How Property Investing Works

Investing in property is often perceived as a secure and relatively low-risk option compared to volatile alternatives like the stock market. This stability contributes to its popularity among investors. While real estate values in Australia have consistently risen, as evidenced by Vanguard’s 2023 Index Chart indicating an annual growth rate of 7.3% since 1993, profitability isn’t guaranteed.

Numerous factors, including location, economic trends like mining, immigration patterns, and media influence, can affect property values. Success in property investment hinges largely on the location of the property and its inherent quality.

The primary objective of an investment property is to generate profit, whether in the short term or over the long haul. It’s crucial to approach property purchases with a rational, numbers-driven mindset rather than letting emotions dictate decisions. Unlike buying a personal residence, the key consideration should be which investment aligns best with your financial objectives and offers the most promising returns.

Step 1: Know Your Financial Goals

  • Determine your affordability: Assess how much you can invest.
  • Establish desired returns: Define the level of returns you aim to achieve.
  • Set a timeline: Determine when you need to see these returns.
  • Evaluate potential impact: Consider how property investment aligns with your overall wealth and financial goals.
  • Define financial goals: Ask yourself why you want to invest in property.
    • Long-term wealth and stability: Are you seeking stability and wealth over time?
    • Building a property portfolio: Is this the initial step toward building a property portfolio?
    • Immediate passive income: Are you aiming for immediate additional income through rental yields?

Understand the importance of these foundational questions in guiding your search, financial structuring, and level of involvement. Identifying your ‘why’ serves as the fundamental starting point in your investment journey.

Step 2. Understand Your Property Investment Strategy

Investing in property is usually for several different financial benefits, capital growth, income from rent, or taxation advantages. Let’s break down your strategy options.

Capital Growth

Capital growth happens when your property increases in value over time. This is the primary goal of most property investment, whether the investor is looking to sell in the future, draw on the equity, or simply benefit from the increase in foundational wealth that the property adds to their portfolio. Capital growth is a long-term strategy; Corelogic reported that the average property that sold for a profit in 2022 was owned for 9 years.

Location is absolutely critical, because capital growth is not guaranteed. Many investors find themselves in a situation where the house does not appreciate. If rental income also doesn’t cover the costs, they experience a net loss year on year.

Rental Income or Cash Flow

When considering property investment for ongoing income, the focal point is rental yield or cash flow. To assess this, utilize a simple formula: (weekly rent x 52) / property market value x 100 = rental yield percentage. For instance, if a property earns $550 weekly and is valued at $865,000, the calculation is ($550 x 52) = $28,600 / $865,000 x 100 = 3.3%. This helps compare yield potential across properties.

However, this figure overlooks associated costs, so for a more precise evaluation of profitability (positive gearing), factor in all expenses related to purchasing and owning the property. If the net income falls short of expenses, the property is negatively geared, resulting in a loss. Continuously negative gearing should be avoided unless substantial capital growth is anticipated.

Tax Benefits

Tax benefits are another incentive for property investment. The Australian Government offers deductions like depreciation, management, maintenance, insurance, borrowing expenses, and interest on investment loans. While typically advantageous for high-income earners, these tax offsets are accessible to most investors.

Negative Gearing vs Positive Gearing

Negative gearing occurs when the expenses of purchasing and maintaining an asset, including the interest on your loan, exceed the income generated by the asset (creating a net ‘loss’). With negative gearing, you’ll have to be able to afford to hold an asset that isn’t ‘earning you income’, but the benefit you get is the ability to offset your ‘losses’ against your taxable income, increasing your tax deductions.

Positive gearing is the opposite – you’re making a profit on your investment, but you’ll also be paying tax on that profit. This is often more affordable for an average or lower income, as the additional cash flow outweighs the tax implications. But for those who are earning a higher income, this could mean you pay more tax (some high-income earners choose a negatively geared property as a tax offset). However, all investors will want their property to become profitable at some point, rather than being an ongoing drain on cash flow.

