How does property fit into super?
Property investment strategies suitable for Super
Creative ways to get existing property into Super
by Anthony J Cordato
Note: This article has been published as Chapter 6 in Russell Medcraft’s new best seller book SUPER RICH or How to create a tax-free income for life
This article deals with
1. The advantages of property as a super investment
2. Property as a tax shelter outside and inside a self-managed super fund
3. Acquisition of property by a self-managed super fund – some creative strategies
4. Selecting suitable property for a self-managed super fund
The comments in this article are applicable to self-managed super funds.
The advantages of property as a super investment
Property people
Some people are property people, some people are shares people and some people are term deposit (cash) people.
Property people are people who love to invest in property, over and above owning their own home. Their joy is investment property.
Property people usually invest directly, buying in their name or in the name of a company or a trust. Some property people invest indirectly, in property syndicates or Property Trusts, to invest in commercial property. In this article we examine the advantages of property investment through a super fund.
Four reasons why property people are passionate about property
Reason 1 – Low risk
My mother favours property as an investment ‘because you can see the bricks and mortar when you drive past it’. To her, the fact that property is visible and solid is very comforting.
The risk of physical damage is low. The risk of damage to the improvements upon the property can be minimised by taking out building insurance and the risk of injury by public risk insurance.
There are financial risks. The main financial risk is rental security. Rental security is increased by proper tenancy selection processes. Residential tenancies are low risk. Housing is a basic human requirement. The low rental yields available for residential property reflect the low risk of vacancy. Factory, office and retail tenancies are a little more risky, in terms of vacancy, being aligned to the economic ‘health’ of the business sector. Longer term leases provide greater rental security. Businesses will commit to long term leases (often 3 or 5 years), while residential tenants commit to short leases (usually 6 or 12 months). Compare a commercial lease where a tenant is legally liable to pay 5 years rent of $300 per week to a residential lease where a tenant is liable to pay 1 years rent of $300 per week – total gross rent receivable of $78,000 (plus CPI increases) versus $15,600.
Title risk is practically zero in Australia. Land titles in Australia are guaranteed by the State Governments which maintain land title registries for the registration of interests in property. The title guarantee is that the registered owner is the true owner, and has full control and entitlements in the property, in terms of renting it out, mortgaging and sale.
Reason 2 – Property is a hedge against inflation
Inflation favours real assets such as property because the value of real assets rises with inflation. My mother likes to say that ‘if you put $100 into the bank, in five years time, you will still have $100, with a little interest. If you put that $100 into property, that $100 will always be worth more with inflation, and what is more, the rents will keep up with the cost of living’.
Taking the Reserve Bank of Australia’s inflation target range of 2 – 3%, then property values and rents will rise in value annually at an average of 2.5% pa simply on account of inflation. In fact, CPI inflation (headline inflation) rose 2.4% pa in 2003, rose 2.6% pa in 2004, rose 2.8% pa in 2005 and rose almost 4% pa in 2006.
Inflation detracts from the value of financial assets such as bonds/interest bearing accounts, which reduce in value according to the inflation rate. The interest received on cash investments must be viewed net of inflation. That is, if the interest is 5.5% pa, and inflation is 2.5% pa, then the ‘real return’ is 3% pa.
Inflation is only one factor underpinning increases in property values. To name a few others: wage increases, increased cost of building, reducing interest rates, easy availability of finance, rent increases, ‘booming local economies’.
As a rule of thumb, property prices double every eight to ten years. According to the Reserve Bank of Australia, ‘average capital city house prices have grown by around 175% since the mid 1990’s; prices outside the capital cities have risen by a broadly similar magnitude’ (Statement on Monetary Policy – February 2007).
This is not a smooth process for either property prices or rents. Prices and rents can remain flat in some periods, and rise strongly during other periods.
The Reserve Bank has noted that during that period since the mid 1990’s rental growth has lagged – rents have increased by only 35% to 60%. The Reserve Bank goes on to note that as a result of low investment in new property because of low yields, the national vacancy rate is low and rents will grow.
