Before buying a rental property, investors must consider a multitude of factors that will ultimately determine the level of success that they can expect to achieve. Three factors that should be at the forefront of any investment property decision are, the expected amount of rental income that the investor can expect to generate from the rental property, the costs associated with owing the rental property (e.g. maintenance, property management costs, unexpected repairs, vacancy periods, loan repayments etc.) and the risk associated with investing in this type of asset class as opposed to another investment vehicle (e.g. the share market, government bonds.
1. How much income will the rental property generate?
When searching for an investment property, it is imperative to calculate the expected rental income that the property will generate over a given time frame, usually 12 months. Factors that will affect the rental income are location, the type of dwelling (e.g. unit, townhouse or free standing house), the age of the property and how many similar properties are available for rent within the same geographical area/suburb.
As mentioned in previous blog, the Gross Rental Yield is a misleading statistic, however, in the following example we will be making use of this statistic.
Example: 2 bedroom townhouse in Zillmere, QLD;
- The purchase price of the dwelling is $300,000.
- By conducting the necessary due diligence on the aforementioned property, I learn that I could expect to generate approximately $400 per week in rental income.
- By using the two figures mentioned previously, I can quite easily calculate the Gross Rental Yield for this property. Simply multiply the weekly rent by the number of weeks in the year and divide it by the purchase price of the property.
- So using the above example, the Gross rental Yield will equal (Rent * Weeks in the Year)/Purchase Price. Mathematically this equates to ($400*52)/$300,000 = $20,800/$300,000) which equates to a gross return of 6.93%. Quite a healthy return!
It is imperative that potential property investors take into consideration one often very overlooked statistic and that is Vacancy Rates. Whether you are calculating the return from a property using the Gross Rental Yield or the Nett Rental Yield, vacancy rates must be at the fore front of your calculations. As mentioned in my last blog, vacancy rates have a direct effect on income generated. Again using the figures from the above example an assuming a vacancy rate of 3%, your Gross Rental Yield will be reduced, all things being equal from $20,800 to $20,800 * (1 – 0.03) = $20,800 *0.97 = $20,176
Next, it is important to take into consideration the expenses you will incur as an investment property owner.
2. Ongoing costs associated with owning an investment property
It is probably best to break down expenses into two categories, fixed (known) costs and variable (unknown) costs.
- Fixed Costs – Fixed costs will vary depending on the property that has been purchased. Using our Townhouse example from above, fixed costs will include, Strata/Body Corporate Fee’s (i.e. this levy in most instances will include a Sinking Fund component), Water Usage charges, Council Rates and any special levies which are imposed on the lot holder in the event that the building needed major repairs and there were insufficient funds in the Sinking Fund to cover the cost of the repairs.
- Variable Costs – Variable expenses are an unknown entity and are in most instances unplanned. Examples of unexpected variable costs may include such things as replacing a broken hot water heater, repairing or replacing an oven or something as simple as a blocked toilet. Variable costs include both general maintenance (e.g. fixing a leaking tap) to more extensive repairs (e.g. a water leak in the shower). It is imperative that funds be put aside in the event that one of these aforementioned problems eventuates. Three additional variable costs that must also be taken into account include, landlords insurance, the cost of engaging a property manager if you are not self-managing and finally the cost of marketing your property to potential tenants in the event that the property becomes vacant.
All of these costs both fixed and variable must be taken into consideration before making the decision to buy an investment property. Due diligence is everything.
Continuing the example above, assume you calculate that property taxes, insurance and routine maintenance will cost about $1,000 per year. You also plan to set aside an additional $1,000 a year into an account that will pay for any major repairs.
Your actual return (net return) on your rental property is now $4,000 per year ($6,000 in annual rent minus $2,000 in annual expenses), or 4%.
That calculation assumes your property stays rented on a continuous basis. You must factor in risks like not being able to find a quality renter.
3. Risks associated with buying an investment property
Before you buy an investment property, consider the following facts;
- Real Estate is about cycles that are generated through supply and demand. It’s hard to pick the bottom of the market and just as hard to pick the peak. At which part of the cycle you buy and sell will determine whether you make a profit, a handsome profit or a loss. Carrying out extensive Due Diligence on each and every property you buy is paramount to making good investment decisions
- A poor tenant will cause untold amounts of stress and anxiety for the property investor. Unpaid rent, tribunal orders, damage to the property etc. are all possibilities that should not be ignored or discarded. You can mitigate the chances of these outcomes occurring by employing the service of a good Property Manager (e.g. Just Residential) and taking out Landlords Insurance (e.g. Terri Scheer Landlords Insurance). In most instances, your insurance will cover the loss of rental income and the damage to property (peace of mind) and your property manager will represent you at the Tribunal.
- If the property investor does not employ the services of an experienced Property Manager or have adequate Landlords Insurance then litigation and expensive repair work is a highly probable outcome. In all the years that we have been involved in Property Management, we are yet to meet a self- managing landlord who has not had a similar experience to the one mentioned above.
- Opportunity cost is at play with every investment decision an individual makes. What is opportunity cost? It is an economic term which basically means if you use a said amount of money for one purpose, in this case buying a Townhouse in Zillmere, then you will not have those funds available to use for another purpose (e.g. setting up a business).
A highly experienced and qualified Property Manager will help reduce property investment risk by finding high quality tenants, conducting regular property inspections; attend to any maintenance issues before they become much larger problems, insure rental payments are up to date and not in arrears and represent you at tribunal if any problems do arise with the tenancy.
Property Management companies in Brisbane typically charge 8% plus GST of the rent received for their services. In addition to this, fees will be charged for the re-letting of your property, usually one week’s rent plus costs associated with advertising your property for rent. Most agencies also charge a monthly administration fee.
At Just Residential, we charge 6.6% including GST and no monthly administration costs. No fees are charged for advertising on all the major Real estate Portals if your property becomes vacant, however we do charge one week’s rent on let if we are qualifying a new applicant for a tenancy.
Investment in property can provide a stable source of income and is a great way to build wealth, however like any investment, it is imperative that you understand exactly what you are getting into, before you buy. And remember, the longer that you maintain ownership of a property, the greater the chance there is that you will generate a capital gain. Property investing requires a medium to long term outlook. Due diligence and good decision making is the key!
Additional resources you may require when purchasing a rental property
Buyer’s advocates or buyers agents as they are commonly referred to, can be a great addition to your team. As with any industry there are good and bad buyers agents, so carry out the necessary due diligence if you are intending to go down this path!
Conveyances are there to assist you with your property transaction (they represent both buyers and sellers but can only represent one party during the transaction). They will assist with relevant searches that should be carried out once you have made an offer on a property and will represent you during settlement to insure that everything is done to the letter of the law.
A good Certified Practising Accountants (CPA’s) is essential to making good investment decisions. They are experts when it comes to reducing tax and will advise you on matters such as negative gearing, depreciation schedules and any capital gains tax obligations that may arise down the track. In addition, a good CPA will have a multitude of clients that have had both good and bad experiences with regards to purchasing rental properties as an investment strategy. In most instances, they’ll be able to provide you with an objective view on the pros and cons of buying an investment property.