Step 3. Calculate Your Budget & Your Cashflow

If you’ve purchased a property before, you’ll have a good understanding of the process and paperwork. With an investment property, your finances will be slightly different, and you may have a few options you didn’t have before.

Buying an investment property with equity

If you’ve paid off a chunk of your current mortgage, or your existing property has increased in value, you might have equity available to draw on. Equity is the difference between what you still owe and the current value of your property. A lender will usually allow you to borrow around 80% of the value of your property, less your outstanding mortgage.

Calculate usable equity: (80% x property value) – outstanding mortgage = usable equity

Calculate it this way:

if you own a property worth $900,000, and your remaining home loan is $300,000, you’ll be able to access equity of $420,000. To calculate your usable equity, follow this formula: (80% x $900,000 = $720,000) – $300,000 = $420,000.
Your equity can go towards a deposit for your investment property. You can also use your equity in a debt-recycling strategy.

How much deposit do you need for an investment property?

When purchasing an investment property, it’s best to save up a deposit that is 20% of the property’s value to avoid Lenders Mortgage Insurance (LMI). This one-off payment protects the lender in the event that you can’t meet your loan repayments, and it is usually required if you have a loan to value ratio (LVR) over 80%. LMI is often higher for an investment property.

If you want to check your LVR, there are many calculators available. To illustrate, I checked an investment home loan of $800,000 against a property worth $900,000 (with a deposit of $100,000). The LVR is 88.8%, and the lender’s mortgage insurance estimate was $17,200 (for a first home with the same LVR, the LMI was $15,600). While LMI can be a beneficial tool to purchase a house even without a full deposit, try and avoid this additional expense.

Understand your borrowing capacity

The most important thing is, of course, what can you afford? I recommend getting a clear idea of your borrowing capacity before you start looking for a property.  Lenders will calculate how much they are willing to lend you based on your financial situation and history, particularly your assets and liabilities:

  • What is your salary or income?
  • Do you have any dependents?
  • What debts do you have?>
  • What are your household expenses?
  • What’s your credit score – i.e. your track record with other debt?
  • What are your other financial obligations?
  • How much is your deposit?
  • Do you have other assets or income?

Owning an existing property with equity can significantly improve your borrowing power, but keep in mind that lenders are required to add an interest rate buffer of 3 percentage points to your loan interest rate. This reduces borrowing power by about 5% for most people.

As you’re building your budget, consider your cash flow. If your property changes from earning money to costing you money, even temporarily, will you be able to afford it? Include upfront costs like stamp duty and upkeep costs like maintenance or body corporate when calculating the affordability of your investment. I recommend ensuring you have a cash flow buffer when taking on an investment debt to ensure you can weather the ups and downs.

Step 4: Find the Right Loan

Investment property loans are also usually more expensive than standard home loans, both in borrowing costs and investment rates. This is because lenders see increased risk in an investment property. You’ll have to spend some time finding the best home loan for you. This includes your interest rate and comparison rate, as well as comparing loan features such as:

  • an offset account
  • redraw facilities
  • extra mortgage repayments

Your financial situation and structure is the foundation of a lot of these decisions. Should you choose a fixed or variable loan?  Do you suit an interest-only repayment plan for a period of time? I recommend seeing a mortgage broker or financial advisor to discuss your options.

Consider getting conditional pre-approval

Pre-approval is when a lender has agreed to lend you a certain amount of money, subject to conditions. Pre-approval is usually valid for 3-6 months, so you have some time to look for a property or enter an auction. Generally, you need to remember two primary things with pre-approval:

  1. You don’t need to stay with the bank that granted you pre-approval. However, if you request pre-approval again from a different lender, you can harm your credit rating (something you definitely want to avoid at this point in time!). So it’s best to be fairly confident in the bank and home loan product before applying for pre-approval.
  2. Pre-approval is conditional. In principle, you will be able to borrow a certain amount, but this can be affected by your property choice or your financial information changing.