In periods such as the 1970s and 1980s, a 10% pa inflation rate underpinned unusually high increases in property prices and rents. In the 30 year period 1977 to 2007, a 1000% property price increase was experienced in many parts of Australia, half of which was due to high inflation. A propey purchased in 1977 for $42,000 would be worth $420,000 today in most places.
But what effect does inflation have on loans? Assuming the house was purchased in 1977 with a loan of $34,000, and $34,000 was still outstanding in 2007 because it has become a home equity loan, the loan has effectively shrunk, because a dollar in 1977 is worth about 10 cents today.
Is another burst of inflation around the corner? Property people will be waiting!
Reason 3 – Low price volatility
Property is stable investment in terms of price. Property does not undergo price fluctuations daily, weekly or monthly, as shares do.
Property prices can rise quickly – in a boom market, a rise of 20% in prices in a 3 month period, and 50% over a two year period, is often experienced. Property prices fall slowly - in a bust market, a fall of 20% in prices can be experienced over a 2 year period. The fall is often cushioned by inflation.
Having said that, property is a long term investment, because over time, the transaction costs are amortised, and because a full boom and bust cycle is recommended to gain full benefit.
For these reasons, it is often considered that 7 plus years is a minimum term for holding property.
Reason 4 – A favourable tax environment
Property investment has a favourable tax environment.
Reasons why tax laws advantage property
Regardless of whether a property is purchased in a personal name, in a company, a trust or a super fund, tax laws advantage property investment in these ways:
Sale of the property – capital gains
- Property tax is deferred until sale:
The tax on the capital gain in a property is not payable annually; as it would be if the gain were subject to income tax (which is payable on income earned annually). Tax on capital gains is paid only when the property is sold. The liability to pay tax on capital gains can therefore be deferred for many years simply by holding on to the property. As the old saying goes ‘tax deferred is tax saved’.
The low volatility of property values makes a holding strategy for capital gain a sustainable strategy.
Illustration: A property is purchased for $100,000. It is sold 8 years later for $195,000. Capital gains tax is payable on $80,000 (i.e. $95,000 gain less $15,000 expenses). The tax is $18,000 (at 22.5 cents in the $1). For the 8 years the property was held, the $18,000 that would be payable as tax on sale has been retained and used to generate income – at 5% pa the income on the ‘tax’ would be $900 pa.
- Concessional tax rate for capital gains:
If the property is owned for 12 months, and if the property is purchased in the name of an individual (or the individual receives a benefit from the sale under a discretionary trust), then one half of the capital gain (net of expenses) is added on to the taxpayer’s taxable income. Therefore, if when the gain is added to the individual’s income it brings the taxpayer into the top tax rate of 45 cents in the dollar, because only one half the gain is brought to tax, the effective tax rate payable will be one half, that is, 22.5 cents in the dollar.
The one half discount applies for individuals and trusts. No discount applies for companies. A one third discount on the super tax rate of 15c in the dollar applies for complying superannuation funds making the tax rate for capital gains in a super fund where the property has been held for 12 months 10c in the dollar.
- The Family Home:
No capital gains tax is payable on the sale of the family home (the ‘main residence’), so long as the family home is purchased in the personal name of an occupier of the home and the occupier lives there. The proceeds of sale of the family home may be tax free in some circumstances after the owner leaves, for example, if disposed of within 2 years of date of death, if the property was purchased before 20 September 1985 or if a marriage breakdown rollover applies. Otherwise, tax is payable based on the increase above the market value of the property at the date the owner left.
Comment: Some commentators have suggested that homeowners should pay tax on what their homes would rent for, had they not been owner-occupied. Needless to say, such suggestions of a tax on ‘imputed rentals’ have fallen on deaf ears politically.
Rental of investment property - deductions
- Rent is taxable income. Taxable income is the net amount of the rent, which is to say, the rent after deductible expenses and depreciation, not on the gross rent received.
- The expenses that are deductible include loan interest, repairs and maintenance, council rates, water rates, strata levies, insurance, real estate management fees, gardening and rubbish removal. The most controversial of these expenses (in terms of tax deduction) is the loan interest expense, which is examined below. Also examined is the depreciation deduction, which is commonly touted in the sale of new property.
