Mercia | Taxation, Business & Finance Advisers

Double Delight – Renovating for Profit in a Rising Market

Purchasing a property, fixing it up and then selling it for a tidy profit can be a solid business plan. But there are times when renovating seems even more appealing, such as when the market is rising. So what are the pros and cons?

It can strike at any time and it affects people from all walks of life. It’s the renovation bug and it becomes particularly active when the real estate market is buoyant and prices are rising.  Seemingly ordinary people wake up one day and decide they want to buy, renovate and flip a property for massive profit.

In Australia, renovating is a popular pastime and has been around since the seventies. We spend tens of billions of dollars on it every year, normally to make improvements to our own home. However, renovating can also be a good pathway to making money if it is done right. Purchasing a property, fixing it up and then selling it for a tidy profit can be a solid business plan. The reason for this is fairly obvious.

Firstly, the potential gains are substantial if the property you are renovating for sale increases in value both from the renovation and the natural increase of the market. I have witnessed firsthand people walk away with over $100,000 profit after a single renovation.

A rising market is also very forgiving, particularly for novice renovators who are likely to make a few mistakes here and there. Even if costs blow out a little or the renovation takes longer than expected, there is a good chance of still making a profit. But renovating for profit in a rising market is certainly not a fool proof strategy for wealth creation.

Whenever someone plans to buy, renovate and sell a property, timing becomes a particularly important issue. Rising markets don’t rise forever so there is a risk that while a property is being renovated, the market turns and values start to fall. Anyone who was renovating for sale as the GFC hit would have definitely been nervous.

Renovations can take time and the schedule can easily blow out without careful planning. There can be delays in obtaining materials, finding the right trades or having to correct previous mistakes. For many novice renovators, the reality is that a renovation almost always takes longer than expected.

Ideally, you would want your property to be ready for sale at the time the market is at its strongest so you can maximise your profit. But nobody knows how long an upward cycle will last or when it will turnaround.

Perhaps the biggest risk when renovating for profit is that of overcapitalising. There is a danger that you will spend money on the renovation that won’t be recouped after sale. Ideally, a renovator would like to gain $2 in value for every $1 spent but there is a point in every renovation where an extra dollar spent doesn’t generate a return and this is often dependant on the location.

For every property in a given location, there is a ceiling price the market is willing to pay. Spending, say, $20,000 on a new kitchen may raise the value of a property by $40,000 but a $50,000 kitchen may only raise the value of the property by the same amount. Renovators must understand how much they can spend on a property given the area, type of property, the expected sale price, the purchase price and the desired profit margin.

Before deciding to purchase a property to flip, astute investors will start their calculations with a likely final sale price in mind. They will then minus the purchase price, all the costs associated with buying, selling and holding the property, and the likely renovation budget. If there is healthy profit left over then they may consider buying the property.

The difficulty of course is being able to estimate all these figures before committing to the strategy, which is why many people end up overcapitalising on a renovation. In a rising market, people tend to become more complacent with their planning and due diligence which leads them into trouble.

Another less risky option than renovating for sale may be to renovate and hold. This strategy helps investors to increase their rental returns, attract better quality tenants as well as boost the value of their property. Executing this strategy still requires sound decision making but the margins aren’t as fine and the pressure isn’t as great as when renovating to sell.

Western Australia Remains in the Fast Lane

Western Australia has once again come out on top as the country’s best performing state when it comes to economic activity, according to the latest CommSec State of the States report.

The report highlights the widening gap between WA and the eastern and southern states.

“Arguably the size of the gap between Western Australia and Tasmania can’t get any greater,” said Craig James, chief economist at CommSec, who expects even more marked divergence among Australia’s regions in the future.

The quarterly State of the States report measures each state on eight separate economic factors, and averages out performance among each.

Second to WA on the economic leader-board is the NT, whose massive growth is underpinned by a single $34 billion natural gas project. However, WA, whose economy has grown by 13 per cent in  a year, is performing better across a range of measures including population growth, investment, construction activity and retail spending.

In particular, WA is the clear leader when it comes to population growth.

“Not only is the annual growth rate of 3.45 per cent the strongest in the nation, it is also more than 48 per cent above the decade average,” said James.

Home prices increased in all states except in Hobart, with the strongest growth being in Darwin, up by 7.3% and in Perth, up by 5.8%.

Acquisitions: Working With a Buyer’s Agent – Part 3

Last issue we looked at what’s involved in sourcing suitable investment properties through both on-market and off-market channels. In this final issue we’ll explain what happens after an offer is placed on a property.

As previously discussed, once the investor is interested in purchasing a particular property, the buyer’s agent will meet with the investor to discuss a ceiling price for the property and devise an optimum negotiation strategy for acquiring the property at the best possible price and with the most favourable terms and conditions.

Critically, when the buyer’s agent submits an offer on behalf of the investor, the offer may include a special clause that essentially provides a set period of time in which to conduct building, termite inspections and other research.

These additional clauses protect the interests of the investor and are a far safer option than relying on the regular clauses provided by selling agents.

As soon as an offer is accepted, the buyer’s agent will put together a comprehensive research report on the property and organise inspections, giving the investor all the information needed to make an informed decision.

Once the investor is satisfied with the outcome of the inspections and the research, the purchase can proceed to settlement. At this point, the investor would typically engage the services of a professional property manager to handle all the leasing and management requirements for the property.

Finance: What’s an Assessment Rate and Why Could it Affect Your Ability to Borrow?

