Mercia | Taxation, Business & Finance Advisers

A Tale of Two Investors

It’s not often in life you get such a stark demonstration of how different decisions can lead to vastly different outcomes. But this was definitely one of those times, involving two property investors.

A client – let’s call him Andy – had entrusted Momentum Wealth to assist in the purchase of an investment property around two years ago. All up he paid $458,000 for the property, which was located in an established area of Perth. I was very pleased to discover that a bank had just recently ordered a valuation on this property and it came in at $585,000.

What made that moment particularly memorable, however, wasn’t learning about a client’s success but rather a sad email that I received. The email was from a financial advisor who was seeking some property-related advice regarding an investor – let’s call him Paul – who found himself in a rather difficult financial position.

Paul was sold an investment property by a well known ‘investment group’. The property, located in an outer-Brisbane suburb, was purchased sight unseen for $428,000 around the same time that Andy had purchased his property.

The shock came when I read the email further, which explained that based on recent sales evidence the property was now worth around $300,000. Paul was now in a difficult predicament, unsure whether to hang on to the property in the hope it will recover its value or cut his losses and sell.

While I hate to see anyone suffer such a loss (albeit on paper), it’s made worse when you think about the success Paul could of had if he had sought proper advice. In fact, if Paul had achieved similar returns to Andy, he would be somewhere in the region of $250,000 better off.

These companies typically operate with a very slick sales process with the ultimate goal of you buying a new property off the plan, sometimes in a distant location which you have been told is a “good investment”. The consultations and service is “free” as a hefty commission is loaded into the purchase price.

These companies spend a lot of time talking to builders and developers from around the country, trying to negotiate deals that involve high rates of commissions in exchange for providing an effective channel for flogging hard-to-sell property.

Investment groups only get paid when they sell you a property, so it’s not uncommon to experience high pressure sales tactics.

Many investors fall for this firstly because there is an assumption the purchase is free. Plus, it is very easy to get caught up in the excitement of buying a new property because it looks so good and offers benefits such as depreciation, low maintenance, and strong demand from tenants.

There are a few reasons why investments made through these companies often don’t live up to the promises that were made, particularly in terms of capital growth.

As with Paul’s case, not only did the property fail to increase in value but worryingly it is now worth around $130,000 less.

The poor capital growth performance of these investments is primarily due to the fact the properties are not what I would call ‘investment-grade’. They are in areas with massive supply potential, typically on the outskirts of major cities or in speculative locations. Additionally, the properties, which are almost always new or off-the-plan, have a high proportion of their value in the building which depreciates over time, limiting the opportunity for growth.

Making the situation even worse, properties sold through investment groups typically have inflated prices to cover the commission that will be paid by the developer or builder.

Clearly, the cost of ‘free advice’ offered by investment groups can end up with a rather hefty price tag. Consultants who represent these companies may say they are helping you but they are just helping themselves.

Any business of course needs to make money but there is a monumental difference between what an advisor does and what these investment groups do. A property investment advisor should offer simply that; advice on where and what to invest in and remain independent from any property sellers. There should be no financial incentive to push you towards one property over another and a buyer’s agent or advisor that you engage ensures this by charging you a fee for service plus there is a legal obligation to act within the best interests of their clients.

The other major difference is to do with transparency. Although employing a buyer’s agent involves a fee for the service clients are completely aware of this fee when they engage the service. Plus, when you consider the scale of the returns that a great investment can generate, as it did with Andy, it certainly highlights the true value of employing a professional who is working within your interests and providing sound property advice.

Finance: Exiting a Loan Can Still Be Extremely Costly

You’re probably aware of the fact that since the first of July 2011, lenders cannot charge “early exit fees” on variable rate home loans. But what some borrowers have forgotten is that the legislation doesn’t apply to fixed rate loans, which are growing in popularity due to the extremely low interest rates being offered.

Taking out a fixed rate loan can be a relatively easy process and deliver significant benefits to certain borrowers. However, breaking such a loan can still be very expensive.

How do you ‘break’ a loan?

There are a few scenarios that could trigger the hefty break costs associated with fixed rate loans. Repaying the loan before the end of the fixed rate period or switching to a different product within this time are the more obvious ones.

But even just making extra repayments on a fixed rate loan can cause some lenders to charge you penalties. While most lenders will allow you to pay a small amount off your loan each year without being charged, going above the accepted tolerance could prove costly.

Why are lenders allowed to charge for this?

A fixed rate loan is a legal contract guaranteeing that you’ll pay a fixed amount of interest on a loan for a certain period of time. Breaking this contract means your lender is entitled to be compensated for any losses incurred.

How much will you pay?

Calculating the costs involved with breaking a fixed rate loan can be quite complex. A key factor is how the interest rate on the fixed loan compares to current interest rates being offered. If interest rates are currently lower that the rate on your fixed rate loan, then the costs could be significant as the lender won’t be able to make as much money from re-lending the money.

On the other hand, if interest rates are higher, then there may be no costs involved with breaking the fixed rate loan. But borrowers don’t often exit a loan if they are paying lower than the prevailing rate.

The amount owing on the loan will also impact on the calculation of break costs, generally the more owed the higher the costs. Similarly, more time there is left in the fixed term of the loan the bigger the costs. Breaking a 10-year fixed rate loan therefore could be extremely expensive, which is why most borrowers typically choose terms of 2-5 years.

