But perhaps there is a third solution: could our couple save the $1m in seven years? Assuming they start with their $60,000 in savings and continue saving about $15,000 per year, as they have been doing over the last four years, where would that leave them?
Not too much better off, actually. Seven years of saving would add $105,000 to their pool of funds, leaving them with a total cash amount of $165,000. Of course, there would be interest payments acquired from term deposits, but even when including that the couple would still be far from their target of $1m. Saving alone won’t do it.
Option 1: Relying on market-driven growth
Not to put too fine a point on it, it is never wise to invest in the real world on the basis of market-driven growth being consistent for a property year after year. It is much safer to assume instead that there are likely to be some growth patches over the seven years our couple will be in the market.
For the sake of simplicity, let’s assume that each year they will see 5% growth in the value of their properties. This is approximately half the rate of growth needed to satisfy the common perception that property prices double every seven to 10 years. It may seem overly conservative, but if we apply this approach in the real world, we are more likely to exceed our planned expectations.
In getting started with this approach, our couple are restricted more by their deposit than their borrowing capacity. Based upon the national average for stamp duty requirements of 5% of the value of the property, and a minimum 5% deposit required by lending institutions to purchase property, the couple’s $60,000 restricts them to a property purchase totalling $600,000.
Of course, using their gross income of $110,000 alone, the couple will not have the borrowing capacity to buy a property for this much, but if a conservative rental yield of 4% from an inner-city investment is factored in, they’ll be able to borrow more than what they need.
On conservative lending measures, a maximum of 30% of joint income can be dedicated to servicing debt. Assuming the average interest rate is 8% (we can currently achieve less in today’s market, but in seven years it is likely to mirror long-term trends and be higher), our couple’s borrowing capacity would amount to $412,500.
With a 4% gross rental yield on a $600,000 property investment, the couple’s rental income will amount to $26,400 a year, provided the property is fully tenanted throughout the year. Banks generally allow 75% of the rental income to be allocated towards servicing debt. In this instance, it means the rental income alone will support $247,500 of the total debt.
In other words, our couple’s income, combined with their rental income, will more than cover all debt from a $600,000 buy-and-hold property investment (95% of $600,000 = $570,000. Total conservative borrowing capacity attainable: $412,500 + $247,500 in rents = $660,000).
While this will give us some clarity and confidence about our starting position, we need to ensure it will allow us to achieve the goal we seek for our couple.
If we purchase to buy and hold for seven years, and assume 5% capital growth, we can expect the outcome shown in Table 1.As you can see, one purchase offering 5% growth will not allow our couple to achieve $1m in seven years.
But what if we purchased a second property after three years of holding this one? Would we get our $1m then?
As a rule, banks don’t generally allow you to draw on equity for reinvesting if it is in excess of an 80% loan-to-value ratio. That means the couple would need to hold the property for six years before they would be ready to release equity and start purchasing more property. That leaves just one more year for any new property purchase to appreciate in value. Not long enough.
Still, what if we ditched the 5% capital growth assumption? What if capital growth was considerably higher? What assumed rate of growth would make this goal attainable?
Table 2 puts it into perspective.As you can see, if we were able to guarantee a rate of return in excess of 17.5% consistently for seven years, one purchase for $600,000 would get our couple the $1m in equity they desire.
The reality is that this is not realistic. Considering this, and our couple’s circumstances, the traditional method of holding property for growth will not deliver the outcome they seek.
Adding value through renovations:
To illustrate how a renovation project might work out, let’s look at a summary of the typical numbers for a cosmetic renovation project worth $240,000 (a project the couple can easily afford).
Explanation of terms
These are the costs required for you to settle on the purchase of the property. They are different in each state, but as a national average it’s approximately 5%.
This is the maximum you can afford to spend on your renovation if you want to walk away with a profit that will make the project worth doing.
If you stick to budget in terms of both time and money, then this is the amount of cash you’ll have increased your bank balance by within six months, provided you sell the renovated property for the nominated price (excluding tax).
These are the costs typically associated with selling a property through your local real estate agents.
The most critical number by far! If you don’t believe your renovated property will sell for 33% more than you are looking to purchase it for, don’t buy the property!
Given that our couple has $60,000 in cash and $412,500 in borrowing capacity, using the value-adding approach they can afford to purchase an unrenovated property for $240,000 on a 95% lend and see the project through to completion.
This would happen without affecting their cash flow or current lifestyle. If done right, it would afford them a pre-tax profit of $24,000.
If they were to do a cosmetic renovation every six to nine months, reinvesting their accumulated cash into bigger and more expensive properties to increase their profits, $1m in equity within seven years would be somewhat more attainable. Here’s how:
If our couple take the profit from the first purchase ($24,000) and add it to their savings ($60,000), they will end up with $84,000 cash to play with. With their borrowing limit of $412,500, they can afford a property purchase of $336,000.
Read on to find out how their second reno project might go down.The numbers at right illustrate the profit potential of a second reno project.
Continuing with this reno approach, assuming the same borrowing capacity, our couple could eventually reach the equity position shown in Table 3. In other words, even if we apply growth, we get close, but we are not quite there yet. This means even more creativity is required to solve this problem.
Option 3: A third approach – that works
As we begin to think differently, there are numerous ways to achieve our objective. Let’s say our couple has now purchased a few unrenovated properties, done them up cosmetically, sold them and made their targeted profits along the way. How might they begin to build on what they know? What about another strategy?
Land subdivisions are not too difficult. There are things you need to know and traps for new players, but in essence it’s not a difficult strategy to execute. Better yet, it’s a strategy that can be combined with other approaches, such as buying-renovating-subdividing and selling.
When you ‘boil’ property right down to its core function, it’s all about people. If you can satisfy more people with your property or give those who want to use your property a better experience, you will be paid more.
The renovation is all about providing a better experience, and the subdivision is all about being able to satisfy more people. In fact, you would typically expect to create a profit in the order of 20% of the purchase price for a reno-subdivision, against a 10%-of-purchase-price profit for simply undertaking the cosmetic renovation. As a result, we have amplified our couple’s productivity and capacity to profit through property.
Building on what we know, if we were able to renovate and subdivide, what might be next? Perhaps build something on the backyard block we’ve created?
If our couple build on what they know, with consistent activity towards finding and managing their deals, there is every opportunity to achieve an equity position of $1.5m after seven
years of doing property purchases one after another. Let’s not forget, though, that we would need to pay tax along the way. But since each individual’s tax circumstances differ, it would be unwise to attempt to address the couple’s circumstances here. With $1.5m in projected profit in seven years, and consistent application to their investing goal, I think their tax bill would be covered!
Disclaimer: This article is of a general nature only. The value of taxes payable is not discussed in any detail within this article and it is written for the purpose of demonstration and education. It should not be considered as legal or tax advice.