Buying a rental property is a popular form of investment. Houses and units are easier to understand than many other forms of investments. However, they do have some complexities that you need to be aware of. Before you enter the property market, make sure this type of long-term investment suits you and your wealth accumulation goals.
Pros & Cons of Property Investment
- Property can be less volatile than shares or other investments
- You can earn rental income and benefit from capital growth (if your property increases in value over time)
- If you take out a loan to purchase an investment property the interest on the loan is tax deductible
- You are investing in something you can see and touch
- Rental income does not usually cover your mortgage payments or other expenses so you may have to use your regular income to cover these costs
- A jump in interest rates will affect your return and decrease your disposable income
- There may be periods of time where you don't have a tenant and will have to cover all costs yourself
- You can't sell off a bedroom if you need to access some cash in a hurry
- If your property investment is your major investment then you may have little or no diversification
- If the property market goes down so does your whole investment. There are many instances where people have ended up owing more than their investment property was worth, this is known as negative equity
- There are very high entry and exit costs
A note on diversification
If you invest exclusively in property, you will have a lot of money riding on one small market e.g. the North Sydney apartment market. If you also own your home, you will have all of your wealth concentrated in the residential property market.
This is poor diversification and increases your risk. Investments such as managed funds allow you to invest in both shares and properties across several markets which reduces market risk factors.
Buying an Investment Property
Where and what you buy will affect your return on investment.
Where to buy:
- Think twice about investing in property markets you are not familiar with, for example one recommended by a property developer
- Buy in a high-growth area where there is potential for capital gains. Read the newspapers regularly to pinpoint the up and coming suburbs
- Look for properties that will appeal to tenants e.g. properties with a view or are close to shops, schools and transport
- Research recent sale prices to give you an idea of what you can expect to pay for property in the same area
- Find out about the vacancy rates in the neighbourhood. A high vacancy rate may indicate a less desirable area. This may make it harder for you to rent your property and may make it difficult to sell in the future
- Think about changes in the suburb that will affect future prices. Things like planned developments or population changes can affect the future value of a property. Don't assume that last year's boom will continue forever
What to buy:
- Look for properties with features that will appeal to as many people as possible e.g. second bathroom or lock up garage
- Look for a property that will attract more than one segment of the rental market such as singles, couples, young families or retirees
- Low maintenance costs are important
- Units can be easier to maintain than houses, although you may need to pay body corporate fees
- When deciding if a property investment is right for you, remember that property prices can go up and down
Buying, selling and managing an investment property can be costly and will affect your return. When you buy a property, you will have to pay for lots of extras on top of the purchase price. Costs may include stamp duty, conveyance fees, legal charges, search fees, and pest and building reports.
As the owner, your costs may include council rates, water rates, insurance, body corporate fees, land tax, property management fees and other costs. Don't forget interest repayments and possibly tax to be paid on your rental income.
If you sell the property, you will have to pay agent's fees, advertising costs and legal fees. You may also have to pay capital gains tax.
Work out your Investment Return
Once you've decided where and what you want to buy, work out how much money you can potentially earn from your investment. Long term, you will be more secure if your rental income largely covers the ongoing costs of holding a property i.e. interest and expenses. If you have a shortfall, consider whether you can sustain this over the long term.
Borrowing to Invest
Most people will borrow to invest in property (called 'gearing'). Remember that the more you borrow, the more you stand to gain or lose and the more it will cost you in interest expenses. That's why you have to be very sure that your property will earn a positive return over time.
Managing an Investment Property
You have two options when it comes to managing your property: you can do it yourself, or engage a managing agent to do it for you.
If you manage the property, you can avoid paying management costs. The downside is that you will have to do everything, from showing the property to tenants to collecting rent and organising repairs. You also need to comply with landlord regulations.
You can avoid this hassle by asking a managing agent to look after your house or unit. You will have to pay them management fees but these are tax deductible.
While you don't need to pay for home contents insurance, you will need to organise building insurance. This covers you for full building replacement if, say, the house burns down.
It's also a good idea to take out landlord insurance. This protects you if your tenant damages the property or if they run off without paying the rent. The cost of landlord insurance is tax deductible.
If you are relying on part of your employment income to cover the interest cost and expenses, make sure you have adequate income protection insurance. Your ability to earn an income may be the most important asset you have.
Investing in property is a good way to grow your assets. As with other types of investments, it's important to do your research and seek professional advice if you're unsure about anything. Contact Southern Advisory to discuss your wealth accumulation strategy and whether property investment is right for you.