PORTFOLIO POINT: There are many mistakes landlords make which can undermine their investment property returns. Here's a list of common missteps, and how to avoid them.
Landlords aren’t charities, but are in the business of making money. So why is it some investors can find, buy and lease properties that earn maximum income, while others repeatedly make choices that cost them any chance of building wealth?
The answer probably lies in the following 10 mistakes commonly made by inexperienced landlords.
1. Going it alone
Not engaging a property manager as the 'middle man’ between tenants and yourself may initially seem an obvious way to save money, but it can cost you dearly in time and, therefore, money when things start to go wrong.
Property manager Samara Bedwell agrees there are many “potential minefields” for do-it-yourself landlords. Failing to ask for a bond, not having a lease, failing to complete a condition report, misunderstanding the Residential Tenancies Act and entering a property without giving the correct notice period are the “five big traps”, she says.
Property finance expert Darryl Simms, a mortgage broker, says landlords mustn’t simply use the cheapest rental manager, but one with a history of managing similar properties and low vacancy rates.
“Not securing good management or expecting property managers to do all for next to nothing can be extremely costly to a landlord (because) routine inspections can be missed, lease renewals may not be kept up-to-date, rent allowed to get into arrears and maintenance may not be reported and acted on promptly,” Simms says. Property management fees are tax deductible.
2. Treating rental homes like hobbies
Most people who buy a business worth $500,000 treat it seriously, including having resources and systems in place to get top results, says Run Property chief executive Rob Farmer. As such, treat your real estate investment like a business by engaging professionals to support your business.
Successful landlords usually consult an accountant, a network of tradespeople, a quantity surveyor, a financial adviser and a property manager; costs that are tax-deductible and can pay dividends in the long term.
“Unfortunately, too many people buy a property and then treat it like a hobby, rather than the investment business it is, and don’t achieve its maximum potential,” Farmer says. “A few dollars spent a week on managing your business can certainly make you thousands of dollars when you keep the bigger picture in mind.”
3. Doing tardy, cheap or reluctant repairs
A landlord who doesn’t see value in maintaining their own investment is making a big mistake, Simms warns. Punctual maintenance is critical if a landlord wants to build and keep a positive relationship with a tenant and property management agent.
Just as importantly, a small repair is often a precursor to a bigger, costly problem if left unattended.
Painting over mould in the bathroom, for example, may be a sign there’s a serious waterproofing problem beneath the shower recess. Don’t ignore it or mask it with a cheap cover-up, says quantity surveyor Mike Mortlock, as it will end up costing more in the long run.
“Not only do you need to understand your legal obligations to undertake urgent repairs, you also need to consider the cost implications, as many investors don’t set aside enough money to cover urgent repairs or stay on top of minor problems that have the capacity to escalate if not managed properly,” he adds.
Similarly, landlords who blame a tenant for any maintenance issue and wait for a tenant to fix the problem are also making a big mistake. Under the Residential Tenancy Act 1997, a tenant must return a property in a reasonably clean state with no malicious damage. The Act takes into account depreciation, wear and tear and the general standard of the property pre-possession. Bond money shouldn’t be seen as a general repairs kitty.
“It’s a mistake for a landlord to have an unrealistic view of how their property should be returned,” Simms says. “Some landlords have a very short memory of what the property was like when the tenant moved in regardless of the condition report.”
4. Doing freestyle renovations
Going into an investment property renovation with an open cheque book is a recipe for financial loss. Equally risky is attempting a renovation without paying for qualified tradespeople where required. While sensible to want to make more rent and add value via market-appropriate improvements to your investment, never try cutting costs by using a property’s on-call handyman to perform electrical, plumbing and/or structural carpentry jobs – unless, of course, the person has qualifications.
By all means, wait until the property is vacant, then roll up your sleeves and do the graft-work to save money; painting, stripping wallpaper and gutting kitchens and bathrooms. But only begin a renovation project if you have a clearly defined objective, a concrete budget and accessible funds to pay for it.
Professional renovator Cherie Barber agrees many people launch into renovation without first studying likely rental returns.
“They get in without benchmarking against the market. If properties are only getting $380 renovated against $300 unrenovated, the investor should have a much narrower budget... and if there’s no proof you’ll earn too much more in rent, say you’ll likely earn an extra five per cent, then only plan to spend up to five per cent of its total value, which will likely cover a cosmetic revamp,” Barber suggests.
“A good rule of thumb is budget to spend up to 10 per cent of the property’s value, regardless of whether they intend to flick it or increase its rental return. And choose hardwearing and durable materials if you plan to keep the property as a rental.”
5. Being a shoestring landlord
Always trying to do things 'on the cheap’ isn’t risky if planning a costume party. It is risky when owning a rental property!
“Entering the market as a landlord on a shoestring budget is the root cause of bad landlords,” Melbourne buyers agent Jason Wier says. “Landlords need to keep 'rainy day’ funds so adequate repairs can be attended to for the benefit of the tenant relationship and asset protection, and not viewed as costly burdens.”
Wier recommends landlords have savings equal to 1% of their investment property’s purchase price, plus three months’ worth of loan interest to cover unexpected costs associated with the property. “This is an absolute minimum kitty that will provide some peace of mind for the landlord that enjoys their sleep at night,” he says.
Rob Farmer says his “pet hate” is “cheap fluorescent lighting found in too many rental properties”.
He says property owners can substantially increase the cash flow from their investments and accelerate the growth of their property portfolio by doing minor and inexpensive improvements.
