I often get asked by people new to the property market about how they should structure their investment property loan. The answer is never simple since there are many things to consider including fixed vs variable rates, interest-only vs interest+principal, your cash-flow situation, your investment horizon and the likelihood of future rate rises.
Fixed vs Variable Rates
Variable rates will generally cost you less in the long run. You can consider fixed rates when you know there are significant rate increases in the near future and where your cash flow may be severely hindered as a result. Although, if you are in this position in the first place then you may have over-extended yourself.
One trap that new investors get in to with fixed rates is the possibility of having to be pay rather large "break costs" should you need to sell or refinance during the fixed rate period. Banks will look for you to pay out interest on the remaining term of the loan, especially when interest rates have dropped since you first took out the loan. This can amount to tens of thousands of dollars. Be careful with fixed rate loans when you plan to sell your property in the short term.
Interest-only vs Interest+Principal
Having an interest-only loan will give you more cash flow. If you can use this extra cash flow in a financially productive way then it is fine to stay with interest only loans especially given the interest expense is tax deductible.
Remember that you don't treat your investment loan the same way as you would treat the loan on your home - your aim should not be to pay off the investment loan as fast as possible if you think you can earn more by investing elsewhere. Consequently, paying off principal on an investment loan is not a priority. You are aiming to grow your wealth via capital growth.
Setting up an Offset Account
Rather than pay off the principal, you can set up an offset account and have all of your spare cash, including the rent, be placed into this account. The offset account will offset your loan, meaning it will save you on interest. One extra advantage of this is that you can still access these funds for future investment purposes without having to go through a re-draw facility or apply for additional financing.
Getting the Best Rate
The interest expense is often the greatest expense of an investment property so one of the most important considerations is the interest rate itself. Push your banks hard and definitely shop around. If you are not getting at least 1.0% off the bank's standard variable rates then you are probably losing out. Saving .1% or .2% can mean a lot, especially on larger loans. Call your bank today and ask for a better deal.
A common question by Australian investors seeking advice is whether they should invest in property or shares. According to the 2017 Russell Long-Term Investing Report, residential property has done extremely well over the past few years, fueled by historically low interest rates. Australian shares have a big tax-advantage through the franking of dividends. If you had the choice, which would be the best investment?
The answer is, if you can, diversify and invest in both.
Why? Diversification is the key to removing volatility from an investment portfolio and having all your eggs in one basket is opening yourself up to more risk.
Investopedia defines diversification as "A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio."
The 2017 Russell Long Term Investment Report lists Australian residential property and Australian shares as the top two for averaged returns over the past 20 year year period. Both asset classes have done well over the long term and both are good growth classes.
The Russell report shows that Australian property has done especially well over the past few years due to the low interest rate climate. Borrowing for residential property investment has been relatively easy and households have been able to take on more debt. However, if interest rates climb over the coming economic period then the great growth in residential property values that we have been experiencing will dry up very quickly.
Australian shares may be due for a resurgence, especially if the economy picks up and investors start to shift their sights away from property. Australian shares also provide the benefit of franking credits, where company tax paid is passed on through to Australian investors, provided a tax-efficient boost to earnings.
Don't stop at Australian shares either. The ASX represents around 2% of the global economy so picking up some international shares via an exchange-traded fund (ETF) will also diversify your share portfolio significantly.
So if you have the option to invest in both Australian property and shares then do it. If you only have property then be sure to consider diversifying to shares. More diversification in your portfolio is a good thing since it will help reduce the volatility of returns.
Choosing the right investment properties in the right locations can really make a difference to the success of your property portfolio. At the end of the day, you need to select properties that will both grow in value and attract tenants. Here are some things to look for when selecting your residential property.
The part of a property that appreciates in value is the land. The building itself depreciates over time. So try to choose a property that has a good land "value". This does not apply only to houses - it also includes townhouses and even units. Go for units with a maximum of 3 stories and you will usually get a much better land value than those units of 30 stories.
