In the Financial Autonomy framework there are three pathways to gaining choice, identified through my many years of working with clients and seeing how those who have successfully gained financial security and freedom have achieved this feat. Those three pathways are investing in shares, investing in property, and self-employment or entrepreneurship. As explored in the Financial Autonomy book most commonly people gain choice through a combination of two or three of these pathways.
Rarely is it the case in my experience that someone achieves financial independence through one pathway alone. So whilst I’m most comfortable investing in shares, property investment is nevertheless still something on the radar.
This week’s post is inspired by a real life conundrum that my wife and I are currently facing. With reports of property prices falling we’ve been wondering whether there might be an opportunity to pick up an investment property at an attractive point in the cycle. The title of this week’s episode is precisely the issue we have been tossing around, namely what is a reasonable price to pay for an investment property?
The good thing is there’s no necessity to do anything. But it doesn’t happen that often in your working life where you’re in a position to take advantage of a weak period in the economic cycle, and so I want to ensure we don’t let an opportunity pass us by. I’ve observed with numerous clients that there is a fair degree of luck involved with the investment properties. Property values tend to rise in spurts. They might leap up for a year or two, but then flatline for five years or more. If you’re lucky enough to have got in at the right time you can see some great growth, but it’s also easy to buy something and see the price go nowhere for years and years, all the while with you paying council rates, maintenance, loan costs etc.
I’m not suggesting in this post that I have all the answers by the way, far from it. But I thought it might be valuable to share with you how I’m thinking about whether a property investment makes sense. Perhaps if this is something you’re also contemplating it might help in your thought process too.
Worth it?
The starting point for me is that investment properties are a headache. Shares as an owner are effortless. The dividends come in every six months, there’s no work required from me, and no ongoing expense. None of this applies to property. So for me to entertain a property investment I have to be pretty convinced that it is attractive.
The number 1 attraction with property investment is the ability to leverage. In fact if it wasn’t for the ease with which you can borrow for a property investment, then property as an asset class likely wouldn’t be on my radar at all. In our case given the equity in our home we are able to borrow 100% of the purchase price. This means that if we get growth in the value of the property we can achieve a very attractive outcome relative to the money we have outlaid. But as touched on in several past episodes, borrowing to invest entails risk. Rising interest rates is one risk, something we will canvas shortly, but the other risk is that if the property declines in value, you still need to pay back the loan, which means borrowing to invest is fantastic if the property value goes up, but it can result in you suffering significant losses if the value declines.
Rental Yield
The return on investment property comes in two parts, the rental income and the growth in value. Of these two components, growth is the one with the big question mark. Historically Australian property prices have grown in value because we’ve had a growing population, and whilst COVID disrupted this somewhat, it would seem likely that population growth through immigration will continue. It is important to consider this though and not simply take it for granted. Japan and Europe have falling populations, and there, property prices don’t tend to rise.
Even with a belief that our population will continue to grow, whilst I have some confidence that property prices will rise over 10 years, growth over any shorter period of time has for me a pretty big question mark, unless of course I spend a whole lot of time and money on renovations, in which case the apparent growth is just getting me my money back.
So growth is something that I hope for and is the reason for investing, but for me if I’m to purchase an investment property I need it to stack up from the perspective of rental income. I can have some confidence around rental income. I can look online see what stock is available, what the weekly rent they’re asking is, and assuming I’m buying in a highly populated area, have reasonable confidence that if one tenant leaves, another will be found in a reasonably short period of time.
If I buy a property, I know that as a minimum I have outgoings of the interest on the loan, council rates, water rates, insurance, and maintenance and/or Owners Corp fees. The amount for maintenance is difficult to pin down but typically on purchase you have a sense of whether the property is rundown and in need of some investment, or has recently been upgraded.
At some point you’ll likely to want to pay principle off the loan as well, so that increases your outgoings, but then again that is also increasing the equity you have in the property, so whilst I need to consider this from a cash flow perspective, I don’t consider it when deciding what is a reasonable price to pay for an investment property.
