You have probably heard that there are generally two types of residential property investment strategies:
Passive strategies
This is where investor puts in a standard amount of effort and therefore the investment has a standard risk profile and standard return.
They also typically require a normal deposit (5% – 20%) and normal finance (95% – 80%), they receive natural capital growth (3%-10%) and a natural yield (2.5% – 8%).
These types of strategies include:
- Cash Flow Properties
- Capital Growth Properties
- Houses
- Apartments
- New Properties
- Established Properties
- Off-the-Plan Properties
- Special purpose Properties
Active strategies
This is whereby the investors puts in more effort on a more “creative” type of opportunity, which typically has a higher risk profile and return.
These strategies usually involve a creative deposit (<5%) and a creative finance solution (>97%).
The rewards for this extra effort are instant capital growth (5%-25%) and higher yield (>8%).
These types of strategies include:
- Renovation
- Small Residential Development
Let’s look at each one of those strategies in more details.
Cash Flow Properties
There are properties with a low capital growth profile of 4-6% and high rental return of around 6 -10%. Occasionally though the capital growth achieved for these types of properties can be very high, however it’s usually not sustainable.
Upsides:
The main advantage with cash flow properties is the positive or neutral cash flow that they generate. Typically, these properties are located in regional areas and so they tend have lower entry prices (as well as lower stamp duty and land tax). Therefore, for investors who don’t have much equity or income it is easy to get started. Moreover, you can use the surplus cash flow to reduce the debt more quickly to release more equity for future investment.
Secondly, because of the popularity of these types of properties, it is not uncommon to occasionally achieve strong capital growth gains due to the demand for high yield properties depending on the economic climate at the time.
Downsides:
First, because you are generating an income from the positive cash flow, you pay tax along the way. You are taxed on this extra income and money in the taxman’s pocket is going to make it hard for you to create serious wealth.
Secondly, these properties are usually in regional or outer areas where they can be quite sensitive to economic cycles and that is why compared to properties located closer to the centre of our major cities, they will generate lower capital growth over longer term.
There are also potential higher costs associated with maintenance and more tenancy problems due to socio-economic factors.
Finally, from a finance perspective, it is harder to get loans for some regional properties due to postcode restrictions imposed by lenders, mostly due to their smaller populations. The result is lower leverage, which in turn requires more deposit from you and reduces your return.
Capital Growth Properties
These are properties with a higher capital growth profile of 7 – 10% (and occasionally over 12% for a short period) and a lower rental return of 3 – 5% rent (occasionally even below 2.5%).
Upsides
The main advantage of these types of properties is the fact that these areas are usually inne areas and high population areas, which are not affected as much by economic cycles and interest rate. Therefore they usually have higher and consistent capital growth over longer term.
This means investors can generate more equity in a shorter period of time, which can allow them to invest further.
The government also makes it attractive for investors to purchase these types of properties by offering tax benefits via negative gearing and delayed Capital Gains Tax (GST).
In terms of finance, most lenders view these types of properties as less “risky” than regional properties, mainly because of the larger populations in these areas. Therefore, there is less risk of tenancy problems because of better socio-economic conditions and the fact that there are more buyers in these areas, in case the property ever needs to be sold quickly.
So from an investor’s perspective, there are more finance options available for these properties.
Downsides
The big disadvantage with these properties is the negative ash flow if you take on a normal mortgage at high leverage level.
Added to this is the fact that these properties are usually more expensive than cash flow properties, in terms of purchase price, stamp duty and land tax. It is harder for beginners to enter the market, simply because there is greater demand for these types of properties than the supply.
Furthermore, in the short-term, there is no guarantee for capital growth every year – you may bet on the wrong horse.
The main disadvantage from a finance perspective is that it gets harder to service the loan as your portfolio get bigger.
Houses
I often have people asking me whether they should buy a house or an apartment.