Your property will be more easily rented if you appeal to the majority of the rental market. Houses with 3 bedrooms and units with 2 bedrooms are the most sought-after properties for renters since they open themselves up to sharing. While single bedroom units will still do fine, you will usually do better with a two bedroom unit since it opens up the pool of available renters. Same applies to houses - a three bedroom house will be an attractive prospect to young families and friends sharing. Larger four or five bedroom homes tend to be more for larger families that are renting. Demographics are also changing where the average household is shrinking so smaller dwellings have a big future.
When buying a house, consider the garden maintenance. While that ornate English country garden may look nice, it will be painful and expensive to maintain. Renters don't want to spend their weekends maintaining your garden. Keep it simple - look for low maintenance gardens when purchasing a house.
Access to transport, education and employment
Access to transport, education and employment is a critical factor in choosing a great rental property. Look for properties near major transport routes - train lines, buses and motorways. Choose something that is within 15km of a CBD for easy access to employment. Look for closeness to schools and universities.
Access to shops
Similarly, access to shops, restaurants and cafes is also a popular requirement of renters. People like to be able to walk to a cafe and have a coffee, or a short drive to their local grocery shopping centre.
Population growth, infrastructure and employment
You can get a fast boost to property values if you choose a property in an area where there is a forecast of high population growth, investment in major infrastructure and a demand for housing. The states urban planning document is a very good indicator on where the government is investing in infrastructure.
Be sure to choose an area with sustainable employment though. For example, you can buy in a mining town where a new mining facility has just opened up, providing lots of employment and great rental yields, but be sure to understand the lifespan of that facility. If the town is built around that facility and the facility one day closes then you will be left out in the cold.
Important features to tenants
Tenants find the following features important, making your property much easier to let:
Bright and sunny
A recent construction
The building depreciation expense provides are great after-tax benefit, especially for high income earners. If you can find something constructed recently, less than 15 years old, then you can claim the building construction as a depreciation expense for some time and this will provide a great boost to your after-tax cash flow.
Avoid properties that are expensive to rent and will restrict your rental pool. That $3m unit on the harbour which rents for $1800/week is likely to be attractive to only high-income earning renters. There are not many of these around so you will increase your periods of rental vacancies and usually have to settle for a much lower yield.
Not the perfect property
Don't always look for the immaculate property. Seeking a property which may require some easy fixes and is priced accordingly can be a good strategy. For example, a house that is $30k below value because it has poor carpet, poor paint and dated kitchen appliances can be a good buy. Spending $8,000 to fix it up will give you an instant value and equity boost. Be cautious though, don't buy something too run-down unless you are handy with renovations.
A good rental yield
Look for something with a reasonable rental yield, around 4.3% to 5.5%. Rental yield is the yearly income you receive from the property divided by the property value. Low rental yield properties will mean you end up paying a lot more out of your pocket to cover interest expenses and, with the probability of future interest rate rises, make your ability to service the loans that much harder. Be wary of very high yielding residential properties as well (those with >9%) since they will be high yielding for a reason - there might be low prospects of capital growth or they may be in a mining town where employment may be temporary. Just be sure you go in with your eyes open.
Good prospects for capital growth
We all want our properties to grow in value. Some areas will grow faster than others. Study up on the cities or regions that you plan to buy in and be sure to look for where they are in their property cycle. Some will be at a peak where others may be at the bottom. Property investment magazines publish data on a monthly basis on property cycles. Pick one up and be sure the area you buy in has good prospects for capital growth.
Reasonable strata fees
While that new unit complex with a gym, pool and 24 hour concierge might seem impressive, it will certainly cost you in strata fees. Such fees can be upwards of $2000 per quarter. A great property is one where you get good rental yields with strata fees that are in the order of $650 per quarter. If you must go for the gym/pool/concierge, make sure that the rental returns include the premium required to cover it.
High rental demand area
Do some research on the rental demand of the area in which you are buying to ensure that the demand is there. Most property investment magazines will give you a "demand to supply ratio" score for each suburb in Australia. Also keep an eye on vacancy rates - ideally, you would be looking for low vacancy rates of less than 2% to give yourself the best chance of finding tenants quickly.