Investor Alert: Is it wise to put all your eggs in one basket?

Some investors are lucky enough to afford a fairly substantial investment property. Perhaps it’s a property around the $800,000 mark or even as high as $1 million. Whatever the exact figure, these investors are naturally excited at the prospect of being able to buy something a bit more glamorous than a run of the mill investment property. But the question is, is it better to put all your money towards this one property or spread it out across a number of cheaper properties?

Personally, I am a firm believer in buying multiple cheaper properties instead of one expensive property. The caveat to this however is that the cheaper properties must still be ‘investment grade’ properties, otherwise you negate any advantages in pursuing this strategy. Generally speaking for Perth, you will find most of these types of properties around the median house price of $400,000 – $500,000 (although that’s not to say that they don’t pop up occasionally below and above this mark). So in the earlier scenario, that could mean purchasing two properties instead of just the one.

There are a number of reasons why I support this strategy and most of them relate to risk.

Firstly, there’s less risk from rental vacancies. Should one property become vacant, the weekly income loss would be far less than if the same situation arose with your more expensive – and only – investment property. With multiple properties, you have a safety net in that your other properties will continue to bring in rental income while you find a replacement tenant for the vacant property. There’s no safety net, however, if your million-dollar investment sits vacant.

Secondly, having multiple properties is better from a liquidity point of view. Even if you invest with a buy and hold mentality, sometimes you may be forced to liquidate your assets despite your best laid plans. With multiple properties, you give yourself more options in that you may only need to sell off one or two assets and be able to retain others, keeping your foot in the market. With just one expensive investment property though, you may be forced to liquidate it and go back to the drawing board.

Thirdly, there’s protection if an area or property you choose doesn’t perform as well as expected or is negatively impacted by some activity or event. You will still have other properties in your portfolio that may continue to flourish which will help you in continuing to grow and leverage off your asset base. The economy is one such factor which can affect properties differently depending on their location and their value. In the economic climate of late, in Perth and throughout the nation, lower-to-mid priced properties have been far less affected than those in higher price brackets. If you had bought a single million-dollar investment property in Perth prior to the GFC, you would be in far more financial pain than if you had spread your funds across multiple median-priced properties.

Aside from risk, there are other reasons why multiple cheaper properties can be a better investment decision. At the median price, rental yields are typically quite good and superior to those achieved by higher value properties. With multiple properties, you also afford yourself more freedom to take greater calculated risks that could pay off handsomely, such as buying one property in an up-and-coming area or an area that could be rezoned. With just one substantially-valued investment property, however, you may be more reluctant to take that chance.

Diversification is important to any investor. Most think that diversification means to spread your money across different asset classes such as property and shares, but as you can see the concept equally applies within one asset class such as property. Buying multiple properties in different areas, in a price bracket that continues to attract demand and minimises your risk even in flatter economic times such as now, is wiser than putting all your eggs in one more expensive basket. 

Land vs building – what’s the right balance?

Most people would be familiar with the phrase ‘land appreciates, buildings depreciate’. While this is a little simplistic, the statement generally holds true. It is surprising then how many investors, armed with this knowledge, still manage to get it wrong.

Real capital growth is derived from the appreciation of land. This is because land is a commodity that is in limited supply and always in demand. Buildings, however, lose value over time because the physical materials deteriorate and the appeal of their style and function diminishes as buyers’ tastes change.

Some people argue that the cost to build rises each year meaning replacement of the same building would cost more in today’s dollars, thus buildings appreciate. Yes, the cost to build increases with inflation but this is irrelevant. If you were to sell a once new property in 10 years, the fact is a buyer is buying the land with a 10 year old depreciated home on it – not buying land with a home on it valued at the replacement cost of building it today. That is why you find many old properties selling at practically land value. To think today’s costs are relevant is no different than trying to argue that your 10 year old Toyota Carolla is valued at the same price as the current year model! Having said all that, it is possible to retain some value in the building if you regularly maintain and update it. However, this obviously costs money and does not simply come about with time. 

Many assume therefore that the message from all this is that the more land you have, the more capital growth you will be rewarded with. While there’s some truth here, this is where many investors tend to become unstuck. Let’s use an example to explain. Do you think the value of 500sqm of land in the heart of a major metropolitan city is the same as 500sqm of land in a small country town? Or even 1000sqm in the country town? Of course not.

