Getting property to pay off

PORTFOLIO POINT: Property investment is not for the fainthearted, but with good financial focus and the right asset it will invariably pay off over time.

I have no claims to being an expert in investing in property. In doing my university study, which was fairly broad and included three masters degrees related to business, the mentions of residential property as an investment were scant.

While this is changing, it still remains a somewhat under researched area compared to other financial investments like shares or bonds. This is surprising given that it is a popular investment that has created wealth for many people.

So, as I came to the decision that I wanted the benefits of residential property in my portfolio (a less volatile asset with potentially good income that I could use to build other parts of my portfolio), I did not have the usual research base that I use to make many investment decisions to fall back on.

I have had my eye out for an investment property for some time – 10 years actually – and about eight months ago I made my decision to buy.

The key aspect of my investment decision was to find a property that met my target of a 9% investment return. I expect rent to increase by about 4% a year, based on an assumption that inflation will be about 3% a year and wages will grow by about 4% a year – meaning rents would grow at the same rate as incomes.

If I stick with my assumption that my rent grows by 4% a year and property prices grow in line with rent, I then need a 5% a year ‘net’ (after costs) rental income return. That will give me my 9% total return; net income of 5% a year and growth of 4% a year.

The decision to purchase a property often comes with the decision to borrow a relatively large proportion of the purchase amount. Partly because it took me a long time to find a property that would allow me the target of a net income of 5%, and partly because I am cautious around debt, I only borrowed around 25% of the value of the property. This has a great benefit in that the investment puts a significant amount of money into my bank account each fortnight – money that I have automatically directed into a share-based investment. This way I have the cash flow from the less volatile but less liquid asset class (residential property) accumulating in a more liquid but more volatile asset class (Australian shares).

While there are a lot of people spruiking the tax advantages of ‘negative gearing’, which is effectively reducing your income by making a loss on an investment property every year, I have always liked the advice in the ‘Rich Dad, Poor Dad’ book (Robert Kiyosaki) that an asset was something that put money in your pocket, in this case rental income.  

Further, I see the point of investing as being to create a stream of income that eventually replaces the income you earn from work. Because of both of these pieces of thinking, I was happy to have only a very small loan on the property, and to enjoy receiving the surplus rent every week.

The property I settled on was a duplex building on a single house sized block of land in Toowoomba. The building looks much like a house, and is split into two units. It is not strata titled, which means that only one set of rates is payable to the council. I was able to purchase the property for around $330,000, even though it was listed at a considerably higher price than this.

My aim was to get a 5% ‘net’ yield (i.e. yield after all costs). I don’t see a great deal of use in ‘gross’ yield figures that are often quoted. These figures are before costs, whereas the reality of investing is that you only get to keep the income ‘after costs’. There are quite a few costs associated with investing in real estate – rates, body corporate fees, real estate agent costs, insurance, the cost of periods of vacancy as well as repairs and maintenance. In looking at unit properties in particular, the impact of rates, body corporate fees, real estate agent costs and vacancies quickly reduced the gross yield significantly.

One cost I was not happy with was the real estate agent fees – often more than 10% of the total rent (usually a base fee of at least 7.5% plus GST, as well as some expenses and a ‘reletting fee’ equal to one week’s rent). I thought that this was excessive. After all, I owned the property and did not want someone else taking more than one-tenth of my rental income. I did have to use a real estate agent because I lived 1,200kms from the property. After some searching I was happy to find a real estate agent who worked on a flat property management fee of $100 per property per month. Because I had two properties I asked them to manage the two properties for $170 a month. They were happy to do this and have done a very good job. It was a reminder to me that negotiation on price is always possible – and that while there are percentage fees everywhere throughout the financial services industry (think fund managers, super funds, financial planners, mortgage brokers, real estate agents and life insurance commissions), there are an increasing number of service providers offering different options.

My estimate of the annual income and expenses for the property are in the following table:

There were a lot of low-quality properties that would have given me my target 5% net return. These often had very old bathrooms and kitchens, poor quality floor coverings and were generally unpleasant. However, from an ethical standpoint, I did not want to own and rent out a property that I would not be prepared to live in myself. The final property had nice kitchens and bathrooms, and pleasant living areas indoor and out. The benefit of this has been that on the one occasion where I had to find a new tenant, there was no concern.

I often hear of landlords that never put the rent up for existing tenants. Their argument is that once they have a good tenant in a property they don’t want to lose them because of a rent increase. Once I bought the property I sent both tenants a small gift to apologise for the inconvenience of all the sale process (pest, building, valuation, real estate inspections), along with a letter introducing myself.

In that letter I reassured them that I had no intent to increase rents significantly, just by $5 to $10 a year to keep pace with inflation. Both rents have since been increased as leases were renewed, with no concerns. While I understand those people saying that once they have a good tenant they should do everything to keep them by not increasing rents, my preference is to get into the habit of small increases in line with inflation.

Five things that seem to have worked:

1.     Being patient (10 years is patient) and saving the majority of the funds to purchase the property means that I enjoy a good cash flow from the property each month – which I direct to share-based investments.

2.     The purchase of a duplex property, that has two income-producing units, has helped provide a net yield of 5%. This fits into my target of a total return of 9% if the income and price increase is in line with my expectation of wages.

3.     Making sure that the property was something I would be prepared live in – something I saw as an ethical aim – seems to have helped with a good ability to find new tenants when others have left.

4.     Keeping an eye on costs – making sure that the net yield is the focus which means keeping costs under control.

5.     Setting realistic expectations around rental increases 

Scott Francis is an independent financial adviser based in Brisbane.