If you’re looking for a quick way to size up a deal before embarking on a lengthy and time-consuming due diligence, read on as Your Investment Property and Jeremy Sheppard, creator of DSRscore.com.au, deliver the ultimate cheat sheet on how to assess a deal fast.
People from anywhere in the world have a common trait. No matter what the product, the words “on sale” attract everyone. When it comes to real estate, it’s no different.
The phrase “you make money when you buy, you realise that money when you sell” continues to ring true. The challenge is being able to spot that good deal which stands out amongst many poor or mediocre deals.
Keeping your properties fully occupied with good tenants creates good cash flow. If you have ever owned properties with high turnover, high maintenance and therefore high management costs, you will appreciate the importance of the following checklist before you reach for your calculator.
You must understand the areas you are buying in. This can be the difference in having a low-stress property with reliable tenants or lots of bounced cheques and many trips to the property and the consumer tribunal.
Employment: Must be an area that attracts good working people with local employment opportunities or jobs within a reasonable commuting distance.
Schools: Having primary and high schools in the area will attract more families. Families will typically stay put longer when there are children going to the local schools.
Amenities: The property should be close to shopping and restaurants as well as easy accessibility to the main thoroughfares.
Crime: Obviously you want your property in a low-crime area. You can check with the local police station as well as ask people in the area about the crime rate.
Future building: This can be good or bad. If the area is growing and there is new housing development happening, stores and schools being built, that’s great. If there is a nuclear plant, jail, low-income housing projects, that’s probably not-so great.
Vacancy rate: You can check the latest vacancy rates at the back of Your Investment Property magazine or online at yourinvestmentpropertymag.com.au as well as local agents regarding vacancy rate. The lower the number, the better, as it indicates strong demand from renters and may be a sign of low supply.
Now let’s crunch some numbers. Doing a full property analysis where all income and expenses are calculated is crucial but time consuming. Smart investors only engage in the full analysis once the property has passed the “litmus test” as it were.
These four calculations can be done in minutes and will gauge whether any further number crunching is necessary.
The 5% rule
A 5% yield would be considered acceptable as a benchmark for quick calculation.
1. Quick way to calculate required rent
Divide the asking price by 1000. Or just knock off the last three digits. So for example, a $400,000 property should receive $400 per week in rent to roughly achieve a 5% yield. Any rent higher than $400 per week in this case would be a better than 5% yield.
This also allows for a two-week vacancy which is roughly 4% (a conservative estimate).
Required rent:............... $400 per week
Gross rental yield:............................. 5%
2. Quick way to calculate a positively geared property
For a property to be positively geared with a typical 80% LVR mortgage you’d need a 10% gross yield.
To calculate this, knock off the last three digits from the purchase price and then double that figure. So for a $400,000 purchase price $800/week would be required for the investment to be positively geared. This is assuming typical vacancy, insurance, management commission, repairs and maintenance.
Asking price: ...........................$400,000
Required rent: .............. $800 per week
...................................................($400 x 2)
To find a positively geared property you would need to look at average or median rents and average or median prices for the suburb as a whole being careful not to mix up figures for houses with those for units.
Any market with about a 7% yield or higher may have some individual opportunities for sale that exceed the 7% average and may get up to 10%.
For example, you may be able to easily convert a three-bedroom property into a four-bedroom home or add income by adding a carport. Obviously a granny flat will help
or renting out per room perhaps to students or renting partially or fully furnished.
Of course all this changes if the investor’s circumstances are different. A higher LVR or higher interest rate or land tax liability will eat into those simple calculations.
3. Quick way to calculate cash-on-cash return
Every investment comes down to only two things: risk and return. Calculating return is a lot easier than calculating risk when it comes to investing in property.
The return is how much money you earn each year as a proportion of how much you invested.
So if you put $1,000 in a term deposit for 12 months at 6% interest, you’d receive $60 for the year which before tax is a 6% return on investment (ROI).
The calculation is: $60 / $1,000 = 6%.
For an investment property your investment amount would be the sum of:
loan establishment cost
LMI if applicable
building and pest inspection fees
This is roughly the deposit plus 5% of the purchase price but varies greatly based on the deposit. So a 10% deposit will attract high LMI where a 20% deposit probably won’t.
So assuming the typical 20% deposit you’re looking at an investment of 25% of the purchase price. A $400,000 property would require $100,000 of savings or equity from elsewhere.
To calculate the cash-on-cash return on investment you simply add up all expenses and subtract them from the total rent to get the net income.
$1,000 insurance per year
$2,000 council rates per year
$2,000 management fees per year
$500 repairs and maintenance per year
$19,200 loan interest (80% LVR 6%) pa
Total: $24,700 per year
Then with $400/wk and 3.8% vacancy (two weeks vacant) = $20,000 rental income per year.
So net income is $20,000 - $24,700 = $4,700 net income LOSS before tax for the year.
After depreciation considerations this will appear a lot better (assuming the investor has other income against which they can claim these losses).
Let’s assume a claim of $5,300 in depreciation, the claimable loss would be $10,000 in total.
A tax rate of 30% would result in paying $3,000 less tax because of these claims.
So the total loss would be $4,700 - $3,000 = $1,700.
Divide the investment amount ($100,000) by this amount ($1,700) and you get a loss of 1.7%. That is the cashon- cash ROI.
ROI= $100,000 / $1,700 = 1.7%
4. Calculating overall investment ROI
The investor may like to consider capital growth in the calculation of their ROI. In this case it would not be a cash-on-cash ROI but an overall investment ROI.
Let’s assume 5% capital growth of the $400,000 property which equates to $20,000.
The total ROI for the investment after year one is:
($20,000 - $1,700) / 100,000 = 18.3%.
$400,000 x 5% = $20,000
Total ROI = $20,000 - $1,700 / $100,000 = 18.3%
But this is not realised until you sell. Even so, it’s a lot better than a term deposit, All Ords, and what most investment funds or superannuation funds provide.
These calculations should be used as consideration for a property purchase. It is necessary to do your full diligence and complete property analysis with actual numbers prior to making any purchase.
Jeremy Sheppard is director of research for Redwerks and a keen property investor.
He created the Demand-to-Supply Ratio (DSR) and is the author of How to Find Property Hot Spots. Visit DSRscore.com.au