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A Complete Guide to Investing in Residential Real Estate

It’s been interesting throughout my career to see how differently clients can see property as an investment vehicle. There really are two very different schools of thought relating to property investment – those who believe bricks and mortar are the safest and best investment of all, and those who would not touch an investment property under any conditions!

Why are there such varying opinions on the validity of property investment and where does the truth lie?

Using the original principles of the economic clock we can see that residential property investment has its place in any investment strategy. It is a well known and defined market that has helped many Australians on their road to financial freedom. I myself have bought a unit, townhouse, house, and even just land itself and although some have been more successful than others haven’t been disappointed with the results.

Most people have an opinion on the benefits of property investment – whether they own multiple properties or none at all!  You may know friends or family who have done extremely well from property investments in the past, or alternatively know people who have had to sell property as they decided they were not comfortable with the ongoing financial drain or hassle of tenants.

There are some fundamental rules which should be followed to ensure successful property investment.  A surprising number of investors do everything the wrong way and the result can be quite horrific. Timing of the investment, financing and tenanting are three major factors that can turn the tables on a potentially successful investment. Remember, residential property investment can be an excellent vehicle to use in the wealth creation process, but like all investments it must be approached with the right attitude and knowledge to ensure that the maximum benefits are gained.

Residential property prices have increased steadily over Australia’s history. This ongoing growth can be attributed to a number of factors such as inflation, population growth and fundamental supply and demand. One of the founding principles of rising property values stems from the fact that there is only a limited amount of land available. This underlying demand, for a commodity that is in limited supply, is what pushes up property prices over time.

 

CAPITAL GROWTH   VS   INCOME

Property can be purchased either for capital growth or for income-producing purposes.  Most property investors who use negative gearing are investing for capital growth. They are prepared to contribute money towards the investment now in the belief that its value will increase substantially in the future. In fact if a property is negatively geared you MUST have growth for it to be successful. Otherwise, at best, it would just end up an expensive forced savings plan.

Other investors purchase investment properties purely for the rental income derived.

Whichever type of investor you are, it is important to understand the limitations and benefits of your property with respect to the income potential and capital growth potential in the future. Most investments have a trade-off between income and growth. In other words, if the primary objective of your investment is to derive income, you may have to sacrifice some capital growth potential.  Similarly if your investment aim is to generate capital growth from your assets, you may have to settle for a lower income from the investments. A high income, high growth investment is something I am often asked if I can help find a client, and of course this is the holy grail, so good luck finding it!

As a long term investment, residential property can provide many benefits to investors. It is a solid wealth creation asset that can be used to accumulate equity and strengthen net worth. One of the major benefits of property investment is the stability it invokes. Unlike the share market where prices are very volatile moving both up and down frequently – property prices tends to be more stable.  Increases in property prices are more likely to be followed by a flat period rather than a downward movement. It’s a “staircase” on the graph, rather than a “roller coaster”.

RISKS ASSOCIATED WITH PROPERTY INVESTMENT

Like any investment, property has a number of risks which must be taken into account by all potential investors.  The most common concerns with property relate to two things:

  1. Vacancy
  2. Capital Growth

The first risk is that the property will remain vacant and the owner will be forced to carry the entire cost of the investment without the aid of rental income. This is an extremely important concern because whether the investor is looking for a stable income stream now, or capital growth in the future, for the investment to be profitable it must have tenants paying rent on a regular basis.

The second issue relates to the potential for capital growth from the investment. This is the fear that the property will not increase in value as we hoped. This risk can be minimised by researching property decisions in depth and looking at a variety of factors that may affect capital growth in the future.

One of the comforting aspects of property investment is that it is very forgiving over time –  even if we have not made the best investment, generally if we hold it for long enough, it should increase in value.  Be aware though, that it you take this approach you must be willing to sit and wait for that growth to happen!

Residential property investment will not be appropriate for everyone at every stage of their wealth creation process.  But it is an important sector that can markedly increase investment returns and generate wealth both now and in the future.

SELECTION CRITERIA

When choosing a residential real estate investment there are a number of factors (selection criteria) that investors should consider

POSITION

MAJOR CITY:  In most residential property situations suburban areas in close proximity to the city or a.significant growth centre will provide higher capital growth opportunities.

CLOSE TO AMENITIES:  Areas that have a close proximity to public infrastructure such as schools,  shopping centres, hospitals, parks and restaurants will tend to maintain and improve their value over time.

