08/10/2009
Many seasoned investors tell you that "you make money when you buy". Or you'll read from books that you should "buy but never sell". The reason? Trading property costs a lot.
"Selling an investment property is like killing the goose that lays the golden eggs," says Paul Do, property investor and author of I Buy Houses. "Not only do you put an end to the golden eggs in terms of the capital growth and rising rental income, but you incur transaction costs up to 10% for a round trip as well as capital gains tax that take a large chunk out of your yield.You should avoid selling any of your properties if possible to maximise your time in the market and take advantage of compounding effect. You also save on transaction costs and capital gains tax (on investment properties) when you do not sell," he explains.
If you buy a property today, unless you have a short term strategy to get in and out of it such as buy-renovate-sell, you should plan to never sell, or at least have the cash flow capacity to hold the property long enough to see the LVR go below 60% according to Bill Zheng, CEO of Investors Direct. "If you can get a property down to 60%LVR, you can then decide whether you need to sell it because cash flow will start to become neutral or positive from there, and you can enjoy the income benefit of a property for the rest of time if you don't sell it," he says.
Monique Wakelin, director, media communication for Wakelin Property Advisory adds that rather than trading up from one property to another one, you should be using the accumulated equity in the existing property to add to the portfolio rather than replace the existing property with an expensive one.
"Most people make the mistake of thinking that at a certain point in time when the property has doubled in value, it's not going to go up any further and it's time to sell it and upgrade to something more expensive. That is absolutely faulty logic and it's a wrong way to think about property," she says.
But is there a good time to sell an investment property?
Wakelin says yes, there are certain times when it's prudent to sell an investment property.
"When an investment property has been held for five years or longer and the capital growth has not performed significantly ahead of inflation consistently during that period, you're basically holding a dud asset and you need to get rid of it," she says.
Another instance is when you're nearing retirement and you're rationalising debt so that you have an unencumbered income-producing base. At that point, Wakelin says it would be prudent to look at your portfolio and assess what you have and should hang on to that's going to produce not only good consistent growth, but also ongoing income stream.
If long-term demand declines, you should also consider selling because your yield on both capital growth and rental income could turn negative for many years, and you might end up having to service the property yourself when vacancy rates rise, and not be able to claim a tax deduction says Do.
"If you see signs of long term demand for homes declining in your area, sell as soon as you can in an orderly manner. It usually starts with the loss of a key employer in the city or the decline of its key industry, resulting in a gradual decline in the population. However, if demand is high and you get a great offer, this might be another reason to sell. For example, you might get a synergistic offer above market value by a developer to consolidate land for higher usage, or the next-door neighbour who wants your property to build a tennis court or own the whole floor in an apartment. However, you should always assess it on its merits," he says.
If you do have to sell, the best time to do it is when market value is greater than intrinsic value. Do advises investors not to rush to sell, but at the same time, don't hold out for too long, because prices could fall even further. "Unfortunately, most people are forced to sell at the wrong time, when market value is less than intrinsic value due to changes in their personal circumstances such as losing their job, or external factors such as rising interest rates," he says.
The key is planning ahead
Developing an exit strategy is best done at the outset when conditions are favourable says Rob Williams, property investor and finalist of the Inaugural Investor of the Year award by Your Investment Property magazine.
"I think creating an exit plan when you're under duress will always lead to the wrong decision. Of course I would never sell, as my entire strategy of living off equity is based on never selling. However, I have always planned my risk mitigation strategies with that goal in mind. At any given point in time, if things go wrong, I shouldn't need to sell any more than the last property I bought," he explains.
Williams likens it to doing a flight plan, where you need to plan fuel usage in advance, plan for alternate airports in mind in the event of emergency and most importantly, work out your point of safe return.