Generally speaking in recent times there has been an increasing acceptance of apartments relative to houses to cater for our accommodation needs. Families are getting smaller; people have less time on their hands to maintain gardens etc. I, for one, do not like the idea of maintaining a huge backyard, that just sounds like an endless war between me and the weeds and I often lose.
You as an investor need to be mindful that tenants gravitate to properties that meet their needs. These needs will largely depend on how they prioritize and weigh up each of the above advantages and disadvantages. How they feel about the notions of space, time, enjoyment and money in relation to a specific property.
Upsides
Houses have typically have more consistent growth over the long term in established areas. Therefore purchasing properties with high land content is a one way to increase your chances of securing better future growth if it is an established area. You usually own the land and have greater control over what you want to do with it. This means there are more options open to you (depending on Council regulations in the area you are purchasing) to modify the property and add value.
Given the reasons above, houses are typically more sought after and therefore it is usually easier to get finance than other types of properties; however, townhouses are now getting popular as family sizes decrease and the number of retirees increases.
Downsides
It might be harder to hold because big houses sometimes can be hard to get good rent. So be careful as sometimes houses to offer lower rental returns as a percentage of their value. Another potential downside is the land tax; you will pay a lot more land tax comparing to an apartment or even a townhouse. All those costs need to be considered before purchasing because they can add up quickly and reduce your expected future return depending on your plan for the house.
Apartments
Upsides
One of the main advantages with apartments (or units) is that they tend to have higher rental, which could be critical to you as an investor because it helps with cash flow.
Moreover, apartments frequently achieve just as good returns as houses in areas where there are no more vacant land and are fully built-up with height limit restrictions on further development.
Over the past few years we have also seen these types of assets start to become popular with younger generation & empty nesters.
Downsides
The main disadvantage is that apartments typically show less consistent growth in areas that are not fully built-up, i.e. there is still room for more apartments to be developed and/or there is no height restrictions so the supply might be higher than the demand and therefore reduces the price.
Owners of apartments also typically have less control over their assets as any changes they want to make to their property usually requires approval from a body corporate. So the opportunity to add value is restricted. Owners have to contribute to the running of the body corporate, so compulsory fees are generally higher.
In terms of finance, it is also hard to get good finance for some type of apartments such as many company titled properties and very small apartments (under 40 sqm).
New Properties
Most of us have bought a car by now. Did you have a hard time deciding whether you should buy a new or used car?
I am sure you have heard people debating the pros and cons of buying a new vs second hand, and to be quite honest, it is a similar debate when it comes to purchasing your investment property.
Upsides
New properties are attractive to passive investors who are time-poor and would like to have a property that requires little effort on their behalf. There is usually lower maintenance, and if there happens to be any defects after completion, the builder or builder’s insurance should cover any repair cost.
New properties have an appeal to tenants as they usually have lots of light and space, and may come with other amenities such as swimming pool and gym (new apartment complexes). Tenants with good income are often prepared to pay higher rent for new properties particularly if they are close to their work.
From a tax point of view, new properties usually offer higher or longer depreciation benefits, not only from the fixtures and fittings but also from capital works. It is possible for investors to use these tax benefits to assist with monthly cash flow.
Downsides
The main disadvantage of purchasing new properties is that the cost to purchase may be higher than that for an old property in the same area, as developers have to cover their costs and profit margins. This is exactly like buying a new car, you pay premium price for it.
Many people who purchase new properties may make emotional rather than business decision, as they may have fallen in love with the look of the place and how it makes them feel. If they have paid an inflated price for the property, it may take them longer to realise capital growth.
Another reason that growth may be affected is because there may be a few very similar properties being sold at the same time, such as in a brand new development. A few hasty re-sales can affect the values of all the properties in the immediate area. This can have an impact if you either are trying to sell a property or trying to release equity from your own property.
