of money. However, the first scenario may prove to be a much better way for a person with a regular day job to invest in.
Not everyone has the desire or the time to spend endless weekends renovating a property. If you happen to have the time, knowledge, skills, and dedication, then it’s probably advisable to stay away from new, but a lot of people would rather spend their weekends with their family instead of doing some tedious renovation jobs. If you’re one of them, then it is worth considering why a new property can be a wiser, cheaper and more relaxed way of investing in real estate.
Let’s start by knowing what goes into the value of a property. When you pay $500,000 for a property you are essentially purchasing two things: land and physical structure. The former is an appreciating component, assuming that demand is driven by immigration and other factors. It becomes more valuable over time. In stark contrast, the physical structure depreciates and only becomes less valuable with time. So property has two components: land value and physical structure, one goes up in price while the other goes down.
The extreme version is purchasing a property and not spending a cent on it for years. You can just imagine how deteriorated it would be. Later, when you decide to sell the property, all that you’ll recoup is land value. However, this is not always the case.
What really happens is the structure deteriorates, and needs to be upgraded with new floors, bathroom, kitchen, and so on. One thing that goes unnoticed is capital expenditure which pertains to the spending involved in keeping the structure up to scratch. This is a key concept, because it involves a substantial amount of money and it’s not mentioned in any real estate data.
When that $500,000 property becomes a million dollars, what is not mentioned is the amount of capital expenditure during the period when someone owned it and spent for its upkeep. When a $500,000 share portfolio rises to a million after ten years, there is no capital expenditure involved. But in real estate, billions of dollars are spent annually on improving or upgrading the structure of investment properties. It is a figure that is not calculated or factored in when assessing growth. When median house prices are calculated and their growth is documented, there is no mention about capital expenditure, but there should be.
Owning an old property entails huge costs, yet it has been estimated that about 90% of people who decide to invest on property without seeking any assistance will likely purchase an old property. It’s puzzling and we can only assume that when it comes to choosing between old and new, people often associate new with higher cost, but not everything is as it seems.
The truth is that it’s about three times the cost to own an old property as it would be to own a new one of the same value because of the extra tax benefits you can claim, generally for the same out of pocket costs. If you are looking for an investment property worth half a million dollars, you may need to spend $15,000 annually to run if it’s old, and only $5,000 annually to run if it’s new.
Moreover, buying new gives a property with no capital expenditure for as long as possible. It could be five years, sometimes even up to 10 years, before you really start spending $20,000 for a new bathroom or kitchen. A new property also requires minimal or no investment of time for maintenance purposes. The bottom line is that when buying new, choose wisely and go for a rentable property that will give you a good yield from day one. It’s a bonus if it will cost you virtually next to nothing to hold that you can afford to forget you actually have it.
Owner-occupier Appeal
Knowing what specific features of a property make it easier to sell is perhaps the single most important yet often overlooked point when venturing into property investment. When purchasing shares, you don’t think about exit strategy because it only costs $30 to sell your shares, but it certainly doesn’t cost you that to dispose off your property quickly.
It costs a significant amount of time, money, effort, negotiations, real estate commissions, stress, and heartaches. The hard truth is that it’s a pain to sell a property. So anything that can minimise stress and raise the final price is good. By far the best way to handle exit strategy issues is to purchase something that an owner-occupier would be eager to buy later.
It has been shown that 7 out of 10 homes in Australia are owner occupied. Hence, owner occupiers have the lion’s share in terms of demand for residential property. If you invest in a property that appeals to owner occupiers, it will appreciate faster compared to a B-grade property that is being marketed to investors.
Moreover, at any given time, at least 80% of buyers in the market are owner occupiers, and the rest are investors. So if you are trying to find an investor to purchase your property, in some cases you may actually be looking for the proverbial needle in a haystack.
For instance, a serviced apartment is an investment that from the start would seem to be a decent option. A holiday rental, for example, in an up-and-coming resort town, which yields high rent during weekends and holidays. However, when you try to sell it later on you’ll find out that there is only a small number of prospective buyers. Compare it to a unit in a small block, on a serene street in a green area of Sydney, with easy access to the CBD. You’re appealing to a much bigger pool of buyers. Hence, it will make selling your investment property a lot easier, and with a much better end result.
