One of the many benefits of investing in property is the full control you have on your investments. However, your success hugely depends on what strategy you adopt and how you implement it. In a three-part series, Bill Zheng, CEO of Investors Direct shows you the upsides and downsides of each approach.
Property investors are a unique breed. Investors in many other types of assets (like shares, managed funds, indirect property, deposits, super etc.) play a relatively passive role in the investment decision making process. The majority of these type of investors allow their advisors (fund managers etc.) to take the drivers seat and make their decisions for them.
Direct property investors on the other hand are fully responsible for their success and failure, not a fund manager or share broker. The property investor is fairly and squarely in the driver's seat.
It is a difficult role to play, and an even more difficult role to do exceedingly well. I believe there are 3 different types of systems a property investor needs to master to be effective:
1. Property Systems
2. Money Systems - your capital, cash flow and finance plan
3. People Systems - your team and self management
In this article I will deal only with the first system: Property Systems. In my opinion there are generally two different types of residential property investment strategies;
• Passive (or defensive) strategies and
• Active (or offensive) strategies.
Passive (defensive) strategies
This is where investor puts in a standard amount of effort and therefore the investment has a standard risk profile and standard return. They also typically require a normal deposit (3%-20%) and normal finance (97%-80%), they receive natural capital growth (3%-10%pa) and a natural yield (2.5%-8%). These types of strategies include:
• Cash Flow vs Growth
• Houses vs Apartments
• New vs Old
• High price vs low price
• Special purpose
Active (offensive) strategies
This is whereby the investor puts in more effort on a more "creative" type of opportunity which therefore typically has a higher risk profile and return. These strategies usually involve a creative deposit (<3%) and a creative finance solution (>97%). The rewards for this extra effort are instant capital growth (5%-25%) and higher yield (>8%). These type of strategies include:
So what are the major advantages and disadvantages of these various strategies? And which one will suit your situation?
Choosing your strategy
Cash Flow vs Growth Strategy
Strategy # 1) Cash Flow properties:
These are properties with a low capital growth profile of 4-6% and high rental yield (return) profile of around 6-10%. Occasionally though the capital growth achieved for these types of properties can be very high. But typically this is only for a short while.
The main advantage with Cash Flow properties is the positive or neutral cash flow that they generate. You can't lose having money in your pocket (unless you get in too late). 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. Moreover, you can use the surplus cash flow to pay down principal to get more equity for future investment;
Because of the popularity of these types of properties it is not uncommon to occasionally achieve strong capital growth gains due to the demand for high yield properties.
Regional areas tend to have slower capital growth over periods of time unless there is an economic change to the area. For example, North Queensland is experiencing growth in property values at the moment due to the mining industry. Traditionally properties in regional North Queensland have been strong cash flow properties. The increase in population has driven a demand for homes and rental accommodation, which in turn pushes the price up for existing properties. These properties would now be giving you good growth.
Buying into the area now however, would give you a higher entry cost and would reduce your ongoing cash flow. Should the mining boom cease or slow down, the demand for properties would drop, which in turn would have an impact on values. So as can be seen, the regional centers can in fact give you both strategies, however you would have to be careful that the growth is not short lived and that then the area reverts back to its normal slower growth pattern.
From a finance perspective the income generated from the asset means it is easier to get a full-doc loan with a higher loan to value ratio (LVR) i.e. you can borrow more (thereby putting in less of your own money).
Because you are generating an income from the positive cash flow, you pay tax along the way. You get taxed on this extra income and money in the tax man's pocket is going to make it hard for you to create serious wealth.
Because these properties are usually in regional or outer areas they can be quite sensitive to economic cycles. Therefore compared to properties located closer to the centre of our major cities these properties will generate lower capital growth over longer term.
There are also potential higher costs associated with maintenance and more tenancy problems due to socio-economic factors.
From a finance perspective it is harder to get low-doc or no-doc loans for some regional properties due to postcode restrictions imposed by lenders, mostly due to their smaller populations. The result is lower leverage which will reduce your return.
Strategy # 2) Growth properties:
These are properties with a higher capital growth profile of 7-10% (and occasionally over 12% for a short while) and a lower rental yield (return) profile of 3-5% rent (occasionally below 2.5%).