Brand new properties do not allow much room to add value by renovating because the developer has already done all the work. Therefore, unless an investor has purchased at a well under market value price, they will need to wait for the natural growth to occur, which in this case may take longer than an established property.
Established Properties
Upsides
One of the main advantages with established properties is the fact that you get less price fluctuation than new properties in the same area, and you have the ability to add instant value through renovations, subdivision and development. Some investors have even managed to get their property for “free” by subdividing a large block and selling off a portion of the land to cover the purchase cost.
It has been proven that the scarcity of land is what drives property value upwards, and older properties generally have a bigger land component.
Investors can be more certain that the property they are purchasing has a ‘true’ market value, with no profit margin set by the seller. They are usually found in well-established suburbs, which can demonstrate consistent growth.
Downsides
Potential high maintenance costs are probably the biggest downside of owning an old property. There may be a loss of rental income if renovations need to be done. It may be also harder to attract good quality tenants to an older property.
In addition, tax benefits are not as good with old properties due to lower depreciation values. Rental may not be as high if the property is in need of repair and/or renovation, which could effect on your monthly cash flow as the rental return you can command will be lower.
Off-the-Plan Properties
In recent years, buying off-the-plan properties has become increasingly popular, especially with the high-rise apartments in the major capital cities around Australia.We will save the high-rise apartments discussion for another time and just focus on the pros and cons of buying off-the-plan for now.
Upsides
1) Higher Depreciation
Off-the-plan purchases have a lot of the advantages I have already touched on with new properties. An off-the-plan purchase is a brand new property, which has higher depreciation benefits.
2) Savings on stamp duty
The stamp duty payable on the purchase is reduced because the property is not yet completed. Perhaps on of the biggest advantages is that there is the potential to secure the property without putting any of your money down. Some developers accept Deposit Bonds to cover the deposit instead of you having to use your own cash. If the property is not completed for a couple of years, this is a much cheaper option and allows you the flexibility of using your cash for something else.
So there is a potential equity gain for the investor to be had, even before settlement. BUT only if you pay the right price for the right property to begin with.
Ok, the good news pretty much stops here. Now, let’s examine the the downsides to the off-the-plan properties.
Downsides
1) You don’t know what you are buying even if you think you do
First of all, there have been occasions where properties purchased off the plan may have dropped in value by the time the property is completed and ready to settle, therefore investors may find themselves out of pocket. These developments tend to be heavily marketed by skilled project marketers and you have to be careful to see through the spin and focus on the underlying fundamentals of the project itself.
2) More margin for error
Secondly, with some new developments the area and type of produce that is being developed may not have been tested before. This is a warning sign. Past performance is the best indication of future performance, without past performance the future is unknown. Therefore, there is more scope for the purchase price to be set artificially as there is no precedent. You need to factor this risk into your decision making process.
3) Oversupply
Paying the upfront deposit prior to any valuations being completed commits you to the property before you have a true “value” on the property. Remember you haven’t actually “seen” the property you are purchasing. If there are a number of large developments going on in the same area, it can reduce the value of the property you have purchased even before it’s completed because there is an over supply (remember Docklands in Victoria?)
With large developments, if a certain percentage of the properties are not sold before construction, there is no guarantee the project will commence, which means you may have lost valuable time and missed out on other property opportunities.
Special Purpose Properties
Serviced Apartments
The main advantage with serviced apartments is that they are less taxing on your time. As they are managed on your behalf, you do not need to worry about tenants and maintenance yourself and you can usually command a higher rental return if the property is managed properly.
The drawback is that it is harder to get finance for these types of properties. The main reason is that they are classified as commercial property. Commercial lenders will not approve the same loan LVRs as they would on residential properties. Typically the LVRs are around 65 – -80%.
They can also be hard to resell given that the market for serviced apartments is not nearly as large as the residential property market. Moreover, their capital growth is tied into rental yield and how well it is operated, not necessarily reflecting local property prices. In other words, the value of the property is affected by the financial viability of the operator, which is typically not something that you can control.