Step 5: Finding the Right Property

This is when the fun part begins – shopping! It’s also where a lot of the hard work preparing your strategy can pay off. What you want to achieve by the time you’re looking seriously for a property is:

  1. Knowing what you want the property to do for you, i.e. your strategy, like rental yields or capital growth
  2. Knowing if you will live there yourself at some future time
  3. Knowing what your cash flow requirements are

If you have a clear understanding of these questions, then you’ll know how to evaluate the properties that you are interested in.

I can’t emphasise enough how important research is. It will provide you with good grounding in what to look for, and help you be on your guard against property ‘gurus’.

 Location, Location, Location!

This old saying exists for a reason. The location of an investment property can make or break profitability, and it is often the most deciding factor in the purchase. There are some tried and true standards for property which I go back to:

  • The most valuable property factor is capital growth, so the area should have a good outlook for growth
  • The best areas for capital growth are within 15 km of the CBD of a capital city
  • Consider cash flow potential from tenants: is the vacancy rate low? Usually, around 3% is a good average
  • Is there good infrastructure or approved planning for infrastructure?

Finding an investment-grade property outside a capital city requires more rigorous research, as regional areas often have less data and less clear trends.

Property Condition: Choosing New, Renovated or Fixer-Upper?

The property condition can tie directly into how much impact you have on the value of the property. If you choose a fixer-upper and renovate, you might be able to quickly score an increase in value. However, if you’re not interested in renovating, then rule out old or un-renovated houses.

Small properties usually require less maintenance and will allow you to dip your toes in the waters of being a landlord. A new house or apartment lowers the risk of ending up with lots of maintenance to do. Therefore, if you want to build up your experience as a landlord, consider keeping your first rental property small and new.

Property Type: Residential or Commercial?

Residential properties are best for a first rental property. However, there are a variety of types of property you could choose from.

Residential

The most common type of real estate, residential properties are dwellings such as houses, apartments, or vacation homes. 12-month leases and changes to rent prices annually are fairly standard. You’ve probably had experience renting, so this is a good place to start.

Vacant Land

If you want to buy unimproved or cleared land, make sure it is in the right place that will see demand in the future. Vacant land requires little upkeep, but it also provides no income. This is best for people who can wait to use the land in the future and don’t need to see immediate returns.

Commercial or Retail

Suitable for more experienced investors, commercial real estate comes with higher costs and maintenance. Secure tenants provide a stable income due to multi-year leases, but financial risk is greater if the property becomes vacant. Long fixed-price lease periods mean you can miss out on improving rental yield.

Industrial Real Estate

Industrial warehouses, manufacturing facilities, long-term storage units, and carwashes all fall under the industrial real estate title. It can be harder to predict the rise and fall of industrial property value due to external factors, such as large retailer activity.

Make a list of all the factors that are important to you in selecting the property. Maybe your real estate agent or buyer’s agent can identify quality properties that fit your initial criteria. Then go through the list and evaluate based on your needs:

  • Is this one a fixer-upper when you want something new? Strike it out.
  • An apartment with a huge body-corporate? Strike.
  • An okay house in a terrible area? Strike.

Step 6: Do Your Due Diligence

We’ve discussed location and property types, and now you’ve shortlisted some investment property options. Now it’s time to evaluate each property itself as well as the area or suburb where it is located. Due diligence is the cornerstone of a successful investment, ensuring that you minimise risks and maximise returns.

Local Market Conditions

  • What’s happening in the suburb or the neighbourhood of the property you’re considering? Start with the more obvious things such as crime rates, good schools, and zoning. Check for infrastructure plans or development in the area that might impact capital growth.
  • Check the demographics of who is currently living in the neighbourhood. For example, if it’s close to a university, it might be more suited to students than as a rental for families. The demographics of the neighbourhood can tie into your rental yields and vacancy rates.

It’s valuable to research the employment trends and median disposable income for the suburb using CoreLogic and ABS databases. Areas with high employment with higher income often see better capital growth and higher rental yields.

Generally, property travels in a cycle, both on a local and national level. Research purchase price trends, auction clearance rates, and demand to supply ratio (DSR) or days on market (DOM) to see if the suburb is experiencing demand.