Land is valued at a different rate per square meter depending on its location. Therefore the lesson is if you’re after strong capital growth, don’t base your buying decision on where you get the largest quantity of land for your money. Instead, focus on the proportion of value that the land component contributes to the overall purchase price of a property.  This is what is sometimes called the land-to-asset ratio. Good purchases tend to be those that have a high land-to-asset ratio, that is, ones in which the land accounts for most of the property’s value.  Although in many instances this directs investors towards older dilapidated houses in established areas close to the city, if you’re on a budget or need stronger rental income do not discount strata-title properties. If you do your homework and purchase carefully, you can find strata properties with a high land-to-asset ratio that perform just as well. 

Tax Office set to change rules for SMSF investors

 A new draft ruling released by the Australian Tax Office (ATO) has relaxed rules for those buying properties in their self-managed superannuation fund (SMSF).

Previously SMSF investors were allowed to maintain their properties but were restricted from making improvements to them. This stance had discouraged some investors from dabbling in property investment through their SMSF because of the strict regulations. 

It is expected that this long-awaited change will have the most impact on cheaper properties in need of some TLC. These properties are now more appealing because SMSF investors would be able to conduct renovations to add value and improve the rental return.

While improvements are now permissible, they will only be able to be conducted if they are funded by cash resources in the SMSF and not borrowings. There are also restrictions on the types of improvements that can be made. Examples of allowable improvements include extensions and bigger kitchens, but the key is that improvements must not “fundamentally change” the property.

The ATO has also taken this opportunity to clarify other grey areas regarding property investment and SMSFs. They confirmed that unlike improvements, SMSFs may borrow funds to undertake repairs provided the repairs do not change the character of the dwelling. 

Hot Property

Overview:

Looking for a high growth investment property in Perth, our clients enlisted the help of Momentum Wealth and its buyers’ agents to do the hard yards.

Given the client’s requirements, we immediately focused on the sometimes overlooked suburb of Craigie in the northern suburbs of Perth. Being a tightly held suburb (both for resale and rental) it tends to achieve good property price growth and also has the benefit of providing plenty of value-add opportunities.

When the right property came on the market, our buyers’ agents kicked into gear immediately. Being familiar with the area from a property investment point of view, we were instantly able to assess the potential and value of the property and place an offer. The property was ideal being an average 1970’s home (yet still achieving reasonable rent) and was situated on a flat corner block in a proposed rezoning area. We secured the investment property for our client within three days of it being listed beating other buyers to the punch.

Despite the competitive nature of securing properties in Craigie, Perth, we still managed to acquire the property under market value, but most importantly, secured an investment property for our client that has potential for great gains in future.

Result:

Purchase of a street front 3×1 brick and tile home in Craigie, 22km from Perth CBD.

Purchase price: $420,000

Estimated market value at time of purchase: $430,000

Savings: $10,000

Suburb Snapshot: Redcliffe

Redcliffe is an established suburb in Perth located approximately 10km east of the Perth CBD.

It’s situated near the suburbs of Belmont, Ascot and Cloverdale and enjoys excellent proximity to the city and airport, as well as being just minutes from the Swan River. The suburb is serviced by key transportation routes such as Great Eastern Highway, Tonkin Highway and the Graham Farmer Freeway, and is ideally located by short drive to commercial and industrial areas in Kewdale and Welshpool for employment. Redcliffe also has access to a variety of amenities such as local primary and high schools, parks, a cinema, and major shopping centre, Belmont Forum.

Over the past 10-15 years Redcliffe has undergone quite a transformation, with a number of developments changing what was once a suburb dominated by tired public housing into a desirable and well-maintained community. Popular estates such as ‘Flemington Chase’ and ‘Ascot Gardens’ were developed, and today much of the older parts are continuing to undergo rejuvenation with a few property development opportunities still available. Redcliffe tends to be popular with property investors, both for development opportunities as well as good rental yields (thanks in part to the consistent demand from fly-in fly-out workers who prefer a property close to the airport). It is also an area that is traditionally blue-collar; however with its proximity to the CBD and Swan River that is slowly changing with an increase in demand from young professionals and families.   

