Deal or No Deal: High rental yields not always healthy profits

High yields and healthy capital growth may sound like sure-fire signs of a sound investment, but you need to really get to the heart of what a property has to offer before you can know for sure.


While there are never any guarantees in the world of property investment, there are plenty of special software programs and online tools available to give investors a helping hand.


We looked into what steps you can take to ensure that irresistible investment opportunity you’ve got your eye on isn’t going to turn out to be a big lemon.


Looking beyond yield


Yields are undoubtedly a good indicator of a property’s potential, but that’s about the extent of it, according to property investor and author of Real Estate Riches Dolf de Roos.


He says that yields are “overrated”, and shouldn’t be seen as any guarantee of future growth by hopeful investors. “A yield is a very simplistic measure,” he says. “Are we talking gross or net returns? Pre-tax or after tax? If it’s for residential real estate you have to take off insurances, rates and maintenance costs to arrive at the net yield.”


And while de Roos acknowledges that yields have some value, he says that more information is required about a property before an informed decision can be made about its prospects. “The yield is a snapshot of how a property is performing at that instant in time,” he says, “and as such it is of limited value.

Software solutions


One way of properly getting to grips with a property’s potential is to utilise one of the many specially designed software packages available. After you input the relevant data, these programs can help reveal all kinds of information, including anticipated yields and equity growth.


De Roos has developed his own software, Real Estate Acquisition Program (REAP). He says that REAP takes many different factors into consideration to reveal the expected equity increase based on capital growth and cash flow returns.


“I didn’t want a snapshot of how the property is performing at present, I wanted a movie into the future,” adds de Roos. “REAP doesn’t just look at current rentals – it takes the current rental and diminishes it by the vacancy rate, then uses the inflation rate to predict what future rentals will be.


Similarly, it takes all costs, insurances, maintenance – then it extrapolates and ‘looks into the future’.” The software has the ability to assess how a property is likely to perform over time, based on the current purchase price, market value, and capital growth rates. “If [you] do this analysis for each of the next five years, you will get the net after-tax cash flow (NAR) after all expenses have been paid for every year,” says de Roos. This information is then used to work out the internal rate of return (IRR).


The IRR indicates the efficiency of your investment. If you put the deposit payable on the property into the bank instead, would you get the same return? Would you get the same cash flow as you would get from the house year after year, as well as the build-up in equity?


“Most banks cannot deliver such high returns,” says de Roos.


John Moore, president of the Property Investors Association of Australia (PIAA), suggests Somersoft’s Property Investment Analysis and Real Estate Investors Property Analyser as alternative number-crunching software. There are also further options online.

The bigger picture


These computer-based tools can’t provide an answer for every investor-related question, however.


There will always be additional factors that make a property or a particular market untenable from an investor’s perspective.


“For instance, I’m cautious about entering the Chinese market, partly because I don’t speak Chinese,” says de Roos.


“REAP is good for crunching the numbers, but there are always factors that it cannot and was not designed to take account of,” he explains.


The REAP software does not indicate whether or not you should buy a particular property, because each investor has a different set of circumstances.


However, it can reveal hidden flaws in a property that otherwise seems perfect. De Roos says that some of the results it has given in his personal investment research have been “very surprising”.


“Sometimes you think, ‘boy this looks pretty good, it’s got a good return’, but when you do the thorough analysis you realise that it’s quite a lousy deal,” he says. “The rents might have seemed high relative to the purchase price, but it had expenses and it had low capital growth.


Conversely and more interestingly there are properties where you think, ‘well this doesn’t look very good’ and you analyse it and it turns out to be a great deal.”


In one instance, de Roos was looking to buy a house in Phoenix, Arizona, at $50,000 below the market value. It seemed to have great rental prospects, but because the software forced him to input all elements of the deal, he discovered that the rates were very high on this property, which also had ‘extraordinarily high’ homeowners’ association fees because it was in a gated community. The pool maintenance was also very high, and it had three airconditioning plants, meaning the electricity bill was also expensive.


“By the time you factored in all those things it just wasn’t a good deal,” says de Roos. “I walked away from that one.”


Buyer beware


According to Moore of the PIAA, you can only work out if you’re getting a good deal if you know your exit strategy.


“That is: is the property going to provide income or capital growth? Income property should provide a good yield and hopefully positive cash flow after tax benefits and depreciation,” he explains. “Capital gain [property] should have all the characteristics of good capital growth. Occasionally you can find properties that have both.”


Two of the most common mistakes made by investors when sussing out  a deal are not spending enough time analysing the property and letting emotion get in the way.


“They fall in love with the property rather than with the deal,” says de Roos. “They let their emotions get in the way. They say things like, ‘but it’s so cute, surely I’ll find a tenant for it?’ They have the wrong reasons for buying property.”

Doing your due diligence


Due diligence is vital when working out whether a property will be profitable within your personal risk profile, says Moore.


It is “a risk management process that is carried out by the purchaser of an investment designed to provide a calculated and predetermined outcome given market factors,” he adds.


“Location, location, location is only part of the equation. New properties look good and can be great purchases but this will depend on your current financial requirements for cash flow, the ensuing taxation benefits, finance requirements and the type of structure that you would use to purchase the property.


“Due diligence then is the risk management process that encompasses the above considerations.”


Moore recommends that investors consider professional valuations, property structure, and accounting and taxation issues before deciding to invest.


Environmental factors are also vital to a property’s success, and this is about more than just location. Moore stresses that aspect, surroundings, pollution, views, streetscape, local council plans, community facilities and transport all play a part.


He also underlines the importance of building issues, such as the history of the developer, architect and builder, as well as the state of the market as a whole.


“Market reports, demographics, history of sales and rentals in the area, and migration and infrastructure information provide valuable information needed to assess the potential profitability of the investment,” Moore says.


“Without addressing each one of these topics, investors are exposed to unknown risk and are only guessing at the opportunities available in a potential investment.”

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