PROXIMITY TO TRANSPORT & ROAD SYSTEMS:  With the modern time pressures faced by both individuals and families, a residential real estate property with close proximity to public transport infrastructure (such as trains, trams, ferries, bus routes and suburb to city road links) will only increase in value as cities become more crowded.

AGE

DEPRECIATION:  A newer property will attract considerable tax advantages which can be offset against the investor’s income and considerably reduce the holding costs of the investment.

ATTRACTIVE TO TENANTS:  The more attractive that a property appears to prospective tenants the easier it will be to rent.  In determining the type of property to purchase attention should be paid to the type of people who live in the area ie university students, young professionals etc. This point is often overlooked to the detriment of investors.

LOW MAINTENANCE / COST:  The newer the property the lower, generally the maintenance costs will be. Older properties require a higher level of maintenance, this can be very time consuming for the owner or very costly when a property manager is looking after the investment property.

MANAGEMENT

Property Management and who you choose to manage your property is extremely important. They are managing one of your biggest assets. Imagine how much thought you would put into someone who is managing a $700,000 share portfolio for you.

A good manager will screen tenants before they put them in your home, they will do 6 monthly inspections and will be on top of any problems long before they become irreparable, they will take care of leasing paperwork and provide tax invoices and receipts for tax time. A good property manager will have contact with local handymen and will often get a discounted rate because of the relationship they have built. A good manager will also know when its time to increase rent and how to be fair and kind to both parties. Afterall, the more you look after your tenants, the more your large asset gets looked after.

Fees are generally the same between property managers so what you are looking for is someone that you can trust and who will look after your property as it its their own. If you have a Brisbane based investment property please speak to Hudson about using the Grow property group to fill this void for our clients. Grow actively manage my properties.

TAXATION CONSIDERATIONS

The Australian Taxation Office allows investors to claim a deduction for some of the expenses  incurred for the period the property is rented or available for rent. If the property is not available for rent for the full year, expenses will need to be apportioned on a time basis.

Common expenses which may be deductible in full are:

  • advertising for tenants
  • agent’s commission for managing the rental property
  • lease preparation
  • insurance – building, contents, public liability and mortgage insurance
  • interest on loans used to finance the rental property
  • rates, water and land tax
  • repairs and maintenance (replacing broken windows, maintaining plumbing, repairing electrical appliances etc.) Note: you cannot claim landscaping and insulating the house as deductions.
  • gardening and garden maintenance
  • travel and car expenses

Incidental Costs incurred in the acquisition and disposal of the property are not tax deductible as they are classed as Capital Expenditure items.  Investors do not miss out completely as the costs associated with buying and selling an investment property benefit the investor because the costs are added to the original cost base of the property and hence lowers the Capital Gains Tax liability that may be applicable on the sale of the investment property.  These include:

  • fees, commission or remuneration for professional services (e.g. by a valuer, accountant, solicitor, etc.)
  • costs of transfer, including stamp duty
  • costs of advertising to find a buyer
  • costs of financing (e.g. bank charges, establishment costs of loan).

DEPRECIATION

Depreciation provides a basis for writing off the capital cost of an item over its estimated life. In the case of rental properties, it affects such items as furniture, washing machines and carpets.

For taxation purposes, you can claim a percentage of the cost of each item each year as a deduction for depreciation.  Where the item is used to produce assessable income for only part of the year, your depreciation deduction is reduced accordingly.

Construction Costs – building write-off deductions may be allowable for the construction costs of income-producing buildings.  This amount will depend on the date the construction began, as shown below.

Date Construction Began                                                                                   Rate per annum

 

Before 18 July 1985                                                                                          Nil

18 July 1985 to 15 September 1987                                                                   4%

After 15 September 1987                                                                                   2.5%

You are allowed the deductions only for the time the property is rented out or is available for rent.

OTHER EXPENSES

1/ Legal Expenses are generally of a capital nature and are therefore not deductible.

Some non-deductible legal expenses are costs relating to:

  • the recovery of damages against a neighbour
  • purchase or sale of the property
  • defending the title to the property
  • eviction of a non paying tennant

2/ Borrowing Expenses are expenses directly incurred in taking out a loan for the property.  These include establishment fees, valuation fees and costs for preparing and filing mortgage documents.

If the total cost of these items is $100 or more, they are apportioned over 5 years or the term of the loan, whichever is the lesser.  If the total is less than $100, they are fully deductible in the year they are incurred.