Properties in Redcliffe generally fall into one of three categories – older undeveloped or partly renovated properties towards the northern end of the suburb (typically 50’s/60’s style on large land), newer strata-titled villas in the older northern end of the suburb (created from private subdivision), and newer homes and villas through the southern part built in the 90’s and 2000’s which are located in the developed estates.

Prices start from the low $300,000’s for small units and homes in less desired pockets. Between $350,000 – $400,000 are 3×1 properties on blocks under 500sqm (generally villas/units), while in the low $400,000’s are a mix of good size 3×2 properties and the occasional smaller 4×2 property. Most 4×2’s, depending on their location, age and land size, are generally priced from $450,000 – $550,000, as are older properties suitable for redevelopment.  A handful of properties are found above $550,000 which include new and near new properties, larger homes, and larger development opportunities.  Rents generally fall between $400 – $500 per week.

Key Statistics

 Source: REIWA.com.au, September 2011.

SPECIAL FEATURE: Momentum Wealth’s Rising Stars

You might think that after buying and selling around 13 properties, you’d be an old hand at property investing. Not so for this young couple which is why they reached out to Momentum Wealth to give them the help they needed.

Trisha Fulton and her husband Ryan have so far turned over more properties in their short lifetime than most people. However, it was always their principal residence that was the subject and not once had the idea of “property investment” entered their minds. Buying and selling was simply a result of their personal circumstances. In fact, due to Trisha’s job, she’s moved in and out of 65 company owned properties in the past 7 years.

When the young couple needed to relocate to Perth from Brisbane back in 2009, they spoke with buyers’ agent Ray Chua at Momentum Wealth to help them find the right home. Although things didn’t work out at the time, buyers’ agent Ray kept in touch and when it came time to take the plunge and buy an investment property in Perth, they knew exactly who to call.

Trisha and Ryan picked up the phone and enlisted the help of Ray and Momentum Wealth to give them guidance and help them make the right decision for their needs.

“Being our first investment property, there’s a different set of criteria than when you’re buying for your own home and you need to make a really intelligent decision based on returns and all that analytical information”, says Trisha.

“(Ray) opened up our minds to a lot of different opportunities that we probably wouldn’t have considered”.

The couple’s primary strategy is to buy properties with future development potential over a 7-10 year timeframe. With a strict 2 week deadline and other equally difficult criteria set by Trisha, Ray begun the search and located them a prime investment property in Rivervale, Perth in July this year. Purchased for $552,000, the property came with a shabby 2×1 property on a duplex sized block. However with buyers’ agent Ray’s insider knowledge and astute research, what really made the property special is its future potential.

“It’s got potential for a triplex development in the future. We wouldn’t have known these things without his help”, comments Trisha.

This determined pair are certainly not short of energy or ambition. With a number of goals set over the coming 10 years, the couple’s next plans are to acquire another 4 properties over the next 2 years across both Western Australia and Queensland. Once these properties double in value, they will start to subdivide and develop them. In 10 years time, they are hoping that they will be in position to not necessarily retire, but choose their work rather than be forced to work.

Although the couple started out as novice property investors, over the last 6 months Trisha has done a lot of her own research to educate herself about investing in property, and has had the help of a property advisor like Momentum Wealth. One piece of advice she decided to take on was to treat property investing as a business, not a hobby. Since starting their investment journey, she’s found this advice invaluable and highly recommends that other property investors do the same.

She also insists that in order to create this business mindset, investors need a good team of people to support them and that to get the most from them, you should treat them as you would expect to be treated yourself.

“If all the right people are in the right place and you look after them and they look after you, you’ve just simply got a good formula for success”.

Using Credit: Subsidy 2 – Low Level Borrowers

For many varied reasons, there will be many people in society who have no debt at all. Perhaps they are in their 50’s and have paid off their home and have no leveraged investments. There will also be people who have low levels of debt relative to their asset levels. There will be some people who have a relatively high level of debt compared to their asset levels. A bank or financial institution will have loans out to the entire spectrum of borrowers.