The main advantage of these types of properties is the fact that these areas are usually inner areas and high population areas which are not affected as much by economic cycles and interest rate. Therefore they usually have higher and consistent capital growth over longer term. This means investors can generate more equity in a quicker period of time which can allow them to invest further.
The government also makes it attractive for investors to purchase these types of properties by offering tax benefits via negative gearing and delayed Capital Gains Tax (CGT).
In terms of finance it is easier to get low-doc and no-doc loans for these types of properties. Most lenders view these types of properties as less "risky" than regional properties, mainly because of the larger populations in these areas. Therefore there is less risk of tenancy problems due to better socio-economic conditions and the fact that there are more buyers in these areas, in case the property ever needs to be sold quickly.
So from an investor's perspective there are more finance options available for these properties. High leverage is available as it's easier to get a low-doc or no-doc loans.
This big disadvantage with these properties is the negative cash flow if you take on a normal mortgage at high leverage level. Added to this is the fact that these properties are usually more expensive than cash flow properties, in terms of purchase price, stamp duty and land tax. So as we are seeing in a number of markets across the country at the moment, it is harder for beginners to enter the market, simply because there is greater demand for these types of properties than the supply.
Furthermore, in the short term there is no guarantee for capital growth every year - you may bet on the wrong horse.
The main disadvantage from a finance perspective is that it gets harder to get full-doc loans to access cheaper interest rate mortgage as your portfolio gets bigger.
Houses vs Apartments Strategy
Generally speaking in recent times there has been an increasing acceptance of apartments relative to houses to cater for our accommodation needs. Families are getting smaller; people have less time on their hands to maintain gardens etc. Investors need to be mindful that tenants gravitate to properties that meet their needs. These needs will largely depend on how they prioritize and weigh up each of the above advantages and disadvantages; how they feel about the notions of space, time, enjoyment and money in relation to a specific property.
Strategy # 3) Houses
Houses have typically shown more consistent growth over the long term in established areas. Therefore purchasing properties with high land content is a one way to increase your chances of securing better future growth if it is in an established area.
You usually own the land and so therefore you also have greater control over what you want to do with it. This means there are more options open to you (depending on Council regulations in the area you are purchasing) to modify the property and add value.
Because of the above, houses are typically more sought after and therefore it is usually easier to get finance. However townhouses are now getting popular as family sizes decrease and the number of retirees increase.
Big houses sometimes can be hard to get good rent. So be careful as sometimes houses do offer lower rental returns as a percentage of their value. There can also be higher maintenance costs.
Strategy # 4) Apartments
One of the main advantages with apartments (or units) is that they tend to have higher rental as a percentage to their price.
Moreover, apartments frequently achieve just as good returns as houses in areas that are fully built up with height limit restrictions on further development.
Over the last decade we have also seen these types of assets start to become popular with the younger generation & empty nesters. They meet the needs of these demographics as lifestyle trends change. Partly because they typically are less labour intensive in terms of maintenance and so there is generally less time involvement and they also have potential benefits over houses because of the shared benefits of many apartment complexes from community/group services e.g. pool, tennis court, gym, activities, etc.
The main disadvantage is that apartments typically show less consistent growth in areas that are not fully built up. Owners of apartments also typically have less control over their asset as any changes they want to make to their property usually requires approval from a Body Corporate. So the opportunity to add value is restricted. Owners have to contribute to the running of the Body Corporate, so compulsory fees are generally higher.
It is also hard to get good finance for some type of apartments. Mainly company title properties and very small apartments (under 40 m2). So watch out for these types of properties!
New vs Old Properties Strategy
Strategy # 5) New Properties
New properties are attractive to passive investors who are time-poor and would like to have a property that requires little effort on their behalf. There is usually lower maintenance, and if there happens to be any defects after completion, the builder or builder's insurance should cover any cost involved.
New properties have an appeal to tenants as they usually have lots of light and space, and may also come with other amenities such as swimming pool and gym (new apartment complexes). Tenants with good incomes are often prepared to pay higher rent for new properties particularly if they are situated close to their work.
From a tax point of view, new properties usually offer higher or longer depreciation benefits, not only from the fixtures and fittings but also from capital works. It is possible for investors to use these tax benefits to assist with monthly cash flow.
The main disadvantage of purchasing new properties is that the cost to purchase may be higher than an old property in the same area, as developers have to cover their costs and profit margins.