“It’s amazing how many landlords overlook the presentation and renovation of their investment properties when a few carefully spent dollars can make the world of difference to the appearance of the property and the demand for it,” Farmer says. “There’s a direct correlation between the presentation of rental properties and the calibre of people applying to lease them.”
6. Not having a depreciation schedule
Landlords can cost themselves thousands of dollars if they don’t claim all tax deductions available. A depreciation schedule is the inventory of items at a property that can be depreciated at a certain rate to claim a tax deduction.
“It’s amazing how many people don’t have one or think this is used only with new properties,” Farmer reveals. “Too many accountants rely on what their client says rather than encouraging them to have a depreciation schedule professionally prepared by a quantity surveyor. The reality is that an investment of a few hundred dollars can save many thousands of dollars in tax, even for an old property.”
Mortlock explains that even a property constructed prior to the qualifying date for capital works deductions, which for residential is properties built after July 17, 1985, should still have significant deductions available 95% of the time.
“Deductions might consist of capital improvements prior to your purchase – concreting, painting, renovations – or simply the residual value of the plant and equipment items within the property, things like air conditioning, blinds, carpets, cooktops, curtains and hot water systems,” he says.
Renovators are also eligible for deductions when throwing away or “scrapping” assets. “The residual value of assets thrown in the bin can often help to finance the renovation,” the quantity surveyor says.
7. Doing sloppy checks
Reference checking prospective tenants may take time, but is one of those things you must do if you want to be a successful landlord. It isn’t wise to skip reference checks to gain a few more days’ rental income.
“Do reference checks. It’s not good enough to simply get three references, you’ve got to actually ring up and check them,” property coach Troy Harris stresses. “Even if it takes a couple more days to confirm histories, don’t try to make an extra $200 in rent by fast-tracking approval of an application only to find out this person has a chequered rental past.”
If you’re working with a property manager, ensure you’re confident with their selection process and don’t be shy about asking questions. And the 'checking’ mistake extends to landlords not sighting body corporate records pre-purchase.
Queensland buyers agent Ann Lindner tells of a client who bought a three-year-old investment unit on the Sunshine Coast but didn’t conduct a $250 body corporate record search. If she had, she would have discovered the unit had a problem with a water leak but, unfortunately, the underlying problem went undetected for five years while her property was tenanted and when she moved in herself in 2010, a hole in the ceiling and the leak appeared, but it was too late to claim the repairs under Builders Warranty Insurance.
8. Not knowing your market
Property managers lament landlords who don’t do any research of what their target market expects and will pay. The experts agree that treating a property like a business means charging market rent. Pricing a rental property too high will attract less prospective tenants, which will reduce the number of good-quality applicants. Conversely, pricing a property too low will negatively impact the financial position of the landlord and not attract your target market.
“Your property manager should be on top of comparable properties and managing your rental reviews. Rental increases need to be reasonable and in line with the market. Don’t make the mistake of charging less than market rent waiting for your lease term to expire – keep pace with the market,” Mortlock stresses.
Knowing your market is also about investing in fittings and fixtures expected by your tenants. “Don’t spend $50,000 on a total refurbishment when your suburb’s target market will only spend an extra $10 per week in rent,” Harris says. “You would be over-capitalising if a $10,000 revamp is all that’s expected and required.”
9. Thinking like an owner-occupier
Selecting a property you would live in or transforming a property into one you’d occupy is the “most common mistake” seen by property coach Justin Wood.
“I’m also guilty of doing this myself, over-capitalising and creating a home you want to live in but not creating a space that’s ideal for your tenant,” Wood admits. “Installing the latest finishes, top-quality kitchens, flooring and bathrooms will mostly go unnoticed and also hurt your hip pocket when you can get the same finish for a fraction of the cost.”
Property managers are reporting missed investment opportunities because investors wouldn’t live in the properties themselves. “You may choose not to live in an apartment with no parking but one near a university and close to public transport may be a great investment,” Farmer suggests.
And while you might choose a new property with tiled floors because you like the look of it, a new property with carpet will return greater tax deductions under the 'diminishing value’ method of depreciation. According to Mortlock, $2500 of carpet will return $500 worth of deductions in the first year; tiles will return only $62.50.
“The difference to a tenant might be minimal but the difference to the Tax Office is that carpet is a plant and equipment item depreciable at 20 per cent, whereas a tiled floor is considered as capital works depreciable at 2.5 per cent,” he explains.
10. Having insufficient insurance
Property insurance can be broken into two major camps: landlords and replacement cost insurance (RCI). With RCI, many investors might be able to estimate a construction cost but there are extra costs that are quite often neglected, according to Mortlock.
A RCI report prepared by a quantity surveyor shows the actual cost to reinstate a building in today’s economic climate and to today’s building standards. “This often results in additional costs such as compliance costs, demolition of the existing structure, site clearing, professional fees and costs associated with the time it takes for reconstruction including design and documentation,” Mortlock explains.
Cash-strapped investors need to ask whether a small saving on their premium is worth not being covered for the full cost of reinstating a property if it was damaged or destroyed. “Cash flow is also a consideration when it comes to landlord insurance. It might feel like it’s just another expense you can do without, but you need to decide how you’d fare should the worst happen. Can you afford a long vacancy period or a tenant in arrears moving out with a cleaning bill that won’t be covered by the bond? What about malicious damage to the property?
“It’s okay to take on risk as long as you’re confident you have a strategy to deal with it. With the majority of landlords having only one investment property, most investors don’t have much wiggle room when it comes to cash flow.”
This article was first published by Australian Property Investor magazine and is reproduced with permission.