Property as a tax shelter outside and inside a self-managed Super Fund
Property (real estate) is many things to many people. It satisfies the basic human need of providing shelter. After all, “we all have to live somewhere”.
But property serves not only as a physical shelter, property serves also as a first class tax shelter!
Gearing as a wealth creation strategy
Gearing is a shorthand term for borrowing against a property.
Super funds are not permitted to gear (borrow money). But super funds can invest in some property trusts, where the trustee gears the property investment. It is therefore important to understand the way that gearing works.
It is generally accepted that borrowing is advantageous for the purchase of a property, where the aim is to build wealth, as opposed to generating income.
The fact that interest paid on the borrowings will absorb some or all of the rent or even exceed the rent, and the fact that the property may need to be ‘subsidised’ using other income is not important, because there is surplus income available from other sources, and the gearing multiplies the gain. This strategy is very attractive for wealth creation in a person’s high income years of 30 to 50, and in a super fund which is in the asset accumulation phase. It is attractive because it leverages the capital gain.
Illustration: The following illustration demonstrates how gearing of 80% of the price will magnify the capital gain on cash invested compared with no gearing at all.
Assumptions
- Price Property purchase price $300,000
Add 5% acquisition costs $15,000
$315,000 - Funding Loan of 80% of purchase price $240,000
Cash outlay – funds invested $75,000
$315,000 - Value of the property increases at the rate of 8% pa., which is the percentage calculated by BIS Shrapnel as the rate by which property prices increase in the long term.
- The property is cash flow neutral – no ongoing cash outlay is required.
Analysis
After 5 years of 8% pa increases, the value of the property (compounded) has grown to $440,800. After deducting acquisition costs of $15,000, the net increase in value is $125,800 ($440,800 - $300,000 - $15,000).
This increase represents a 167.7% return on funds invested over a five year period (i.e. $125,800 ÷ $75,000).
Contrast the return on funds invested without gearing. The return would be 39.7% over the same five year period (i.e. $125,800 ÷ $315,000).
Negative gearing as a tax shelter
If the interest expense, when taken together with the other expenses exceeds the rent, then there is a net negative cash flow / loss on that property. The loss is known as ‘negative gearing’. The tax laws permit this loss to be applied against a taxpayer’s income from other sources, which reduces the taxpayer’s taxable income, reducing tax payable.
The negative gearing coupled with the depreciation deduction is the tax shelter.
Unfortunately, negative gearing cannot be utilised by super funds because super funds cannot borrow. Super funds must purchase for cash.
Comment: Some commentators suggest that the losses from negative gearing be confined to the property, and be available only to offset future rents or capital gains on the property. This suggestion was implemented unsuccessfully between 1985 and 1987, when it was abandoned because investors refused to invest in rental property during that time, as a consequence of which investment in property fell and property rentals rose.
Negative gearing is the ‘carrot’ for the sale of many off the plan properties to investors. In other cases, investors will borrow a high ratio of the purchase price, to purchase a higher priced property or to conserve cash.
The high attraction of negative gearing as a tax shelter must be counterbalanced by its deficiencies from an investment perspective.
From an investment perspective, negative gearing is a ‘bet’ that the value of the property will increase by more than the money outlaid to pay for the cash flow loss. If that is not the case, as is quite possible where property is purchased and sold in less than 5 years, then the negative gearing will result in an investment loss, even though the property may have increased in value, because the money outlaid (after tax savings) during the five years has exceeded the increase in value f the property.
Although high gearing will conserve cash outlaid when purchasing, over time, the cash outlaid with negative gearing will fetter a person’s ability to build cash reserves for the purchase of more investment property, and their ability to borrow further.
The recommended strategy is therefore to be cash flow neutral, or better still, cash flow positive, where the rental exceeds the interest payments and other property outgoings.
Where an existing property generates a cash flow loss, the use of vendor finance techniques may turn the property into being cash flow positive.
The building and fittings depreciation deduction
For all investment properties, tax can be reduced without a cash outlay by investing in newer properties to take advantage of the depreciation. A relatively new property can provide $5,000 a year in depreciation benefits as tax deductions, without spending a dollar!