Many people who purchase new properties may make emotional rather than business decisions, as they may have fallen in love with the look of the place and how it makes them feel. If they have paid an inflated price for the property it may take longer to realize capital growth.
Another reason that growth may be affected is because there may be a few properties that are very similar being sold at the same time, such as in a brand new development. A few hasty re-sales can affect the values of all the properties in the immediate area. This can have an impact both if you are trying to sell a property or are trying to release equity from your own property. If properties have been sold for lower prices, it will reduce the market value of your own property.
As a general rule, brand new properties don't allow much room to add value by renovating as all the work has already been done by the developer, so unless an investor has purchased at well under market value they will need to wait for the natural capital growth to occur.
Strategy # 6) Old Properties
One of the biggest advantages of old properties is the fact that you get less price fluctuation than new properties in the same area, plus you gain the ability to add instant value through renovations, subdivision and development. Some investors have even managed to get their property for "free" by subdividing a large block and selling off a portion of the land.
It has been proven that land, and the scarcity of it is what drives property value upwards, and older properties generally have a bigger land component.
Investors can be more certain that the property they are purchasing has a 'true' market value, with no profit margin set by the seller. They are usually found in well established suburbs which can demonstrate consistent growth.
High maintenance costs are probably the biggest disadvantage of old properties. There may be a loss of rental income if renovations need to be done. It may be also harder to attract good quality tenants to an old property, unless it has had some renovations done to it to modernise it.
Also, tax benefits are not as good with old properties due to lower depreciation values. Rental may not be as high if the property is very run down, which could impact on your monthly cash flow as the rental yield you can command will be lower than could be achieved with a new property.
High vs Low Price Property Strategy
Strategy # 7) High Price Properties
High priced properties are usually in well known suburbs and come on to the market irregularly. So there are less of these types of properties available.
The marketing effort is considerable for this type of home as prestige is something people strive for. So it is relatively easier to track when these type of properties become available.
Affluent suburbs have strong demand, limited supply and typically have a solid past growth performance. These factors will continue to keep the prices increasing.
The price of these properties will mean a higher rental figure which could put them out of the reach of mainstream tenants which generally means the quality of tenants will be of a higher standard.
In times of economic downturn, it is the higher priced luxury items that suffer first. As there is less demand for these types of properties there will be very little capital growth. Having the best house in the worst street or area does not give you good capital growth. It makes more sense to have an inexpensive house in an expensive suburb.
From a financing point of view, it can be harder to arrange finance on a higher priced property. Don't forget lenders base the amount they are willing to lend against a property on how quickly they could sell the property to realise a debt.
The higher the value of the property, the less demand there is from the general population to purchase it. For example a 60% loan to value ratio (LVR) for a $3M property looks decidedly pale against the easily achieved LVR of up to 95% for a more modestly priced property of $500k
You can also expect higher stamp duty and land tax costs if you are looking to invest in these properties.
Strategy # 8) Low Price Properties
Lower priced properties in established suburbs can handle economic down turn better; the lower price will mean these properties are still relatively affordable. The lower mortgage balance allows investors to continue to purchase during these times.
Given that there are more lower priced properties available and they are spread throughout most locations an investor can have a better spread of suburbs to buy into. This means that lower priced properties have a more stable performance if they are priced around the median price of the suburb they are located in.
Greater diversification reduces the risk of not having sufficient tenants in the market for this type of property or seeing a downturn in one suburb as opposed to another.
These properties also have lower stamp duty and land tax costs.
Of course the disadvantage of the higher availability of lower priced properties means there will be more competition to purchase the properties. It could take an investor a lot longer to find and purchase.
It could be harder to find tenants if the area is not supported by infrastructure. Lack of nearby public transport, shops, schools etc will make them less appealing to prospective tenants who may have families with small children.
If the property is too run down the rental returns will be much lower, which in turn could attract a lower quality tenant. While renovating the property to gain some equity and increase the rent could mean over capitalising depending on the area.
Strategy # 9) Off-The-Plan Strategy
Off-the-plan purchases have a lot of the advantages I have already touched on with new properties. An off-the-plan purchase is a brand new property which has higher depreciation benefits.
The stamp duty payable on the purchase is reduced because the property is not yet completed.
The Foreign Investment Review Board will allow an overseas investor to purchase an 'off the plan' property, where they can't purchase an established property.
