PORTFOLIO POINT: Whether real estate prices go up or down there are rules to follow all the same. This is the third in a four-part series on investment commandments.
The debate about property investing over the past year, as in fact with every year, has focused on whether property is going to rise or fall (see my article on this from November and Monique Sasson Wakelin's rebuttal).
Almost everyone has an opinion and because almost everyone has some kind of stake in the matter – whether as an owner or a prospective buyer – it’s understandable that those opinions can be emotionally charged.
Yet it’s perhaps a sad reflection of the level of rigour in property analysis that emotion and hyperbole has seeped into the media. Making matters worse is the characterisation that one can be pro or anti-property, whatever that means.
Just as being a sharemarket bull or bear doesn’t make you for or against equities as an asset class, being a real estate bull or bear shouldn’t make you for or against property investing. Nearly everyone at some point in their life will purchase real estate, whether for living or for investing, and regardless of the state of the market it’s an important asset class to understand.
There will be good and bad markets for property, just as there are good and bad markets for shares and fixed income. There will also be good property investments within the market, no matter what the aggregate condition, just as some shares can do very well in even the deepest bear market.
The main thing to remember is that just as with any type of investing, there are rules to follow. And continuing a series of articles since the beginning of the year, here are my Ten Commandments of property investing.
1. Thou shalt not buy what thou canst see
This commandment works three ways. Don’t buy off the plan, don’t build and don’t buy in places you don’t understand, let alone haven’t been before. Off-the-plan property investment can be a great way to invest – just like building your own house or development – but this isn’t property investing, this is venture capital. Unless you’re an architect, builder, developer or real estate agent, chances are you won’t know what you’re doing. And if you’re not, you need to do some serious homework beyond what is covered here.
Similarly, if you need to go interstate, let alone overseas, to find a great property investment, why not just save yourself the hassle and buy shares in a listed real estate trust? The property market is so idiosyncratic and localised that few will have the foresight or experience to select good investments in places they don’t intimately understand. The grass may seem greener on the other side, but are you willing to put a mortgage on that assumption?
2. Thou shalt not go to property investment seminars
Perhaps because it’s an industry that doesn’t fall under financial services law, property investing is especially prone to scams and conmen. Every week, somewhere across Australia, there is a snake-oil salesman holding “information sessions” about how to get rich in property. Usually, their advice falls into one of two categories: 1) buy their book, attend another seminar or buy their special, once-in-a-lifetime, exclusive $4,000 DVD set; or 2) buy a property they have already selected for you (usually off-the-plan: see the First Commandment, above).
3. A real estate agent is not a real estate adviser
Just like a stockbroker, a real estate agent’s job is to sell property, not provide sensible investment advice tailored just for you. The same is true, dare I say it, with a buyer’s advocate. They advocate for you as a buyer, not a considerer or contemplator. The real estate industry, where it is run on success fees and commissions, is – like most of the financial services industry – based upon churn. Unless you’re paying someone to act as an independent adviser, usually on an hourly rate, you’re only as good as your ability to open your wallet.
4. Thou shalt not renovate
There’s an entire industry built around fixing up property and selling it (“flipping”) or renting it out (“adding value”). There are even prime-time TV shows built around the concept.
This isn’t property investing, however, like construction or off-the-plan investing, this is venture capital. Basically, by renovating a property you are making an additional capital investment in a residence based on your own assumptions, which may or may not be sound, regardless of the fact that in real estate it really is location, location, location. Most of a property’s value is in the land, not the dwelling.
Of course, if you’re an architect, interior designer, real estate agent, heritage consultant, or professional builder then chances are you will come across some great investment opportunities that could be improved with selective renovation and/or redevelopment, but this is an endeavour more akin to running a small business than investing on the side. It’s a process that’s dependent upon skill, luck, time and determination, not just cold analysis and research.
5. Thou shalt not own a dwelling in which thou would not dwell
It’s absolutely normal and entirely acceptable to buy a small rental property that you wouldn’t live in for reasons of family size, lifestyle or location, but there’s a big difference between this and owning a place that you wouldn’t even stay in for a night.
This, however, is unfortunately what many Australian landlords do and inner cities are crowded with substandard rental properties that, unsurprisingly, either don’t get rented easily or attract the type of tenants that are worse than no tenants.
Slum-lording is not only ethically suspect, it’s financially dubious and will sap your time and energy, not to mention your karma. Many university-oriented property investments fall into this category. That studio unit in Carlton, Toowong or Haymarket might look good in terms of location, but what will be its condition in one, two or five years and what will be its resale value? Can you afford the bother of maintenance or the fees of a manager? Can you afford damages if someone cooks in the bathroom, irons on the floor or throws parties on the balcony?
