5 Critical Questions to Ask Yourself Before You Buy Your First Investment Property
Many people aspire to own at least one rental property as part of their wealth accumulation strategy. After all, brick and mortar investments appeal to many as they are perceived to be more tangible and solid than shares on the stock market. Every now and then, however, I meet people who got burned by property investments, which made me wonder if they have considered their purchase carefully before signing on the dotted line.
The following are five critical questions I think everyone should ask themselves before buying their first investment property...
1. Am I paying too much for the property?
Anyone who has looked for a property on the market would know that subtle differences in two properties may give rise to a significant price differential. When it comes to an investment property, as opposed to a home, people are often more enamoured by the idea of owning an investment than the property itself, so there is a temptation to sign a contract without really understanding what lies behind the asking price for the property and engaging in some sensible price negotiations.
Ironically, the price is more relevant than you think. Given that many property investors negative gear rental properties, you have to ensure that the negative losses on your property are ultimately outweighed by its future capital gain. If you pay too much for the property upfront, you could set yourself back for years in your wealth creation plan. On the other hand, if you manage to snap up a property that is underpriced, eg, a distressed sale or the sellers are going through a marriage breakup and are pushing for a quick exit, etc, you could be putting yourself well ahead of the game.
To determine if you are paying a fair price for a property, there are certainly clues you should look for to give you some comfort on the price but you will have do a bit of homework, rather than rely on the words of the real estate agent, who incidentally works for the seller.
For instance, if the property is already rented out to tenants, you could calculate the rental yield to see if it is commensurate with the average yield achieved on similar rental properties on the market; you could also compare the floor size of the property with that in similar properties on a per square metre basis. In the end, property prices are by and large interrelated, so doing a number of comparisons should give you a good idea of what a property is really worth.
Further, a good buyer’s agent may be a good alternative if you are time poor, who could do some of the leg work for you but, in the end, it is your property, so you should try and understand as much as you could and be responsible for your own financial future.
2. How rentable is the property?
You will often hear in business that “cash is king”. In property investment, positive cash flow comes predominantly from rent. From the time you buy the property to the time you sell it, rent is one of the essential ingredients that dictates how good your property is as an investment.
When you buy (and presuming that you need finance), the bank will generally include the rent, albeit discounted, to determine if you have the necessary income to service the debt. Therefore, the higher the rent, the better chance you have in obtaining finance; during the life of the investment, rent enables you to keep making loan repayments and paying rental expenses; when you sell, rent provides a good ball park on how much you should be asking for your property. This is why the “rentability” of your property is of paramount importance.
Rentability can be affected by many macro and micro factors. For instance, on a macro level, what is the vacancy rate for similar properties in the suburb? What is the population growth rate in the area? How extensive is the infrastructure in the neighbouring area such as public transport, supermarkets, schools, entertainment venues, etc? Also, keep an eye out for future developments around the area, which may increase the appeal of the property once the development is done; on a micro level, is the property in good condition? Will the property be furnished for rent? How many parking spaces are available?
In most cases, while your requirements of your living environment may be different from someone else’s requirements, asking yourself if you would want to live in the property is a good start in assessing if it will be attractive to tenants.
3. Can I afford the property financially?
In some ways, the question of whether you could afford the property is already addressed by the bank to some extent when you apply for finance or pre-approval. The two key indicators a bank would often use to predict affordability are security and serviceability.
Security is measured by the loan to value ratio (LVR), which is different for different types of properties under different economic conditions. For instance, currently, most banks would accept a loan application if the required loan does not exceed 80% of the value of a residential property without mortgage insurance (or up to 95 per cent with mortgage insurance) or 70 per cent of the value of a commercial property. However, security is only half of the equation, the other half is serviceability.
Serviceability pertains to the ability of the borrower to repay the loan and is measured by way of the debt service ratio (DSR), which is calculated as the total monthly debt repayments (including minimum repayments for undrawn but available finance facilities) as a proportion of monthly income. Like the LVR, the acceptable DSR may vary between financial institutions. For example, a bank may accept a loan application where the debt service ratio does not exceed 35 per cent.
While the bank may accept a loan application if both security and serviceability conditions are met, I would recommend that you prepare your own cash budget to ensure that you have sufficient cash flow plus a safety margin to fund the property.
Further, while it is sensible to include the negative gearing tax benefit, if any, in your budget, you need to take into account the timing of this benefit as it will not be available until you lodge your tax return after the end of the relevant financial year, unless you could reduce your PAYG tax payments by way of lodging the relevant PAYG variations with the Australian Taxation Office.
4. What are the risks associated with the property?
Your rental property is affected by the broader economic environment, which is why your cash budget should be tested to assess your sensitivity to potential future changes in economic conditions, eg, could you still afford the property if the current interest rate increases by one, two, or three per cent? What would be the cash flow impact if the property becomes vacant for one to two months of the year? Such a sensitivity analysis may help you sleep better at night if you use it as a basis of assessing the affordability of the property before you commit yourself to the purchase.
In addition to the quantitative risks, you also need to be aware of the potential qualitative risks that may confront your property and take mitigating measures where possible. For instance, to minimise the risk of buying a lemon and subsequently having to sink tens and thousands of dollars fixing up the defects, a building inspection at the time of purchase is essential; similarly, a building and landlord insurance policy may prove to be a prudent decision if a disaster strikes, given the relatively low cost of the insurance premium.
Other risks may not be readily mitigated, eg, if the property is heritage listed, you may be prevented or limited from improving the property in future to increase the value of your investment. However, a risk assessment is about awareness – once you become aware of the risk, you may then evaluate the risk to determine if it is acceptable or otherwise, depending on your specific circumstance.
5. Do I have the means to manage my rental property?
Owning a rental property is not for the faint hearted because you need to have the means to manage the property. Apart from dealing with minor issues such as tenant procurement, periodic negotiations to increase rent, routine repairs to the property, etc, you may be confronted with more difficult issues such as tenants falling behind on their rent, damages committed by rogue tenants, and even tenant evictions, all of which are timing consuming, less than straightforward, and down right unpleasant. If you are a passive investor already engaged in full time employment or running a business, these property management tasks may be daunting to say the least.
In this regard, a reliable and reputable property manager may be an invaluable resource, although they do come at a cost. At present, a residential property manager may charge anywhere between 8 to 10 percent of the gross rent received for managing the day to day issues associated with the rental property (eg, collect rent, organise repairs, etc); they may also charge a letting fee when they procure a tenant on your behalf. As the cost of the property manager is generally tax-deductible, it may very well be justifiable in light of the peace of mind it buys.