Display Homes
Display homes are usually built to above standard quality because they are used by developers to showcase their design and level of finish. You can secure a higher rent than normal properties, which is guaranteed for a contracted period because the developer will continue to use the property. Your maintenance costs are non-existent for the contracted period and there is no need to look for tenants.
On the flip side, display homes can be overpriced in compensation for the fact you are receiving a guaranteed rental return that is higher than the market rate. You need to be careful as the developer’s financial viability can affect the rent they guaranteed.
It also can be hard to obtain finance from some lenders due to difficulties with obtaining an accurate valuation and the commercial nature of the arrangement you are entering into.
Student Accommodation
Much like serviced apartments, student accommodation that is managed can achieve a higher rental return if it is managed properly. Similarly, you do not have to worry about tenants and maintenance.
The biggest advantage over serviced apartments is the purchase price. Student accommodation is typically more affordable.
Student accommodation can be hard to resell sometimes due to its special purpose nature. Like serviced apartments, their growth is dependent on the rental yield and how well it is operated, not necessarily reflecting local prices. Many lenders are reluctant to lend on student accommodation due to the size of the property as student accommodations are frequently studios or 1-bedroom apartments less than 40 square meters.
Renovation
You might have been following the reality show ‘The Block’ in the recent years, in which the participants renovate the old properties and some of them make decent profits in a very short time frame. Is it renovation as easy as it looks?
We talk about property development, specially property development process in Melbourne in another post.
Upsides:
As seen earlier with the strategy of buying established properties, there are many advantages to renovating.
The main advantage is the ability to create instant equity that you can access for further investment or to create an equity “buffer” to manage your risk better. Spending money on a renovation if done right is a very efficient use of your money.
Renovations do not have to be major to be add instant value. Cosmetic renovations have lower town planning requirements and do not carry the risk inherent in building a brand new property. They can be as simple as a new kitchen or bathroom, fresh paint and floor coverings.
This increased value could also generate a higher rental return, not just creating more equity. It can also lead to higher tax advantages due to higher building deprecation.
Sometimes you can buy properties under market value that need renovation. However, these properties in recent times are highly sought after and so competing parties frequently bit this benefit away.
Another positive is that if you are purchasing these types of properties, most of the money you pay is going into the ‘land component’, which appreciates while the building on the land depreciates over time. Therefore, with a higher land component you are ensuring solid future growth.
Downsides:
Firstly, sourcing the right property for renovation is a time-consuming exercise and same as developing a new product, you will have to do your homework to understand what features/improvements will attract potential homebuyers and/or tenants in the target area/market. E.g., features that are more stylish are more likely to attract buyers in areas such as inner city suburbs where people are prepared to pay a bit more for the life style.
Inexperience could cost you more money if you do not anticipate issues with structural, engineering or council permits. You may not see trouble spots until half way through a renovation (electrical, plumbing or structural issues). It is very easy to underestimate the time, cost and work involved in a renovation.
In addition, you would have to ensure that the money spent is going to give you the increased value in the property and that you have not ‘over-capitalised’. You have to ask yourself, will you be able to create enough equity on the sale ore revaluation to make it worth our investment in time and money? Can you increase the rent sufficiently in the area to make the exercise worthwhile?
Last but not least, renovation requires a lot of work if you do it yourself. Even if you outsource it, it requires a lot of management if done by others and your profit margin will reduce significantly as result.
There you have it, a summary of the proven property investment strategies in Australia. I didn’t invent those strategies, which were tried and tested by other property investors before us.
Do they work? Absolutely!
Which one is the best? No idea. 🙂
Understanding your own unique life and financial situation is the number ONE key to successful property investment. Any of the aforementioned strategies could work if it works for you.
Remember, property investment is just a tool that we use to achieve our goals in life. You won’t be successful in property investment until you have a clear vision of what your goals are in life.