Assume a person owns their home worth approximately $500,000 and they have a loan of $50,000.  What risk do you think the bank or financial institution is at of not getting their money back on this loan? Almost nil I’d suggest. If someone owned a property worth $500,000 and they had a loan of $250,000, what risk do you think they are to the bank or financial institution? Very little I would suggest. If they stopped the repayments the bank or financial institution has enough of an equity buffer in the secured asset that even in the event of a fire sale the property would have sufficient funds to cover the repayment of the loan.

If someone owned a property worth $500,000 and they had a loan of $400,000 what risk do you think they are to the bank or financial institution? There is some risk to the lender. If they stopped paying the loan and let the property go to ruin it is quite possible that the lender could lose some money. If you were lending money, wouldn’t you much prefer to lend to the person who owes $50,000 on the $500,000 home rather than the $400,000? Wouldn’t you be expecting a higher rate of interest on the higher level of borrowings to compensate for the extra risk?

While there is a larger risk to the lender by lending $400,000 versus $50,000 against a $500,000 asset, the financial institutions rarely charge different interest rates to different borrowers. The lender knows that across the board they will have a range of people at different levels of debt and in order to be able to offer a competitive interest rate they typically offer one interest rate across the board (except to high net worth borrowers who often get discounted interest rates). They know that if the economy went into a severe recession and property prices went down, there are enough borrowers who have low levels of borrowing that the lenders potential bad debts would not become too significant.

What do you think would happen if everyone borrowed up to 80% of the property value and kept it at that level? Suddenly the lenders would have a much riskier portfolio on their hands and they would have to increase interest rates to compensate for the risk. If the economy went into recession there is a chance that a high percentage of loans could go into default and the banks may lose significant amounts of money.

Those who borrow to a lower level relative to their assets should really be getting a cheaper interest rate than those who borrow to a higher level. Lenders have never been able to figure out a way to effectively price the different risk on property loans. They typically use the arbitrary figure of 80% loan to value as the point where loans become more risky. They don’t differentiate between 5% borrowings and 79%. Fortunately for highly leveraged borrowers, not everyone borrows to their maximum. Those who borrow to lower levels relative to their assets are effectively subsidising those borrowers who take higher risks and borrow towards the maximum.

Property Tax Tips: When are interest expenses deductible?

Generally interest is deductible if it is incurred when the borrowed money is used for income producing purposes. If the borrowed money is used for some or all private purposes then the interest on the private portion is non deductible.

For example, if you borrowed $300,000 from the bank and $200,000 was put into a property investment to generate income and the other $100,000 to purchase a home to live in, then 2/3rds of the interest would be deductible (being $200,000 / $300,000).

This is referred to as the “use” test or “tracing” test which generally means that:

(a) When borrowed money is used solely to purchase investment property then the interest will be deductible (while the property is rented or available for rent)

(b) Where borrowed money is partly used for investment purposes and partly for private purposes, the interest will be deductible to the extent it is used for investment purposes.

Many people believe that if they use an investment property as security for a loan than the interest on that loan is tax deductible regardless of what the money is used for. This can be a costly mistake. The deductibility of interest has nothing to do to with the security used to borrow the funds. You can use your own house, a car or a boat or anything. What matters is what the borrowed funds are used for.

Property Management: Case Study

Bianca started managing the properties and found the following:

Upon inspecting the properties, she discovered over $10,000 of urgent repairs that needed to be completed. She organised quotes, agreed on prices and negotiated payment plans with contractors. This meant the tenants were safe and the client could have all repairs completed at once without stress or financial strain.

Three of the leases had expired exposing the owner to the potential of an unexpected vacancy. New leases were signed  with the tenants with the expiry dates staggered at different times in the year so no two properties would be vacant at once, protecting the owner’s cashflow in the event of a vacancy.

Four of the tenants were in arrears – one was 5 weeks behind.  Bianca spoke with the tenants about their arrears and negotiated payment plans which has now led to all of the tenants paying their rent two weeks in advance.

Bianca has now spoken with the owner and his accountant and formulated a maintenance plan for the upkeep and refurbishment of all of the properties. This has given the client and his advisers a clear picture of when works are to be completed, what will be done and how much this is likely to cost.