"You need to work out the point at which you will turn back and the point at which you will divert to another airfield, well in advance and while not under stress or duress. Most people don't plan their risk management or exit strategies until it's way too late. When things are going wrong is not the time to be making rational decisions. It's better to have a plan in advance, rather than wait and be at the effect of the problem and its consequences," he says.
4 ways to avoid panic selling
1. Buy with careful consideration of future cash flow
The key to successful residential property investment is cash flow says Justin Wang, director, Property Investors Alliance. "The variable facts in investment cash flow equation are rental, income and interest. Rational investors should always consider the balance of today's rental return and tomorrow's capital gain and plan to cover any shortfall. While the values of Australian residential properties have been on the rise for a long time, when people are forced to sell by the bank because their cash flow breaks down, they are more likely to lose money."
2. Create enough buffer
Smart investors always have some money set aside from the first day of settlement of their investment property says Pino Tedesco, director with Capital Property Advisory.
"I'd always plan for something such as if the market turns bad or if this property becomes a problem, what would I do with this property? I'd calculate what my interest costs are going to be in the next 5 years. Then I add those interest cost and land tax cost and other costs that I'll pay in the next 5 years and I leave them in an offset account that I don't touch. As long as I'm covered in 5 years then I'm ok. If you have to sell, you have no choice, that's when you realise a low price. Having a buffer enables you to ride out the downturn and would not have to sell."
3. Develop a solid plan of action to deal with the worst case scenario
Preparing for the worst case scenario well in advance help you avoid selling at a loss according to Rob Williams. "In my case, if my rental property is left vacant for 8 weeks, I'll fund the shortfall from my cash reserves. If my property is vacant for three months, I'll engage a real estate agent to give me an appraisal before making the decision to sell. If my cash reserves or LOC fall below $X amount, I will look at which, if any properties to sell. I don't wait until the tank is empty. If I lose my job, I'll fund my living expenses from my reserves until they reach $X amount, then look to sell underperforming assets," he says.
4. Have the appropriate insurance in place
Wakelin says investors should have landlord insurance in place. "If you have significant gearing, then you must have income protection insurance. The contingency is to have insurance in place to help you not to sell an asset if things went a bit pear-shaped," she says.
Real life: Applying the exit strategy
Helen Collier-Kogtevs, director, Real Wealth Australia, author of 47 Biggest Mistakes Made by Property Investors and How To Avoid Them, and a property investor.
"Some years ago now, I purchased a property in Kalgoorlie simply because the property was earning $330 per week in rent and the purchase price was $173,000. I was looking for cash flow opportunities and thought I had struck gold.
However, as it turned out it was a government lease that was not renewed, and thus the property was put onto the open rental market. The property ended up renting for $260 per week, a huge difference in cash flow. The house was 20 years old and required more maintenance, thus the expenses were high. To make it worse, there was a problem with the plumbing, which would cause a flood in the back yard at least twice a year. A couple of old trees were damaging the drive way and required removal, plus the plumbers assessment of repairing the plumbing required the digging up of the concrete driveway.
For a property that was purchased purely for cash flow, it did not provide the return we were looking for. At the time, there was very little capital growth and the maintenance costs were in the thousands. With the quotes back from the plumbers regarding the digging up of the drive to repair the plumbing, we decided to apply our exit strategy and put the property on the market. Our worst-case scenario was to at least get our money back so that we could re-use it elsewhere and for a better return. As it turned out, our tenants bought the property from us for more than we needed, and we managed to walk away with a small profit.
One of the risks with older properties is the cost of maintenance. At what point do you say enough is enough? For us, it was a combination of poor cash flow, poor capital growth and high maintenance expenses. You never know what's around the corner, so as part of my risk mitigation strategy I always have a planned exit strategy for each property.
If you're going to purchase investment properties, I suggest you start with the end in mind. Before you take the plunge and purchase the property, have a think about what you'll do as part of your risk mitigation and ultimately your exit strategy. If you can reduce the risk factor to low, then great - go for it! But if you can't, then consider walking away.