6. Thou shalt not buy at the beach
Similarly, while it’s absolutely normal and entirely acceptable to buy a country retreat or a beach house, unless you are doing this as part of a lifestyle decision, or to seriously enter the tourism or short-stay business, it’s just not property investing.
Arguments about Australia’s scarcity of coastline (“they’re not building any more of that”) or the coming boomer sea-change migration (“watch those grey nomads fly”) have their bullish attractions, but such arguments haven’t prevented thousands of Australians from losing their retirement savings in costal property or Gold Coast apartments. Sure, the tourism market has been hit hard by a strong Australian dollar and with it the fortunes of many investors. But even if the Australian dollar fell and those lost fortunes were reversed, is tourism investing really residential property investing? No. It’s a completely separate business.
7. Thou shalt research religiously
One of the attractions and pitfalls of property as an investment class is its inefficiency: you’ll find bargains that a more “efficient” market would arbitrage out, but you’ll also find more bubbles and boondoggles. And considering the idiosyncrasies of every house, unit and building, close, careful and diligent research is essential.
Beyond researching the state of the market as a whole, the drivers of finance, the sentiment of investors and the strength of the economy, there’s the analysis of a particular suburb or town’s fundamentals, its industries, its demographics, its infrastructure and its geography. And then there’s the land itself: its location, its proximity to amenities and transport, its neighbourhood, its boundaries; not to mention the dwelling: its structural condition, construction, energy efficiency, rooms, period, heritage value or restrictions, plus its dimensions, features and floor-plan.
None of this is simple and there’s no exact template or check-list that will cover everything. Moreover, there will be few who can help you without condition: see the Third Commandment, above. Research will require serious time and effort.
8. Thou shalt use leverage wisely
This was an important commandment in the first part of this series: The Ten Commandments of trading. Put simply, you shouldn't use leverage that you can't afford to lose. And if this means that you’re priced out of the property market, then you’re priced out of the property market.
Considering Australia’s love affair with property investing, we sometimes forget that owning real estate is a privilege, not a right, and if you can’t afford it without dangerous leverage, then you’re putting yourself in the same position as a subprime investors in the United States before the crash.
Consider your loan to value ratio not just at the time of purchase, but in the event of a hypothetical 40% decline in the value of your property (something that, judging from experiences overseas, is not so impossible after all). Consider too your ability to repay your mortgage if you’re getting no yield from your property investment after one month, two months or a year. Consider also your ability to keep an investment mortgage afloat if the value of your primary residence declines or you lose your job or major income.
Consider whether your mortgage is right. Is it at a fixed-rate or a variable-rate? What are the terms and conditions? What is the lender and what is the repayment schedule on the interest and on the principal? Are you able to repay your loan early if you can or late if you must? Do you have it marked to any other form of collateral and do you have an emergency fund if things suddenly go wrong?
With generous negative gearing laws and a financial system skewed towards real estate, it’s dangerously easy to get a home loan in Australia for most kinds of investment property. Don’t let that work that against you. As a rule of thumb, be as conservative as you would be if you were investing for your grandmother '¦ and start small if you’re new to investing. A smaller mortgage is, as the saying goes, a smaller mistake.
9. Thou shalt not invest for tax
This is a repeat from the second part of the series: Buy and hold’s Ten Commandments. Just as Australians may have a slightly irrational enthusiasm for investment property, they have an irrational enthusiasm for tax breaks: two phenomena that are probably interrelated and mutually reinforcing.
Property investing, perhaps more than virtually any other commonly discussed asset class, is highly tax-efficient, but one man’s tax situation is another man’s tax mistake. Just because Joe Bloggs down the road is saving a lot of tax through his Central Coast condo doesn’t mean that you will too. Don’t ask your real estate agent for advice on this, ask your accountant. (Or, Ask Max – ed.)
10. Thou shalt put everything in writing
There’s an adage that there are no friends in business. Sadly, that’s especially true with the business of real estate.
Sign contracts with everyone from your agent to your advocate to your tenant, solicitor, accountant, valuer, contractor, supplier, vendor, business partner '¦ even your family. A happy home can make a happy family, but a messy property investment can make a messy divorce. Don’t let your bricks and mortar investment become a stone around your neck and don’t let an unwritten agreement become a matter for the courts.
Everything to do with your property should be in writing, preferably with multiple copies kept in multiple locations.
Coming up, we conclude this series with the Ten Commandments of investing for income. If you have any extra commandments you use or would like to share with others, email them to firstname.lastname@example.org.
Follow Michael Feller on Twitter: @mfellereureka