Property Investing - Debunking the Myths
Property Investing– Debunking the Myths
The great Australian dream has always been about home ownership and this is understandably so. This theme has also flowed further where we also want to own an investment property. The very words seem to carry a warped form of social status when you can utter the words “I have an investment property”. But is it all it is cracked up to be?
I often find myself in general everyday conversations with people who will state that they want to have an investment property. More often than not I cannot help but pose the question – why? Not because I am questioning their decision, but I am more interested in their level of understanding of what they are committing to. Why do you want to have an investment property? The answer is typically “I want to put in tenants and have them pay it off for me” AND “I want to secure my retirement”.
Clearly there is a complete misconception out there about Property investing fuelled by magazines, tv shows and commentators. Let’s take some time to debunk some of the myths associated with Property Investment
Changing Themes and Trends
You will often here those currently in their 60’s taking up property investing as something which works – and there is certainly no shortage of propaganda handed out there in the media about becoming a millionaire investing in property. The trouble is – the reality is a far different beast. All those bestseller books, magazines, TV shows and stories you see don’t quite provide you with all the facts – and for good reason. The numbers do not add up.
In 1990, you could reasonably purchase an investment property for 3 to 4 times median incomes for that area. So if the median income is $50,000 you could purchase an investment property in that area for $150,000 to $200,000 and reasonably expect a rental income of 6%. In 2014, banks are lending 11 to 12 times median income. So these same houses are now actually costing $500,000 to $600,000 and the rental return in 4% and this doesn’t include costs. The reality is that to successfully build a portfolio of properties to finance your retirement requires significantly higher borrowings and to have these paid off in the times required means you need to have a very high “disposable income”. Higher than most have.
The numbers simply don’t add up – however this isn’t as exciting to sell magazines and papers so the average Australian doesn’t get the whole truth.
This is one that has most Financial Planners scratching their heads. Every year at tax time people are excited as that Tax cheque arrives. What isn’t understood is that tax cheque is only approx 30% of the total amount you have lost. For example, you earn $15,000 from your investment property in rent and pay out $25,000 interest and expenses so you have made a loss of $10,000. For someone earning less than $80,000 the government gives them back $3250 of that $10,000. What they don’t realize is that they have lost $6750. They have to hope that the capital value of the property has increased which is merely speculation.
So while you might be keen to reduce you tax – negative gearing is not the answer – don’t trade paying tax for losing money.
The tenants will pay it off for me
This is fundamentally not true and hasn’t been for 20 years. At the moment interest rates are on average 5.5% and gross rental yields are typically 4.5% so right away you are out of pocket. Not only do the tenants not pay off your house they do not even cover the interest. You then have to add, rates, insurance and real estate agent fees (let alone maintenance) and you are well behind having the tenant pay it off.
The only time this works is when you have reduced the loan on the property so that it is positively geared and therefore the Rent Received is higher than the costs.
I want to secure my retirement
To secure your retirement, unfortunately having your house and another investment property is going to leave you well short of a reasonable retirement. For people who wish to take the “property route” to finance their retirement need to factor in considerably more than one investment property for several reasons. The average income for retirees at the moment is around $42,000 per annum, however most people would prefer $52,000 ($1000 per week). Now to achieve this you would need to have (speaking in today’s dollars) you would need to have four (4) properties returning $400 per week as an absolute minimum as after costs and tax you might still scratch out $52,000 per annum. Given current rental yields are scarcely above 4.5% this would see you needing to accrue properties valued at over $470,000 which equates to $1.88milllion in assets.
The next issue you have is access to cash – you become asset rich but cash poor. While you have $1.88million if you wanted $30,000 to buy a new car or take an overseas holiday you cannot sell the front yard. You either have to go into debt, or you have to sell an entire property. You just have to save up from your income.
Diversification becomes as problem as now you have $1.88million invested in just 4 investments. More often than not these will be in the same area and therefore lack diversification. Furthermore, what if you had bad tenants and required a house to empty for a period of time for repairs – you lose 25% of your income.