3/ Acquisition and purchase Costs are not able to be claimed as a deduction.  Unless the property was acquired after 19 September 1985, these costs are then considered as capital expenditure and increase the cost base which reduces Capital gains Tax on disposal.

KEEPING RECORDS

It is advisable to keep records of both income and deductions relating to a rental property for at least 5 years from the date you lodge your tax return.

You must keep records relating to the acquisition and disposal of the property and depreciable items for 5 years after  the disposal of the property.

LEGAL CONSIDERATIONS WHEN PURCHASING A PROPERTY

When contemplating purchasing a property, whether it be for investment purposes or simply a principal place of residence it is imperative to have appropriate legal advice to safeguard both yourself and the property.  Before continuing it is necessary to define some different legal terms you will come across when dealing with property-related issues:

Contract of Sale (Offer and Acceptance): a contract used in the transfer of property which sets out the terms and conditions relating to the purchase / sale.

Certificate of Title: a document which shows the registered owner of land under the Torrens system.  It details the dimensions of the land and whether there are any encumbrances on it

Settlement: the completion of a sale.  The purchaser hands to the vendor a bank cheque for the balance of the purchase money.  The vendor in turn hands the purchaser the completed transfer documentation to allow the transfer to be registered.

Vendor: the seller of the property.

Mortgage: a form of security for a loan.  Typically property which is held as collateral security to ensure the borrower repays the loan.  The lender, the mortgagee, has the right to take the real estate if the borrower, the mortgagor, fails to repay the loan.

Mortgagor: the person who borrows the money.

Mortgagee: the person or body who lends the money.

Vendor’s Statement: document setting out various details relating to the property.

Conveyancing: the legal process for the transferral of ownership of real estate.

Contract: is a legally enforceable agreement  between individuals or entities.  In terms of property, contracts are typically exchanged when the deposit is paid.

Joint Tenants: a form of ownership of property where two or more persons have joint ownership.  If one party dies, their share passes to the survivor/s.

Tenants in Common: a form of ownership of property where two or more people have equal or unequal holdings.  If one party dies, the property is divided according to law. That portion of ownership of the property becomes part of the estate of the deceased and is treated accordingly by the laws of succession.

If you are successful in buying the property of your choice, you will need to ensure the following documents are completed:

  • Contract of Sale (Offer and Acceptance in WA)
  • All documents necessary to transfer to the title into your name.
  • Mortgage documentation
  • Insurance policies

Your solicitor will assist in the completion of all the necessary documentation and in agreeing upon the settlement date with the vendor.

STRUCTURING A LOAN FOR A RESIDENTIAL PROPERTY INVESTMENT

TERM OF THE LOAN

When it comes to choosing the term of you loan, you have three options to consider;

  • to pay interest only
  • to pay principal and interest, or
  • to have a combination of interest only and principal and interest payments

In general the term of a principal and interest loan will be over 20 to 30 years. The longer the period the lower is the committed payment. Increased payments at the borrowers discretion will reduce the period of the loan without financial penalty for a variable loan rate.

INTEREST RATES

Interest rates are very competitive between the lending institutions looking for your business. Interest rates quoted will be either fixed or variable and these can be combined with interest only and principal repayments. Standard interest rate combinations for an investment property loan include

  • variable, interest only
  • fixed, interest only
  • variable, principal and interest, and
  • fixed, principal and interest.

These combinations allow flexibility in the loan structure so that the individual borrower can choose the loan structure that is applicable to their own situation. A variable rate loan will consist of an interest rate that will fluctuate with market movements. This loan will allow the borrower to make repayments above the required set repayments stated.

A fixed rate loan will have a fixed interest rate that is agreed upon for a set period of time. This loan will not allow any extra payments to be made.

Interest only payments require only the minimum repayments of interest to be repaid, whereas principal and interest repayments require higher repayments than interest only repayments but will reduce the debt and increase equity for further investments.

Within the term of the loan, borrowers can switch from variable to fixed, from fixed to fixed or from fixed to variable. Switching will probably incur a switching fee for doing so. Lending institutions allowing switching from a fixed rate to another fixed rate or a variable rate during the agreed term, can be subject to a prepayment cost or benefit. This will depend on the prevailing interest rates at the time. For example, if the interest rate is higher than the existing fixed rate then a benefit will occur, whereas if the interest rate is lower than the existing fixed rate then a cost will be incurred. Other institutions will charge a prepayment fee of usually 3 months interest to switch.

