The formula that could help you buy the right investment property
Property is one of Australia's favourite way to invest.
More than 1.7 million Aussies (or 7.9% of the population) own an investment property. As an asset class, an investment in bricks and mortar is not considered to be as safe as cash, but it's less risky than equities.
Regardless, landlords want an acceptable return on their investment.
When it comes to real estate, the return on investment takes the form of a "rental yield".
This is a measure of the rental income as a percentage of the property's value. It can be calculated as a gross percentage (before expenses are deducted) or as a net percentage (with expenses and purchasing costs included).
Let's crunch some numbers to see how it works in practice. Let's say that you buy an apartment for $800,000 and charge $800 per week in rent.
This generates an annual rental income of $41,600. Dividing the $41,600 income by $800,000 x 100 produces a gross rental yield of 5.2%.
While the gross rental yield only requires two figures, calculating the net rental yield entails many more factors.
There are myriad fees and expenses associated with owning a property. Most of these costs are variable - and some will be known while others need to be estimated. So, net rental is harder to calculate but produces a more accurate yield.
Regardless of the yield methodology used, soaring property prices cause yields to plummet if rents can't keep pace with the growth. In the example above, if the value of the property jumped from $800,000 to $1 million and the rental income remained unchanged at $800 a week, the yield would drop to 4.2%.
This is why the recent house price boom in the Sydney and Melbourne markets pushed rental yields to near record lows.
Gross rental yields for houses in Australia's two biggest capital cities are now below 3%. Paradoxically, the two cities with the greatest property investment activity in Australia are also the cities with the lowest rental yields.
Unless investors are banking on future capital gains or a large rise in rents, further investments in Sydney and Melbourne should be approached with caution.
Over recent weeks, house price growth in Sydney and Melbourne has moderated, so future capital gains on investment properties will be more subdued.
Chasing capital growth ahead of rental yields is a legitimate investment strategy. It does, however, raise the age-old debate about which strategy is better.
In a perfect world, the best possible investment outcome for a property investor is a combination of decent house price growth and rising rental income.
But the world is not perfect, so choices must be made. Over recent years, property investors have been excessively eager to buy at prices that imply they are betting only on future capital gains rather than meaningful rental returns.
Where and what to buy are also important investment decisions. Savvy investors know that apartments tend to offer higher rental returns than detached houses because the initial investment (purchase price) is lower.
Also, it is invariably better to buy in a suburb with affordable rents rather than a blue-chip suburb with sky high rents that few can afford. Those who do buy in an expensive suburb need to be confident that the rental demand in the area is strong enough to offset the higher costs of ownership.
To state the blindingly obvious, a vacant investment property does not produce income and there will be times when a property is not tenanted.
But this must be the exception, not the rule. Landlords must keep a close eye on vacancy rates which compare the demand from renters with how much rental supply is actually available to them.
The Australian Securities and Investments Commission (ASIC) has some useful information on its website about buying an investment property. Among other things, ASIC advises the following:
- Familiar markets - consider buying an investment property in an area you are familiar with as it will take you less time to research. Check recent sale prices in the area to give you an idea of what you can expect to pay for local properties.
- Growth suburbs - look for areas where high growth is expected, where there is potential for capital gains.
- Rental yield - look for areas where rents are high compared to the property value.
- Low vacancy rates - find out about the vacancy rates in the neighbourhood. A high vacancy rate may indicate a less desirable area, which could make it harder to rent the property out, or sell it in the future.
- Planning- find out about proposed changes in the suburb that may affect future property prices. Things like new developments or zoning changes can affect the future value of a property.
Property investment is not rocket science - anyone can do it.
With a bit of research and a level head, you too can find an investment property to suit your budget.
Finally, it is important to remember that property is a long-term investment - it's not a quick fix to financial problems.