Smart Investment Decisions
By Craig Lowe
If you currently own an investment property it may be time to revisit the numbers to see if it is still a worthwhile investment to hold in the current economic climate. After such a long run of capital gains in the property market, many investors are sitting on large un-realised paper profits but relatively unchanged cash-flow (rent).
Most investors make the mistake of working out their rental yield on the value of the property when they purchased it. To truly understand how your property is performing when compared to other investments it is crucial to do your numbers on what the property is likely to be worth today. If, due to the increase in value of the property, the rental yield has dropped to a level that you, as an investor, would not be willing to purchase it on because you can get better cash-flow elsewhere, you should consider selling the investment to realise the capital gain for re-investment elsewhere (or maybe it’s time to spend it!). With yields currently at record lows across the country, and the outlook somewhat gray for capital gain in the future, this scenario is likely to be the case for many investors.
Conversely, if you are thinking of purchasing your first investment property, or perhaps adding to your portfolio, it is important you make your choices based on thorough research. Analysing the facts and ignoring any emotional influences. This can be the difference between making a good or great investment decision over making a poor or downright bad investment decision.
While it still holds true that the worst house in the best street can often be a money maker if you are prepared to put the effort in to fixing it up, the old maxim of “location location location” is not the be-all and end-all of property investing anymore. You must analyse the numbers and consider the return on investment or yield the property will give you over time. A few years ago in the Wellington market you could virtually throw a dart at a map of Wellington to choose an investment property and by now you would already have seen significant returns. But the market has changed, and while residential property investment is still a very sound investment choice, we need to be a little savvier with our purchasing decisions. Is the return satisfactory when you weigh up the risks involved (borrowing), and will the return outperform other investments? If the answer is no – keep looking.
Cash Flow and Capital Gain
To analyse the return on a property you need to forecast both its cash flow and its potential capital gain over the years you own it. In New Zealand we are still benefiting from the lack of a capital gains tax (or stamp duty for that matter) that makes investing in property all the more attractive and profitable for anyone thinking of investing.
Purchase Price = $380,000
Gross Rent per annum = $28,600
Yield = Gross Rent/Purchase Price
Yield = 0.075 or 7.5%
Now 7.5% is an OK return – it’s slightly more than what you might get putting it in the bank (but don’t forget owning property carries responsibility and risk that having money in the bank does not). But this return is over simplified; it does not take in to account the expenses of running an investment property or the effect of owning the property over time – where rents may increase as well as the value of the property.
We have come to the above return of 7.5% using the gross income our property will generate. We now need to calculate the net income. To do this we need to subtract all the expenses involved with running the rental property from the gross rental income.
Purchase Price = $380,000
Gross Rent Per Annum = $28,600
$1,000 Other Costs
Total Costs = $ 4,500
Net Income = $24,100
Yield = Net Income/Purchase Price
Yield = $24,100/$380,000
Yield = 0.0634 or 6.34%
The return has dropped by over 1%. This obviously makes the investment look much less attractive. But we have not yet looked at the effect of owning it over a number of years will have on the properties value.
Important considerations when calculating a properties real return include:
- The time value of money and the effect that inflation has.
- Likely changes in rental levels over the holding period.
- Likely changes in expense levels over the holding period.
- The likely capital gain over the holding period.
I am available anytime on 021 764 647 for obligation free investment advice.