First published 14/03/2013
If you’re a beginner, scrambling to understand what some investors did to become millionaires, here’s how you can learn the basic wealth building principle behind property investing
Just flick through the pages of Your Investment Property, and you’ll come across tale after tale of ordinary people who have built – or are in the process of building – substantial property portfolios. Million-dollar figures are bandied about with regularity as investors talk about how they’re moving towards financial independence. It’s an enviable position to be in, but how do you join the club?
The answer is that it’s surprisingly simple – whether you already own property or not. Each and every property investor started exactly where you are now – with no experience in the world of property, and worried about making a wrong move. In fact, mustering the courage to start a property portfolio is often the most difficult part in property investing.
As long as you understand a few key concepts and are clear about your goals, property investing can become a much less daunting proposition.
How do you profit from property?
While there are many different strategies that you can employ to make money out of property, there are really only two real ways to make a profit: the first is from rental income, the second from capital growth.
The first puts money directly in your pocket. If the rental income from a property exceeds its costs, the remaining rent is the profit – these properties are known as cash flow positive. Cash flow positive properties usually have a gross rental yield of 9% or above.
The second way of making money relies on properties increasing in value. Property has historically increased in value, typically faster than inflation: you’ll have already noticed this if you’ve bought your own home and sold it for a better price, making a profit.
As you borrow a fixed amount to buy a property, the increase in value is all yours – and as such you’re making a profit. If you hold property for the long term, you can see significant increases in value – and as such make a significant gain.
Properties that exhibit annual growth of more than 9% are generally deemed to be good properties for this approach.
Both methods have their pros and cons, too.
Positive cash flow – pros and cons: While all investment properties eventually become positive cash flow in theory – once you’ve paid off the debt owing on the property – not all properties produce a positive cash flow to begin with. Indeed, most do not, and investors may have to search hard to find properties that will create an income from the outset.
“Typically, these properties are located in regional areas and so they tend to have lower entry prices as well as lower stamp duty and land tax – so for investors who don’t have much equity or income it is easy to get started,” says Bill Zheng, CEO of Investors Directs. “Moreover, you can use the surplus cash flow to pay down principal to get more equity for future investment.”
However, because you are generating an income from the positive cash flow, you pay tax along the way. You get taxed on this extra income: money in the taxman’s pocket is going to make it hard for you to create serious wealth. Also, many cash flow positive properties are in regional or outer areas, and can be quite sensitive to economic cycles; plus, while they do increase in value, their capital growth tends to be relatively slow. It can also be trickier to obtain finance for regional properties.
Capital growth – pros and cons: The strength of making profits through capital growth is that you can potentially make significant gains – particularly where properties are held for the long term. In fact, this is where most property investors make the bulk of their money.
“The main advantage of these types of properties is the fact that these areas are usually inner city, high population areas which usually have higher and consistent capital growth over the longer term,” says Zheng. “This means investors can generate more equity in a quicker period of time which can allow them to invest further.”
The big disadvantage with these properties is the fact that, while you eventually make money in the long term, they typically cost you money to hold, as the rental income is unlikely to cover holding costs – especially if you take on a normal mortgage at a high leverage level. To counter this, the government makes it attractive for investors to purchase these types of properties by offering tax benefits via negative gearing – allowing you to claim the difference between cost and income as a tax deduction –delaying capital gains tax until property sale, and other benefits such as depreciation.
These properties are usually more expensive than cash flow properties, in terms of purchase price, stamp duty and land tax, and it can be harder for beginners to enter the market.
Also, in the short term there is no guarantee that there will be capital growth every year. However, there are numerous ways to manufacture capital growth by improving, renovating, developing or subdividing properties – which can also increase their cash flow potential too.
Cash flow or capital growth?
So, seeing as types of properties tend to veer towards one or other of the main strategies, is one ‘better’ than the other?
Most market experts recommend pursuing a growth strategy, as the higher gain it typically results in is more effective for investors trying to build a portfolio of properties that will act as an asset base, and ultimately wealth creation. However, cash flow properties can be suitable for certain investors: beginners on moderate incomes looking to break into the market, retirees looking to fund lifestyles and investors with a largely growth-focused portfolio looking to offset the holding costs of their negatively-geared properties.
While property author Stuart Wemyss is certainly of the ‘go for growth’ school, he adds that investing for cashflow is better than not investing at all. He explains investors without the income to facilitate negative gearing can use a cashflow strategy as “a longwinded way to build an asset base” by purchasing positive cashflow properties and reinvesting the extra income to add value and slowly increase equity.
The challenge for every investor is treating the perfect balance between growth and income as a bonus, rather than a right and making a solid decision about which strategy best suits their personal circumstances.
“If you are a retiree with an asset base, you may want income and that is what you need at that point in time,” says Wemyss If you have a low asset base you need capital growth assets, so you invest in blue chip property or look at property development, even if it is just buying a rundown property and doing it up. It is really just horses for courses and choosing the right tools for you.”
Is it time to buy?
Knowing when to begin developing a property portfolio is often harder than knowing how to begin a property portfolio.
Entering the investment market is typically done in one of two ways – either by saving for a deposit and buying an investment property as your first property in exactly the same way you would buy a home, or by leveraging the equity from an existing property as a deposit. This requires some or all of the original loan to have been paid off and/or the property to have increased in value.
Many investors will begin investing after they have paid their owner-occupied mortgage off and are beginning to think about financial strategies for their future. However, if you are waiting until your owner occupied home loan is 100% paid off, you might be jeopardising the full potential of your property investment portfolio.
The other concern about entering the investment market is the fear that you’ll lose your money. Property is a not insignificant investment, and the experiences of the US and UK during the GFC have made many prospective investors nervous. However, the Australian market is seen to be quite different from other international markets, which is underpinning strong long-term growth. Reasons for this include:
- Strong employment
- Relatively little national debt from the GFC, which creates less of a drag on the economy
- The resources boom driving regional economies
- High migration, especially from overseas
- A net shortage of properties, reducing supply as demand increases
- Additionally, even though property in the short to medium term is expected to flatten or fall slightly, the long term prognosis is for overall growth of around 7%. Bear in mind, too, that the Australian property market does not move as one: different regions, cities and suburbs experience growth at different times due to different local economic drivers.
To keep up with the movements of the property market, you should aim to find time to log onto online property forums, sign up for electronic market updates and read magazines – such as Your Investment Property – which feature in-depth reports about top performing suburbs and comprehensive suburb listings. The most current of property data is vital in your ability to pick a good bargain in a range of property markets.