Infrastructure
Think of a house in the middle of a desert, with nothing but sand around it. On its own, the house has a certain value. Then someone comes along and decides to build a big industrial estate. The value of the house will likely appreciate because of something that has transpired next to it. Another person comes along and puts up a cafe nearby and not long after someone else arrives and builds a school and a road. All of these developments affect the value of the house.
In the same manner that the house in the desert gained huge value from a lake, shop, school and road that appeared nearby, a suburban Brisbane house, for instance, can appreciate in value because of what’s going to be around it. What we’re trying to point out is that it pays to consider what infrastructure is located close to a prospective investment, and what other infrastructure are in the works.
For instance, in the area you are eyeing to invest in, there may be plans for an industrial site to change zoning and then turn into a supermarket. This particular change alone can affect the entire face of the area, and raise the value of your investment.
Infrastructure also plays out on a much larger scale. For instance, the state government decides to construct a $2 billion port in an area which was once purely industrial. What that typically means is a significant change in the entire area, including a sharp increase in employment opportunities. More jobs mean more people wanting to live nearby, which puts upward pressure on housing. So huge infrastructure projects are a leading indicator of what the future holds in terms of house prices in the area in two or three years down the line. Therefore, it’s good to know where and what infrastructure is being built.
Note that there are instances when infrastructure has a negative effect on the value of a property. For example, the Westconnex roads project in Sydney could negatively impact the value of a house if it were close by.
Infrastructure can and does have a serious and far-reaching effect on property values. You need to have extensive knowledge and understanding in order to be able to make a wise property decision, which means either conducting research or employing someone to do it for you.
As you’ve gleaned by now, there are several crucial considerations that go into making a sound real estate investment decision. Arm yourself with as much information as possible in order to end up with the best decision. You can do the research and data gathering on your own or you can get people to help you with the decision-making process.
So what are the available sources of advice? The mainstays are your local real estate agent, books or a get-rich-quick seminar run by people with questionable qualification and motives. Credible and reputable property advice is not easy to find, and it continues to be unregulated.
The property advice sector in Australia is largely unregulated. Federal law and the Australian Securities and Investments Commission (ASIC), which enforces corporate and financial services legislations to protect consumers, creditors and investors, don’t recognise property as a financial product. Meanwhile, state-based legislation, which is meant for real estate agents, does cover the mechanics of property transactions, but makes no mention on how to advise about it.
As a result of this legislative vacuum, it’s very difficult to find a reputable adviser who specialises in investment property. Moreover, this area has been tainted in the past by unregulated operators who exploited the desire of everyday Australians to seek advice on how to venture into the investment property market.
The good news is that a new generation of professional property advisers are emerging and filling that void, bringing planning and research-based principles. A good place to search for the right professional is the Property Investment Professionals of Australia (PIPA). PIPA is the peak industry body developed to bring about standards and accreditation in the Property Investment Industry. As such all their members subscribe to a voluntary Code of Conduct and are committed to fostering best practice by raising standards, facilitating professional development and market integrity. Your Financial Planner or cannot recommend a specific property for you to buy.
We support clients seeking professional property advice most likely via a fee for service buyer’s agent. Fees for this service vary, however the cost of selecting the wrong asset are huge. Beware, as not all buyer’s agents are created equal, plus due to the lack of regulation they do not have to disclose their sources of remuneration. Be sure that they are acting in your best interest, rather than theirs. As always, seek professional financial advice before taking any action.
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Author: Pat Casey – Managing Director & Financial Planner Sydney – Assure Wealth
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Disclaimer: The information provided on this website has been provided as general advice only. Assure Wealth does not provide direct property advice. We have not considered your financial circumstances, needs or objectives and you should seek the assistance of your Walker Lane Pty Ltd Adviser before you make any decision regarding any products mentioned in this communication. Whilst all care has been taken in the preparation of this material, no warranty is given in respect of the information provided and accordingly neither Walker Lane nor its related entities, employees or agents shall be liable on any ground whatsoever with respect to decisions or actions taken as a result of you acting upon such information.
Assure Wealth Pty Ltd ABN 31 965 466 780 Corporate Authorised Representative no. 1244817, Patrick Casey Sub-Authorised Representative no. 1244748 of Walker Lane Pty Ltd ABN 70 626 199 826, an AFSL holder No 509305.