Here’s what to do

If you currently have a fixed rate loan and need to break it, before you do anything ask your finance broker to obtain a quote from the relevant lender regarding all break costs. From there you can make an informed decision about whether the benefits outweigh the costs.

If you are considering choosing a fixed rate loan for a new purchase or to refinance, think sensibly about the flexibility you’ll need in future and the potential costs you could face by locking in a fixed interest rate. Again, your finance broker will prove invaluable in helping you to make this important assessment.

Property Management: Is Now a Good Or Bad Time to Increase the Rent?

The rental market in Perth has changed considerably over the past 12 months. An extremely tight market, where rents increased more than 10 percent annually, has now been replaced by a far more balanced one.

One of the biggest changes has been the fact that the number of properties available for rent has been steadily increasing, with the Perth vacancy rate sitting just over 3 percent.

Why the slowdown? There are a few reasons. With historically low interest rates, many renters have decided to buy rather than rent, reducing the pool of potential tenants. The slowdown in mining investment has also had a flow-on effect on the rental market, but predominately at the upper end.

With more properties available for rent, tenants now have a greater choice than before and landlords must react accordingly. If you have a vacant property, you must be careful not to make your property uncompetitive in the marketplace. Your Property Manager should provide you with a plan outlining what the competition is, what the market rent is and what improvements and or lease conditions can be offered to minimise the vacancy period.

What about if you are renegotiating a new lease with an existing tenant? Again, if you price the property too much above the market rate then you risk the tenant deciding to leave. A vacant property can be costly, so you’ll need to consider the current market conditions to see if an increase is warranted.

The market is constantly changing and conditions can vary dramatically from area to area, so it’s best to rely on the advice of your property manager to set the correct market rent. A good property manager will always be able to show you evidence of whether or not an increase is supported by the market and what can be done to the property to make it competitive and appealing to tenants.

Understanding Motivation is the Key

It’s often said that most of the profit in property is made when a purchaser buys the property. While that isn’t always the case, being able to negotiate property deals is crucial to making a lot of money in property investment.

Most people go wrong in property negotiations by not understanding that the person you are dealing with on the other side is human just like you, who has needs and emotions. You will be a far more successful property negotiator if you understand the underlying positions of the other party.

To understand the other parties’ position, you have to ask questions. If the seller is using a real estate agent then you can ask the agent those questions.

There are 7 important questions you must ask a seller. One of those questions is simply “why are they selling”. You want to ask this question for two reasons. Firstly you want to find out the other parties’ level of motivation. How desperately do they need to sell their property? Secondly you ask this question because you want to see if you can structure a deal that meets their needs and at the same time gets you a great deal as well.

Next time you go to a home open, ask the agent this question. Often you will get lots of information that can greatly help you get the best property deal.

An important area to property success is using contract clauses to protect your interests when buying. In some states, a standard contract is used in most property purchases. In other states, the contract is drawn up by the seller’s solicitor. Usually these contracts have one thing in common. They aren’t particularly friendly to buyers.

You need to insert your own clauses to protect yourself when placing offers. They are what I call are “get-out” clauses.

You also should be very wary of accepting real estate agents clauses for building inspections and other contract clauses. Don’t forget the real estate agent is representing the seller, not the buyer. Only a Buyer’s Agent truly represents you.

Property Tax Tips: Types of Investment Structures – Individual / Joint Names

Continuing on from our July edition regarding the factors to consider when choosing an investment structure, this month we’ll focus on the first type of structure – investing in your own name or in a joint name with a spouse or partner.

For most people the easiest way to acquire property is to purchase it in your own name or joint name with a spouse or partner. This is one of the most common structures and also one of the most simple.

Advantages

One of the biggest advantages is its simplicity and thus low cost. There is no actual structure to set up and no fees or compliance costs that other structures incur. You don’t need to take any specific action in order to purchase a property in this manner, you are ready to act immediately.

If you choose to sell your property, you are also able to utilise the full 50% capital gains tax discount (if you hold the property for more than 12 months). When you invest in your own name, you can take advantage of negative gearing by offsetting any losses against income such as salary or wages. Depreciation on your property also acts as a tax free ‘cash back’ each year. And lastly, you can pre-pay interest for up to 12 months and get an interest deduction.

Disadvantages

This type of structure has two main disadvantages, both of which can have long-term effects on your wealth. The first is that there is no asset protection. If you or your spouse or partner were to be successfully sued, your property may be taken to pay off your debts.

Secondly, it is quite an inflexible structure when it comes to distribution of income or capital gains which can have big tax implications. To minimise your tax, if a property was producing an income even after interest expenses on the loan, you would ideally distribute income to the person with the lowest taxable income. Likewise when you sell a property, you would also want the capital gains distributed to the lowest income earner as they will pay the lowest amount of tax. If you are making an income loss each year on your property, then you would want that loss to be in the name of the highest income earner to offset their income.

Unfortunately investing using this structure can only allocate the gain or loss to the named individual (or shared equally amongst the joint owners). It does not provide the flexibility to make any decisions about income allocation as your circumstances change with time (such as when a negatively geared property becomes positive or a partner leaves work to raise children).

With all structures there are always positives and negatives that need to be considered when assessing the right structure for you.