With the rapid rise in prices in 2021 and now the rise in interest rates in 2022, there is a lot of negative press around about the viability of property investment, so is it still worth it?
There are a number of factors to consider when trying to answer this question and it boils down to these three key questions:
What is the cost of owning an investment property?
Is investing in property still viable when considering return vs cost?
Can I live with an investment property?
To answer these, we need to break down what property investment looks like. Property investment can be split into two different categories - capital and income. But for this sake, we will focus on the income side in this Thrive Bite.
Another way to describe income is cash flow. Here's how we calculate cashflow:
Revenue - Expenses = Cash flow
For property, this can be expressed as:
Rent - Operating Costs (interest, insurance, rates, body corp, etc.) = Cash flow
In the current environment, this equation will likely result in negative cash flow due to higher interest rates. This negative cash flow is commonly referred to as a 'cost to own'.
Let's look at a real-life example:
A new build investment property is purchased for $650,000 with 100% lending
Market rent for this property is $480/w and we allow for 2 weeks of vacancy
Costs (including loan payments) are estimated to be around $33,600 per year
Cashflow calculation:
Rent - Operating Costs = Cost to own
($480 x 50 weeks) - $33,600 = $185/w cost to own
Because the cost of ownership is almost inevitable in today's market, it's important to compare the return investors can make on the property in comparison to the cost of owning that asset.
In its most basic form, a viable investment can be defined as an investment in which the projected return outweighs the cost of the investment.
For property investment, we say that as long as the forecast equity outweighs the cost of ownership over the investment term, then it is a viable investment.
Forecasting equity is as simple as prescribing a capital growth rate for a property over the investment term and then subtracting the mortgage. For instance, if we used a capital growth rate of 5% over 10 years for the property in the example above, the forecast equity would be:
Property value now | $650,000 |
Property value in 10 years (at 5% growth) | $1,058,782 |
Mortgage value in 10 years (assuming interest only) | $650,000 |
Forecast equity | $408,782 |
In the example we have used, the cost of owning this property is $185/w which is $106,472 over 10 years (if the cost were to remain consistent). Since the forecast equity outweighs the cost of owning the property, this is a viable investment.
Despite the fact that the investment still stacks up, investors can do even more to reduce this cost of ownership.
Buying new-build investment properties can attract a discount interest rate from some main banks which will drop the cost of borrowed money from the current market rate.
At the time of writing this, ANZ has a discount floating rate which is discounted by 2.76%. Albeit, this is only for two years, every 1% saving on the interest rate saves roughly $6,500 per year in extra cost.
Negotiating a discount as a cash-back at settlement is another tactic.
Rather than a direct price reduction, your lawyer returns a small amount of the purchase price as cash to you (say $10k) as a buffer. You may decide that you will consume this to subsidize the cost of ownership and if stacked with the first tweak, the property could potentially run at no cost for a number of years.
If no cash-back is available, have your mortgage broker arrange a revolving credit facility of $10k as a buffer which you can use in conjunction with the first tweak to run your property at a smaller cost.
This may all sound short-term, and it is.
Property is normally a long-term investment and the housing cycle mirrors the business cycle which most people accept is around 10 years and the goal is to be able to live with your investment long enough to see a meteoric growth phase.
As a result, the fourth tweak to make isn't a financial one, but a mindset change. Investors, especially new investors, have very short financial horizons in mind.
We are at a point in the property cycle where prices have accelerated rapidly and rents have lagged. This is not surprising as most properties are leased for a year and landlords are reluctant to increase rents on good tenants even at rollover dates (and fair enough).
It is typical for the relationship between the cost of an investment property and the income it generates to be a little stretched at this point in the property cycle.
Rents will gradually drift upwards so the options in this explainer should be thought of as 'bridging strategies' so that by the time the property is fully independent, rents will have returned to a level relative to price and as a way to enable the investor to start populating their portfolio now.
So yes, property investment is still a viable investment despite rising costs, but these costs won't last forever either. When rents go up and prices level out, the attractiveness of property will escalate further.
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