You will probably be familiar with the concept of negative gearing. This is where the outgoings for an investment are greater than the income being received. The loss incured is tax deductible so negative gearing is sometimes presented as this wonderful outcome that helps you build wealth in a tax subsidised way. Whilst there is some truth to this, it shouldn’t be ignored that this only comes about because your investment is making a loss. There’s more going out than coming in. You might save a little on tax, but in the long run this only ends up being a good outcome if the value of the property rises, and as discussed earlier, whilst over the long term there is a good chance growth will occur, at least based on Australian property history, that growth is far from guaranteed, and does require a lot of patience on the part of the investor.
For me, a small amount of negative gearing is fine, but I don’t want to see too much of a gap between rental income and outgoings. The way I’m currently thinking about this is via the rental yield, so the rent as a proportion of the property price. I want to see the rental yield be about equal to the cost of the loan. In this way I know that the interest expense on the loan to buy the property is covered, and I just need to come up with the other expenses associated with ownership. I also run the risk of interest rates rising, the property being untenanted for a period, and the normal wear and tear that a property receives meaning that at some point things like carpets need to be replaced and kitchens updated.
The point is, with the rent simply covering the interest, I’m still accepting a fair bit of risk as an investor, but for me that’s the level of risk that I am comfortable with, and how I’m thinking about what is a reasonable price to pay for an investment property.
Interestingly though, what I found so far in looking around is that rarely does the rent cover the interest expense. It seems that property prices haven’t sufficiently adjusted for the cost of money being 5% or more. Perhaps rents need to rise more as well, but it appears to me that rents have risen reasonably quickly. Property prices, thus far at least, don’t seem to have adjusted sufficently.
Our preference is to buy a property with an owners corporation because it is more headache free for us. This means predominantly apartments and therefore you’re generally considering one or two bedroom properties with or without a car park.
On the research I’ve done so far, it seems that one bedroom properties are more viable to acquire where the rental yield is around about equal to the loan interest rate cost, but this is much harder to do with two bedroom properties. It’s an interesting dynamic. A one bedroom unit might sell for $320,000 and generate $300 per week of rent, whereas a two bedroom unit might go for double that price yet the rent is only 50% higher at $450 per week. Our preference is to buy a two bedroom property on the basis that this would have a higher level of demand from potential tenants. If they’re working from home they might want the second bedroom as a home office. A single parent might want the second bedroom for their child. Or two people might share a property using a bedroom each. But whilst that’s our preference, at present it’s a struggle to make the numbers stack up.
Future Interest Rates
Because my focus is on the income equation, assumptions around interest rates are a significant input. Currently the expectation is for the Reserve Bank to lift interest rates by half a percent more from here. I can factor that in but what if that’s wrong? And even if it’s right, how long will they stay at this level? If I do my numbers based on a 5% interest rate but 18 months from now the interest rate is 7% I’ll be pretty unhappy, and almost certainly sitting on a loss in the value of my investment. But what if, as some forecast, rates peak in the coming months and decline within a year or two. If that’s the scenario that unfolds and I can pick up a property where the rental yield and todays interest rates are roughly aligned, then I could be in a great position.
But no one has a crystal ball, so you have to think about the probabilities of each scenario, operate from a conservative or worst case viewpoint and then move forward from there. Investment is not without risk, as it should be. Risk is why we receive the returns that we do. It’s our job as investors to think through the risks appropriately and find opportunities where the likely return makes sense relative to the risk.
How do you assess liveability?
As we’ve been shopping around, another challenge is determining what value to place on liveability. How much is it worth to be close to the beach for instance, or within walking distance of a train station? What’s a car park worth or a trendy shopping strip within walking distance?
I really haven’t figured out the solution here but my sense is that the rent ought to reflect these qualities and so I don’t believe I should need to adjust my consideration process significantly. If living close to the beach is that much more attractive, then it should be the case that rents are commensurately higher, which means my evaluation criteria of the rental yield roughly matching the interest cost on the loan should still hold. But I have to say that my research so far doesn’t really bear that out. In may be that the greater the liveability, the more attractive it is to owner occupiers, and this pushes the price of properties up without rents necessarily increasing to the same extent.
Like I say, this isn’t something I’ve worked out a solution for, but it’s definitely a factor in property investment. Having spoken to several buyers agents over the years they often talk about the importance of buying a “quality” property whatever that means.
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