Finance issues you might be overlooking when investing in property

It’s easy to get carried away with the excitement of buying a property, so Eddie Chung lays out the finance issues you need to take into account before investing in property.

Let’s face it. Buying your first investment property is often an exciting experience. In between property inspections and speaking with real estate agents, it’s easy to get caught up in the moment and overlook the financial aspects of the purchase. Luckily, some financial consideration is a good way to temper the impulse when buying an investment property. After all, a financial misstep could set you back for years.

Property value
Contrary to popular belief, what you are willing to pay for a property does not necessarily equate to its market value. It is possible to overpay for a property. There are ample real-life examples that have involved marketeers artificially inflating the value of properties for sale to unsuspecting investors. Therefore, some proof of the value before you start negotiating a price will put you in good stead. Here are a few ways to gauge the value of the property you’re interested in.

Check out listing sites
Perhaps the best place to start when it comes to estimating the market value of a residential property is to use internet websites that provide the sales history of similar properties in the neighbourhood of the property you are considering. Some of these websites require a paid subscription, while others provide free – but limited – information. The more recently a comparative property was sold, the more likely it is that the sales price of the property will approximate to the market value of the property you are comparing it with. Usually, based on a number of commensurate properties nearby, you should be able to get a fair idea of the range of values for the property you are considering buying.

Check out the price per square metre and compare it to properties on the market
Another way to assess the value of a property, albeit by no means precise, is to calculate the value of similar properties recently sold around the neighbourhood on a per-square-metre basis and compare that against the asking price per square metre of the property under consideration. 

To ensure comparability, the calculation usually excludes outdoor areas such as balconies and patios, which is especially true for units and apartments. On the other hand, if houses are involved, the total land area may sometimes be used for comparison purposes, given that the size of house blocks is generally decreasing and the value of land therefore increasing.

Get a professional valuation
If all else fails, there is always the option of obtaining a formal valuation from a professional valuer, who will most probably conduct a stocktake of recently sold properties in the neighbourhood that is not dissimilar to what you could do yourself. However, a professional valuer could arguably conduct the exercise in a more systematic and efficient manner, which may save you some time and effort at a cost.

Some people may argue that if you need finance to acquire the property, the bank will use their own panel of professional valuers to value the property as part of the loan application process anyway, so there is no need for you to assess the value of the property independently.

However, unless the value of the property on the contract is grossly overstated, it is likely that the bank’s valuer will nominate the contract price as the market value of the property. After all, the value of a property is theoretically determined as the price an unanxious buyer would be willing to pay to an unanxious seller in an arm’s length transaction, which is what you have negotiated with the vendor to pay for the property on the contract.

At other times, a valuer who is engaged by a bank is generally conservative and may come back with a lower value than the contract price, with a bias in favour of the bank. Therefore, an independent valuation may not be a bad idea after all.

Valuing commercial properties
Valuing a commercial property is generally more complex as its value is often dictated by the remaining term of the lease(s) on the property and the prevailing yield of similar properties on the market. The annual gross rent on the property may simply be divided by the prevailing gross yield, which may give you a reasonable market value for the property. 

However, notwithstanding this mathematical approach to valuing commercial properties, there are other factors that may affect their value.
The current yield on a commercial property may not render it an attractive investment, but the potential of the site under an alternative use may produce a far greater return (for example, if the property is redeveloped), which may compel a buyer who is a property developer to pay a higher price than a value that is determined with reference to the yield of the property alone. 

Given that higher values are usually involved in commercial property transactions, compared to those of residential properties, and the valuation complexities involved, there may well be a stronger case for the purchaser to obtain a formal valuation and undertake a due diligence process to prove the asking price and other details associated with the property (for example, the state of the existing leases).

Banks generally consider your finance application to buy a property based on the loan-to-value ratio (LVR) and debt service ratio (DSR).

Loan-to-value ratio
The LVR ensures that the bank is getting sufficient security over the loan, so that if you default on the loan they can sell the property and use the proceeds to repay the loan, even if the property is sold in ‘fire sale’ conditions. The LVR essentially provides a margin of error for the bank to allow for any discount required to sell the property quickly to enable them to get their money back. 