Perhaps one of the biggest advantages is that there is the potential to secure the property without putting any of your money down. Some developers accept Deposit Bonds to cover the deposit instead of you having to use your own cash. If the property is not completed for a couple of years, this is a much cheaper option and allows you the flexibility of using your cash for something else. So there is a potential equity gain for the investor to be had, even before settlement. But only if you get it right.
There have been occasions where properties purchased off the plan, may have dropped in value by the time the property is completed and ready to settle, therefore investors may find themselves out of pocket. These developments tend to be heavily marketed by skilled project marketers and you have to be careful to see through the spin and focus on the underlying fundamentals of the project itself.
With some new developments the area and type of product that is being developed may not have been tested before. This is a warning sign. Past performance is the best indication of future performance, without past performance the future performance is unknown. Therefore there is more scope for the purchase price to be set artificially as there is no precedent. You need to factor this risk into your decision making process.
Paying the upfront deposit prior to any valuations being completed commits you to the property before you have a true "value" on the property. Remember you haven't actually "seen" the property you are purchasing. If there are a number of large developments going on in the same area, it can reduce the value of the property you have purchased even before its completed because there is an over supply (remember Docklands in Victoria?).
With large developments, if a certain percentage of the properties are not sold before construction, there is no guarantee the project will commence, which means you may have lost valuable time and missed out on other property opportunities.
Special Purpose Property Strategy
Strategy # 10) Serviced Apartments
The main advantage with serviced apartments is that they are less taxing on your time. As they are managed you don't need to worry about tenants and maintenance yourself and you can usually command a higher rental return if the property is managed properly.
The draw back is that it is harder to get finance for these types of properties. The main reason is that they are classified as commercial property. Commercial lenders won't give you the same loan LVRs as they would on residential properties. Typically they are around 65-80%.
They can also be hard to resell given that the market for serviced apartments is not nearly as large as the residential property market. Moreover their capital growth is tied into yield and how well it is operated, not necessarily reflecting local property prices. In other words the value of the property is affected by the financial viability of the operator, which is typically not something that you can control.
Strategy # 11) Display Homes
Display Homes are usually built to above standard quality because they are used by developers as their showcase. You can secure a higher rent than normal properties, which is guaranteed for a contracted period because the developer will continue to use the property. Your maintenance costs are non existent for the contracted period and there is also no need to look for tenants.
Display Homes can be overpriced in compensation for the fact you are receiving a guaranteed rental return that is higher than the market rate. You need to be careful as the developer's financial viability can affect the rent they guaranteed.
It also can be hard to get finance from some lenders due to difficulties with obtaining an accurate valuation and the commercial nature of the arrangement you are entering into. On top of this these types of properties are usually in outer areas which have historically displayed slower long term capital growth.
Strategy # 12) Student Accommodation (Managed)
Much like Serviced Apartments, student accommodation that is managed can achieve a higher rental return if it is managed properly. Similarly you don't have to worry about tenants and maintenance.
The biggest advantage over serviced apartments is the purchase price. Student accommodation is typically more affordable.
Student accommodation can be hard to resell sometimes due to its special purpose nature. Like serviced apartments their growth is tied into yield and how well it is operated, not necessarily reflecting local prices. The value of the property is also affected by the financial viability of the operator. A lot of lenders are reluctant to lend on student accommodation due to the size of the property as student accommodations are frequently studio's or 1 bedroom apartments less than 40m2.
Strategy # 12) Renovation Strategy
As seen earlier with older property strategies, there are many advantages to renovating. The main one being the ability to instantly create additional equity that you can access for further investment or to create an equity "buffer" to manage your risk better. Spending money on a renovation if done right is a very efficient use of your money.
Renovations don't have to be major to add instant value. Cosmetic renovations have lower town planning requirements and don't carry the risk inherent in building. They can be as simple as a new kitchen or bathroom, fresh paint and floor coverings. This increased value can assist by also enabling a higher rental return, not just creating more equity. It can also lead to higher tax advantages due to higher deprecation.
Sometimes you can buy properties under market value that need renovation. However, these properties in recent times are highly sought after and so competing parties frequently bid this benefit away.
Another positive is that if you are purchasing these types of properties, most of the money you pay is going to the 'land component'. It is the land which appreciates in value, while the building on the land depreciates. So with a higher land component you are ensuring solid future growth.