Each year with a property investment there are costs that need to be factored and unfortunately often these are not. Insurance, rates, agents fees are the obvious ones but those not often identified are maintenance and of course your time. While it is great to be able to pull up out the front and say “I own that” with this comes other responsibilities. As the asset is tangible this means it requires upkeep - and unless you are the handyman type who loves this kind of thing I know many who get very frustrated with having to address issues that arise. You need to place a cost on that.
Speculation and expectation
“Its safe as houses” - When I heard this statement as a younger I assumed that was because within your home was a safe place. I would learn as I got older than it actually mean that a house is always a safe investment and was the place to be if you were a cautious investor. I am often surprised how many people believe that when you purchase a property the only way is up. That this one investment is not as affected by market forces like all others. What frightens me more than anything is this fact combined with the level of commitment they have to that asset in dollar terms especially when they will say they are conservative with their money. Purchase a $400,000 investment property and you spend $1500 on legals and more than $12000 on stamp duty. You then have an asset which by its very nature requires ongoing maintenance as its condition will deteriorate over time. You likely take on a significant debt affordable only by someone else paying some rent and then if you make a mistake or need to sell the property you pay an agent another $13000 and $1500 in legals. Again to professionals who work with this everyday this is confusing as it is anything but conservative. Ask this same person to purchase a $5000 worth of ANZ bank shares which have proven to out strip average property growth for the past 25 years and there is hesitation based on fear. Its an interesting concept
You can lose money owning investment properties, and you cannot buy one and expect that it will just go up in price. Remember if you have it negative geared, you need it to be going up by 5 % just to break even.
Property investment requires a large investment upfront and therefore a large commitment – especially when you factor in the costs noted above. With this comes more lack of flexibility, as we discussed if you need some money you cannot sell off small amounts of the property. If you need money you have to then sell the entire asset, pay agents fees and legal fees and then potential tax for any capital gains. If you have a change of circumstances you cannot just “sell off some of the asset and reduce you loan like you can with other investment options. The loan is what it is.
Interest Only loans
I am often amazed when people have interest only loans with an investment property. While this can be a sound strategy as part of a larger one – it rarely has this justification. With interest only you are actually never paying off the asset and therefore will never actually own it. You are relying solely on growth of the asset value and then subsequently having to sell it to access any money which would see Capital Gains Tax payable. Furthermore, you spend years paying interest which is dead money as remember only part has any tax benefit.
The allure of property investing comes back to the “tax treatment” of the costs associated with the investment. It feels good to “claim a tax deduction” from the ATO. Again this has to be kept in perspective, and how it sits within an overall plan. As we discussed above – while it seems a great outcome to get a tax cheque, the reality is that you are losing money. Buy an investment property to build your assets - Not to get a tax break!
Furthermore, when you are retired and living off the rent from the properties, it needs to be understood that that income is fully taxable. That is there are no tax breaks afforded to you. Therefore it is vital this is factored into any calculations.
The only time that your average Australian can justify purchasing a property in an SMSF is if they are purchasing the premises for them to run their business. Otherwise unless you have $2million + cash and can diversify sufficiently this strategy makes absolutely no sense. There are rules for residential properties in SMSF and for good reason – in time people suffer cash flow issues and flexibility problems. Borrowing in an SMSF is something which should be an exception as opposed to a rule. You can see above that purchasing property is no longer as attractive as it was let alone adding the complication of a super fund.
While it might seem that I am anti property investing, this is not true. What concerns me is that people commit hundreds of thousands of dollars and take on significant debt and don’t really understand what they are doing. Further to this, some people are amazed to know that if they just got their Super organised and focused appropriately then they could spare themselves paying out hundreds of thousands of dollars in interest and spend this money more effectively on enjoying their life.
If you are purchasing an investment property it needs to form part of an overall strategy. If you are going to take this road – you should be able to answer the following questions
Understand the purpose and the numbers before committing yourself.
If you cannot answer these questions and especially number 3 in fine detail then you should seek out advice before committing yourself to a significant investment. A good start is Michael Phillips Financial Planning Pty Ltd 0409 846538 or firstname.lastname@example.org
Michael Phillips Financial Planning is a Corporate Representaive of Libertas Financial Planning Pty Ltd (ABN 27 160 419 134) AFSL 429718 Corporate Representative 339038 Authorised Representative 242227