For residential properties, the bank will usually lend up to 80% of the value of the property without any mortgage insurance. The LVR may go up to 95% if you agree to take out mortgage insurance, which can usually be added to the loan. 

In contrast, given the higher volatility of commercial property prices, the bank will usually lend between 60% and 70% of the value of the property, depending on the bank to which you are applying for the loan and the prevailing economic conditions. In a sluggish economy, the bank may perceive that there is a higher risk associated with the property as security, so they may reduce the LVR to reflect their risk appetite.

Debt service ratio
In addition to the LVR, the bank will also assess the DSR to satisfy themselves that you will be able to service the debt over the term of the loan. The DSR is calculated by dividing the periodic loan repayment amount by your gross income over the same period. For residential properties, banks are generally happy to lend where the DSR is no more than 30% to 35%. A higher DSR may indicate that you are stretching your finances, which increases the chance of you defaulting on the loan from the bank’s point of view.

Debt coverage ratio
For commercial properties, banks sometimes substitute the DSR with the debt coverage ratio (DCR), which is also commonly known as ‘interest cover’. The DCR is calculated by dividing your net operating income (ie gross income net of operating expenses) by the interest expense that would be payable on the loan if it is approved. Banks will generally look for a DCR of at least 1.5 before they will lend you the funds. In any case, it may be an idea to use a mortgage broker to source the loan for you because your current bank may not always provide you with the best deal, and, even if they have done so, using a broker may give you confirmation that you are getting the best deal possible.

Budget and safety net
Notwithstanding how a bank may assess your loan application, it is critical that you prepare a budget for yourself, which takes into account all your income and expenses, as well as the rental income and rental expenses associated with the property you are considering buying. 

You should also discount the expected rent for the full year to account for potential vacancy, and include the loan repayment as an expense under the assumption that the loan is approved, which will tell you whether you can afford the property. 

To build in an additional safety margin, it may be prudent to calculate the loan repayment on a ‘principal and interest’ basis even if you are applying for an interest-only loan. You should also calculate the repayment under a scenario in which the interest rate on the loan is doubled, and import this repayment amount into your budget. 
This is known as a ‘sensitivity analysis’ as it gauges how sensitive your budget is to potential future interest rate rises. In fact, I have been known to advise clients to assess their budget based on a whopping 17% interest rate, which was how high interest rates reached back in early 1990!
In the end, where you draw the line and deem the property as affordable will depend on your personal risk appetite but a sensitivity analysis should always be done so that you are fully informed of how robust your finances are in case the economic conditions surrounding your property change in the future.

Before you sign
Apart from the key financial issues above, consider the following tips before you sign the contract to buy an investment property:

1. While the real estate agent may recommend that you put down the ‘standard’ deposit of 10% of the value of the property upon signing the contract, this is not absolutely necessary and you should try to negotiate a lower amount to free up your cash flow.

2. Even if you do not need it, always include a ‘subject to finance’ condition in your offer, which will allow you to secure finance that is most suitable to your needs and circumstances.

3. Do not sign the contract until you have made the decision on the ownership structure of the property; for example, you may want your discretionary trust to buy the property instead of owning the property in your own name. In some parts of Australia, you may be required to pay double stamp duty if you subsequently change the buyer of the contract to another entity.

4. Upon signing the contract, speak to your insurer and take out insurance on the property. In some parts of Australia, the risk of the property is passed to the buyer from the contract date, while such risk is passed to the buyer at settlement at other locations. In my view, the relatively small insurance premium is well worth your peace of mind if the unthinkable happens.

5. Upon signing the contract, speak to your insurer and take out insurance on the property. In some parts of Australia, the risk of the property is passed to the buyer from the contract date, while such risk is passed to the buyer at settlement at other locations. In my view, the relatively small insurance premium is well worth your peace of mind if the unthinkable happens.

6. For commercial properties, make sure that you check the GST clauses and determine if the contract price is GSTinclusive or GST-exclusive. Ask your accountant to review the contract because the purchase may be GST-free under a specific exemption in some circumstances.

Eddie Chung is partner, tax & advisory, property & construction, at BDO (Qld) Pty Ltd.

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