Can I Afford an Investment Property?
8 min read
This should come as no surprise but Australians love property and they especially love investment property. I’m sure at some stage it’s crossed a lot of your minds becoming a property mogul and having a multi-million dollar portfolio. It’s official, the most common path to ultra-wealth in Australia is property, with 50 of the BRW Rich 200 making their fortune from bricks and mortar.
But before we talk fast cars and beach side mansions let’s start small and look at what it takes to get an investment property today.
Cash Flow – What disposable income do you have each month to contribute towards an investment property?
Are you a first time home buyer looking to rent out your investment property? Or do you have an existing home with a mortgage and wanting to invest in another property? You must be able to plan for the newly added expense and we highly recommend building a buffer for unexpected costs or time the property goes untenanted. Here is a real life example of these costs, although there are many calculators available to do this legwork but we like this one.
Timing – Is now the right time in your life to be taking this leap?
If your employment isn’t exactly stable or you have a partner and are thinking of having a baby in the near future, this may not be the right time. Another element a lot of people attempt to consider when it comes to timing your purchase is the property market. While opinions differ on this topic, Entourage Finance believes that when it comes to timing your purchase we advise to ‘Buy well’ and ‘Hang on’. This gives the property a chance to grow in value. Often people say they are waiting for a crash before buying in Melbourne. In a weak market and in our experience, quality properties in quality areas don’t crash, they plateau.
So you’ve worked out you can afford the investment property and it’s the right time for you, but what next?
Borrowing the Money – How do you plan on financing your purchase?
After crunching the numbers, you are certain you can afford this purchase.
However, sadly (and maybe luckily!) lenders won’t take your word for it. They will do their own assessment on your ability to service the loan. When it comes to servicing calculators, lenders insert large buffers on what you can borrow to protect themselves and you simultaneously. For instance, the interest rate the lenders may assess you at 7.5% paying principal and interest. However, when you actually get the loan, you may get a rate of 4% paying interest only which is a significant difference in monthly commitments required. It’s at this point in the process we can’t stress the importance of a mortgage broker. Having up to date industry knowledge indisputably saves you your most precious commodity, time.
If you pass all the above and you have gained pre-approval to buy, it’s time to shop around for a good investment property.
Selecting the Right Investment
There is one main performance question to consider when looking for an investment property;
Do you want solid Capital growth OR a High rental income?
Of course everyone wants both.. and if you stumble upon a double whammy you capture that unicorn and contact me immediately so we can put it out to stud!
But back to reality…. See the following examples of 2 properties performance. If you were to buy an old unrenovated house in Preston 5 years ago on a 500sqm block of land, you would have seen amazing growth but a rental yield of either 3% or below. On the contrary, if you purchased a brand new apartment in the CBD or surrounding areas, you could achieve a rental return of 5% but the capital growth is next to nothing or sometimes backwards over the past 5 years.
Successful clients I’ve spoken with over the last 10 years have normally opted for capital growth over rental returns. If you are younger I believe you should always aim for capital growth in order to build equity which will give you options down the track. See below a 5 year example:
|Preston House – $600K
Rental income @ 3% – $18K per annum
Capital growth @ 10% per annum = $966K approx.
|CBD apartments – $600K
Rental income @ 5% – $30K per annum
Capital Growth @ 1% per annum = $635K approx.
If we look at what’s happened over 5 years, the CBD apartment has grossed $60K more in rental income. For the sake of simplicity, we won’t factor in the expenses that come with a CBD apartment like owner’s corporation fees, which would be in the $1,000’s.
The capital growth of the Preston house with its own component of land has outperformed the apartment by $330K. If we minus the gross rental return of the CBD apartment then the Preston house is $270K in front. If a buyer purchased the CBD apartment instead of the Preston House, this $270k would be what we refer to as the opportunity cost – the loss of other alternatives when one alternative is chosen. But more on that in our next blog piece.