Lenders don’t use the current interest rate when assessing a borrower’s capacity to make payments. Instead, they use what is called an assessment rate, which can impact on a borrower’s ability to get a loan and the amount that can be borrowed.

Before deciding to lend money to someone, say, for the purchase of investment property, the lender will carefully evaluate the borrower’s ability to make the necessary interest payments. The size of these payments, as we all know, is determined by the loan size and its particular interest rate.

But lenders don’t use the current interest rate when assessing a borrower’s capacity to make payments. Instead, they use what is called an assessment rate which is typically between 1 per cent and 2.5 per cent higher than the interest rate on the loan.

Why do lenders use this inflated interest rate? They do it to allow for any future movements in the interest rate or, more specifically, to ensure you can still afford the loan if interest rates increase.

Each lender will set their own assessment rate so the rates will vary from lender to lender. Plus, one lender may have different assessment rates for each of their loan products. Sometimes, for instance, a fixed rate loan will have a lower assessment rate than a variable loan because the interest is locked in for a set period of time. An assessment rate can also vary depending on whether it is for a new or existing loan.

Clearly, assessment rates can impact on a borrower’s ability to get a loan and the amount that can be borrowed. It’s worth noticing, however, that lenders have a whole series of internal lending policies that will determine whether a loan is approved or not, or how much can be borrowed. For instance, it may hinge on what percentage of rental income the lender will accept towards servicing, or policies regarding credit cards.

Assessment rates, which aren’t typically publicised, are one of the reasons why online calculators can be extremely misleading. If users input into an online calculator the current interest rate when assessing their borrowing capacity, they may later be disappointed when their capacity to borrow is much less than expected. It’s worth remembering that online calculators are a sales tool and should only be used to determine a ballpark figure.

Since different lenders have different assessment rates and will offer different amounts, it clearly pays for borrowers to contact an experienced, qualified finance broker who can guide them towards the lender that is most suited to their needs and situation.

Property Management: Mind the Gap

Every investor will inevitably find themselves in a situation where their tenant is vacating for one reason or another. In a perfect world, you would have one tenant move out and another move in on the same day, thereby minimising the “changeover time” when no rent is paid. But this is rarely possible and for good reason.

It’s far more natural for there to be a few days, before a new tenant can occupy the property. For starters, it’s extremely rare that the new tenant’s timetable will be perfectly aligned with the needs of the landlord, given that there is often a notice period that needs to be served with the previous landlord. Sometimes it may just be a slow market or the need to undertake work on the property that extends the changeover time.

While every landlord wants to minimise the changeover time between tenants, there are important processes that need to be followed, which take time. So, what does a property manager do when a tenant vacates? There are many things.

One of the main goals at the end of a tenancy is to make sure the property is adequately cleaned by the vacating tenant and prepared in a suitable condition for the new tenant. This involves conducting the final inspection. The final inspection will enable the property manager to evaluate the condition of the property according to the Property Condition Report (PCR) created at the start of the tenancy.

The property manager will look out for any excessive wear and tear and any areas inside or outside the property that require further cleaning or tidying. The property manager will also make sure that nothing has been wrongly removed or added to property, the correct keys are returned and that items such as appliances are in good working order.

In some cases, the outgoing tenant may have to go back to property and address the issues that were uncovered during the final inspection. After this has occurred, the property will then need a reinspection by the property manager.

When everything has been completed to the satisfaction of the property manager, the bond can be finalised and the appropriate amount returned to the tenant. At this point, an updated PCR can be created for the new tenancy.

While the changeover time allows for key processes to take place, it also provides an opportunity for the landlord to conduct any maintenance or repairs that may be necessary or desired. Some jobs are better done when the property is vacant, especially things like flooring and painting.

Although vacancy periods cost landlords money in terms of lost rent, it’s easy to justify a brief changeover time when you consider the important processes that need to be followed. These processes are ultimately in the interest of the landlord and the long term success of the investment.

Property Tax Tips: Repair or Improvement? Getting it Wrong Could Cost You

It’s one of the most common traps property investors fall into when it comes to tax time: incorrectly claiming property improvements as repairs rather than as a capital cost. So when conducting work on a rental property, how do you know what you can claim as a tax deduction and what you can’t?

Expenses that relate to repairs and maintenance of a rental property will usually be deductible when they are incurred, but any work that is considered an improvement, such as installing a new kitchen, will not be deductible and instead deemed to be a capital item that may be subject to depreciation.

There are a few important points to consider:

• A repair is the replacement or renewal of a worn out or dilapidated part of something, but not the entirety. For example, if some part of the carpet needs to be replaced that would be a repair, but if you replaced the entire carpet throughout the house, that would be an improvement and not immediately deductible (but may be depreciable).
• An item of expenditure is considered to be a repair when it brings something back to its operational efficiency, but does not significantly improve it. For example, a few light fittings may need replacing. Normally this would be considered a repair, but if you put in expensive chandeliers, it would be considered an improvement and not a repair.
• Initial repairs after you buy a property will often be considered capital improvements. The courts consider that these repairs would have been factored into the purchase price and therefore are considered capital in nature.

Generally it is wise not to conduct any repair work for some time after you purchase an investment property, unless it is of course necessary for safety issues. There is no fixed time specified by the law, but if you were to claim a large amount of repairs in your tax return the first year you purchased a property, it could certainly arouse the interest of the Australian Taxation Office.