Inexperience, however could cost you more money if you don't anticipate structural, engineering or council permits. You may not see trouble spots until half way through a renovation (electrical, plumbing or structural issues). It's very easy to underestimate the time, cost and work involved in a renovation;
You would have to ensure that the money spent is going to give you the increased value in the property and that you haven't over-capitalised. You have to ask yourself, will you be able to create enough equity on the sale or revaluation to make it worth your investment in time and money? Can you increase the rent sufficiently in the area to make the exercise worthwhile?
Doing a renovation requires a lot of work if you do it yourself. Even if you don't do it yourself, it requires a lot of management if done by others.
It also takes a lot of time to find the property that can make the numbers work.
Strategy # 13) Development Strategy
The main benefits of developing are the potential for you to make a good profit above your costs by creating the equity instead of waiting for it over time with capital growth. It also allows you to express your creativity.
There is no question about it, developments are exciting projects to work on and there is a certain amount of pride that goes with completing a project. You also get to call yourself a developer!
From a finance perspective the main benefit with development is that you have the potential to get finance and capital based on the strength of the deal, instead of your own personal equity or income capacity. While there are multiple exit strategies to make money, depending on how quickly and how much profit you want i.e. subdivide and sell, sell with plans and permits, secure plans and permits construct, subdivide and keep, secure plans and permits construct, subdivide and sell etc...
However, like anything, where the potential return is higher, so is the risk. I could write another article just on the complexities of the finance risk in development. Let alone the planning risk, building risk and selling risk!
Developing is a complex business. It's easy to make a loss if you don't know your craft. It requires high commercial skills and people skills if it is to be done successfully. It also requires good timing. You have to be able to read the property market extremely well.
And from a money perspective it might not be the most efficient use of your money due to long lead times. There are potential delays in every step of the development process; planning, permits, finance and construction.
Therefore it frequently requires a larger capital commitment (than originally estimated) from the developer, as these delays cost money. So you have to factor in that you will have a lower income while holding the site.
Strategies 14 - 18) Unconventional Strategies - Wraps, Rent to Buy, Vendors Terms, Joint Ventures, Options
These extremely creative property strategies usually combine with other property strategies we have already touched on, and are attractive for a number of reasons. Namely that they require very little or no money down, have positive cash flow and create instant equity on entry and/or exit
Don't underestimate just how hard you will have to think, how hard you will have to work and the amount of time you will have to spend, firstly learning, and then executing on your chosen strategy.
To make any of these strategies work you also need to be very entrepreneurial and the fact is that entrepreneurship is not necessarily something that can be learnt.
Moreover, because these strategies are so advanced and different, you can run into significant difficulties in managing the expectations of investors, vendors, real estate agents and tenants/purchasers. These people are all important parts of your strategy and more often than not will not be familiar with these concepts. So you will have to educate not only yourself, but them as well!
You can also expect extra legal and accounting expenses if these are the types of strategies you want to pursue.
Which one is the best?
Each of the above strategy has its own unique characteristics and none any better than the other. We have clients that make good money out of all of these strategies. Some focus on just one and become very efficient at doing just that. While others will spread themselves across a number of different strategies and do equally as well.
But which one suits you? Are you better off with a Passive (Defensive) or Active (Offensive) strategy?
I think the best piece of advice I can give any investor is...there is room for both.
Firstly, you always need to have a passive strategy in place. A passive strategy will ensure that you get more predictable results - you are guaranteed 'not to lose' in a sense. If you incorporate this type of strategy into your property system you will ensure that you are less emotional and more consistent. It also means you will always be making good use of your TIME which has to be a major consideration for any investor.
Secondly, you should use active strategies at the right time. If you start with nothing or very little, you can start with more active strategies to build your equity and/or cash flow, and be good at one thing first.
My advice would be to focus on one strategy initially and become very good at it. This is your best bet to make serious money before become diversified and defensive.
Be careful though. When considering adopting an Active strategy to take advantage of a great opportunity, the time to do it is only when you are sure it will not affect your overall financial stability.
Talking about financial stability. Next month we will delve in more detail into the finance side of your property investment strategy. We will explain what a Money System is; how it underpins your Property System and how if you don't have a money strategy that works effectively your property strategy, no matter what it is, can suffer.
Article supplied by Investors Direct.
Investors Direct is a property finance company that provides financial solutions exclusively for property investors and understands that your mortgage is an asset, not a liability.