The interest rate applicable to the loan will be calculated on the daily balance and charged to the loan account monthly.

Going one step further, a Revolving Line of Credit or a Home Equity Line can be used to aid in the funding of the purchase. This facility establishes a credit limit which is very similar to a credit card, but it is secured by a registered mortgage over your property. The facility can be used to fully fund the investment property or to fund a 20% deposit and any expenses outlayed for the purchase, such as bank and government fees, solicitor fees, stamp duty on the purchase contract and any other fees applicable to the purchase. The Line of Credit is basically an interest only facility, with the interest rate generally being 1% above the standard variable Home Loan rate. The interest rate cannot be fixed, so it will fluctuate with the variable rate.

USE A LENDING ADVISER, specifically Hudson’s

Don’t approach a bank directly  – you will not be able to receive an unbiased opinion and I can almost guarantee you that the interest rate on offer will not be as competitive compared to using a broker.

Don’t do it online – there are various pitfalls and traps out there and a broker can give you invaluable advice to avoid these and also on the best structure  for the lending.

Don’t use any old broker – Speak to Brendan Gilmour at Hudson Financial Planning. Brendan has a background in Law and can provide you with the best advice on how to structure your lending. Due to the magnitude of lending we do at Hudson we have access to rates than many other brokers do not.

SECURITY

The lending institutions issuing the finance will register a first mortgage over the property to be purchased to secure its liability. Generally speaking, lending institutions will lend up to 80% of the assessed value of the property. The borrower is required to contribute the remaining 20% of equity. The remaining 20% of equity required will be available via a cash deposit already saved or by unlocking the equity available in an existing property.or other asset (If using equity in another property the lending institution will require that their interest be noted on the mortgage, that is, they will register a charge over the property offered as security.)

LENDERS MORTGAGE INSURANCE, LMI

Generally speaking any debt that is applied for above the maximum loan to valuation ratio of 80%, will often require the borrower to pay Lenders Mortgage Insurance (LMI). Therefore, LMI is applicable if the total borrowings are more than 80% of the total lending institution’s assessed value of the property. This is an additional cost which the borrower pays but it protects the lending institution should the borrower default. With investment properties, the lenders will expect a minimum deposit of 10%, that is a maximum LVR of 90%. The cost of Mortgage Insurance that is applicable, will vary due to the product type, the purpose of the loan, the property value and the size of the borrowings. Mortgage insurance can also be incorporated into the total loan amount if equity is available. There are exceptions to 80% rule for LMI – called LMI Waivers, offered by certain lenders including up to 85% for owner occupied borrowers, as well as LMI waivers up to 90% (whether owner occupied or investment) for various occupations and professions. For medical professionals it is even possible to borrow 95%-100% of the value of the property.

FEES & CHARGES

Fees and charges will consist of two sections, Bank fees and Government charges.

Bank Fees; The main Bank fee is a loan application fee. This can generally range from $300 to $1000. This fee will usually include the loan assessment, valuation, legals and the settlement itself. If the fee is low, expect to pay additional for each separate item.

 

Another fee which may be applicable to certain lending institutions is an ongoing fee or a loan administration charge for the loan facility that is in place. This fee will generally range from $0 to $30 per month.

Government Fees; Government fees are where the majority of costs will be incurred. Fees applicable will consists of;

  • stamp duty on the mortgage
  • registration of the transfer of land
  • registration of the mortgage
  • discharge of the existing mortgage, and
  • government search fee

These fees will vary depending on the State in which the property is purchased, the value of the property under consideration and the level of debt incurred.

All bank fees and Government charges can be financed or incorporated into the loan amount if there is available equity to do so.

Disclaimer:  This document has been prepared for persons interested in the information for their own purposes.  The material herein should not be construed as advice.  It has been prepared as general information and thus cannot take into account individuals situations and changing market valuations.  The information is believed to be accurate however no warranty is given to accuracy or applicability to individual circumstances. Hudson Financial Planning, it’s officers, employees or associated persons do not accept any responsibility for errors or omissions in this document and will not be liable to any persons for any loss or damage incurred from acting or refraining to act in reliance in whole or part upon anything contained in this document.  Persons should not rely on this document to make investment decisions and should satisfy themselves through independent means that any decisions are appropriate.

 

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