Buying as the suburb is growing is ideal, but if you are planning to sell the property within a year or two, you don’t want to buy at the peak time. Look out for over-inflated prices; research what similar properties are selling for in the same area and if the median sale price for the area is increasing or decreasing.

Property Details

Review the condition of the property thoroughly with the help of a professional property inspector and make a note of any maintenance needs or improvements required. Questions to consider include:

  • Does the property contain hazardous materials like asbestos?
  • Is the property in a flood zone? If so, is it resilient or insurable?
  • How much value can be added to the house through renovation?
  • Does the house have any desirable or distinctive features?
  • If the house needs some renovations, do you have the budget for that?
  • If the property already has tenants, review existing lease agreements, security deposits, and rental history. Check for any ongoing disputes or issues with tenants. Once you’ve got a thorough understanding of the properties’ good and bad points, you might have an opportunity to negotiate repairs or purchase prices.

Calculate Your Cash Flow

An absolutely vital step is making sure the cash flow of the property will suit your strategy or financial situation. A property that generates positive cash flow is ideal for most real estate investors. If the cash flow won’t cover all your expenses, you’ll need to plan for covering costs and for the future of the property. You should also think about an exit strategy, particularly if your return on investment doesn’t improve.

Calculate your cash flow by subtracting your total expenses from the total rental income. If a property is already tenanted, you could also request the rental history of the property to learn about income trends and vacancy rates.

When calculating your expenses, don’t forget to include things like utilities, property management, landlord insurance, strata or body corporate fees, property taxes, legal costs and advertising costs. These can be overlooked but will dent your profits.

Once you know how much the property will make over the year, take that number and compare it to your budget. With negative cash flow but in a growing area, the property could still pay off for you in the long term. But can you afford to cover the cash flow gap now?

Step 7 – Find the right help

Accountant

It’s helpful to get professional advice before investing in a large-scale asset. Speaking to an accountant  help you avoid expensive mistakes like buying in the wrong location or not getting your cash-flow right (and having to sell at a loss).  Just as important, you can get help with coordinating your property strategy with your tax, your family goals, your savings and your retirement plan.

Mortgage Broker

Your mortgage broker can help you accurately gauge your borrowing capacity before applying, advise on preparing your financial records to get the best chance for approval, as well as researching loan options and completing your application. They can also negotiate your interest rate and your borrowing capacity on your behalf. Start strong by speaking to a few mortgage brokers early in the process.

Buyers Agent

A buyer’s agent will do the heavy lifting of research and local sourcing to find a property that fits your needs and budget. With insider connections, buyer’s agents will use your financial and strategy requirements to identify suitable properties both on and off the market.

 Real Estate Agent

A real estate agent can be your main source of property information. They can provide you with a list of suitable assets, arrange inspections for you, prepare any contracts, and liaise with the seller on your behalf.

You need to be able to trust your real estate agent. Make sure your agent is working for you, not just for the seller, and beware of property groups and spruikers that make huge commissions from selling low-quality properties to you. Your agent should focus on your priorities, know the market well, and be honest and direct.

How can we help? if you have any questions or would like further information, please feel free to give our office on 08 9221 5522 or via email – info@camdenprofessionals.com.au  or arrange a time for a meeting so we can discuss your requirements in more detail.


General Advice Warning

The material on this page and on this website has been prepared for general information purposes only and not as specific advice to any particular person. Any advice contained on this page and on this website is General Advice and does not take into account any person’s particular investment objectives, financial situation and particular needs.

Before making an investment decision based on this advice you should consider, with or without the assistance of a securities adviser, whether it is appropriate to your particular investment needs, objectives and financial circumstances. In addition, the examples provided on this page and on this website are for illustrative purposes only.

Although every effort has been made to verify the accuracy of the information contained on this page and on this website, Camden Professionals, its officers, representatives, employees, and agents disclaim all liability [except for any liability which by law cannot be excluded), for any error, inaccuracy in, or omission from the information contained in this website or any loss or damage suffered by any person directly or indirectly through relying on this information.