Building depreciation and fittings and fixtures depreciation under the Income Tax Act provide a non-cash tax benefit in that these form part of the purchase cost, yet are deductible annually over many years as an ‘expense’. With a depreciation deduction, a property can be cash flow neutral but still generate a tax loss!
Every part of a building will need repair or replacement in the long term. The fact that the Income Tax Act allows depreciation to be deducted against income annually provides a useful reference of how long an item can be expected to last before it will need to be substantially repaired or replaced.
Building depreciation (applicable to buildings built after 1970), continues for 40 years. Fittings and fixtures depreciation continues for shorter periods. Depreciation is expressed as a percentage to be applied annually against the cost price. Where the cost price is not known, a building estimator can determine it. The following percentages are based on the prime cost method, where the same percentage is applied against the original cost each year, until the item is fully depreciated down to zero.
Illustration: Building depreciation 2.5% pa
Bathroom fittings 5% pa
Kitchen cook tops, ovens 10% pa
Carpets, linoleum, vinyl 10% pa
Dishwasher, range hood 12% pa
hot water system 12% pa
Refer: http://www.ato.gov.au / Legal database / TR 2006/15
Super funds are able to use building depreciation and fittings and fixtures depreciation as a tax deduction, in the same way as individuals, companies and trusts are able to use it.
Note that on sale, any building depreciation claimed is deducted from the cost base before capital gains tax is calculated.
Superannuation as a tax shelter
Superannuation is the latest tax shelter for property. It is attractive for both wealth accumulation and for maximising income during a person’s retirement years from their 60’s, during the pension phase of the super fund.
- Concessional tax rates and capital gains tax discount:
Rental income and capital gains in a super fund are sheltered from full rates of taxation. Income in a super fund is taxed at a concessional rate of tax, 15 cents in the dollar, rather than the individual’s marginal tax rate, which could be as high as 45 cents in the dollar (+ 1.5 cents Medicare levy). Capital gains in a super fund are taxed at 10 cents in the dollar, if the property is owned for more than 12 months (if less than 12 months, the rate is 15 cents in the dollar), as against a possible tax rate of 22.5 cents in the dollar for the individual and 30 cents in the dollar for a company.
- Property tax deferral applies:
Super funds are not taxed annually on the increases in value of their assets. Therefore an increase in a property’s value will not be taxable until the property is sold.
- Property expenses and depreciation apply:
The normal property deductions are available, being for expenses such as repairs and maintenance, council rates, water rates, strata levies, insurance, real estate management fees, gardening and rubbish removal. Building and fittings depreciation also applies to be offset against rental income. There is no interest deduction, as there are no loans.
- Super funds cannot include the family home as an asset:
The family home should not be purchased in or transferred to a super fund. As the law stands at present, the transfer of the family home to the super fund or the purchase of a residence for a beneficiary of a super fund is not permitted. If a property ceases to be a family home, and is rented as an investment property, it may be able to be transferred. But rarely are stand-alone residences suitable for property investment property, on account of repairs and maintenance and high rates and taxes (see below).
Acquisition of property by a Self-Managed Super Fund = Some creative Strategies
Property is a ‘lumpy’ asset, in terms of the fact that it is a high value item, and the super fund may not have sufficient cash reserves to fund the purchase the property.
If an individual, company or trust has insufficient cash to purchase a property, they will borrow the balance required. Super funds cannot borrow.
There are a number of creative strategies that can be used for a super fund to acquire a property without breaching the superannuation laws which prohibit borrowing by a super fund.
But first, it is useful to note that there is both a ‘purpose’ requirement and a funding requirement to be satisfied for the acquisition of property, namely:
- The acquisition of the property must be for the sole purpose of paying benefits to members of the fund when they retire or meet the prescribed age or die. A super fund cannot for example acquire a holiday apartment for use by members of the fund before retirement. Refer www.ato.gov.au / Superannuation Professionals / Fact Sheets
- The acquisition of the property is to be funded entirely from the resources of the superannuation fund, usually cash resources. This is a legal requirement. A super fund cannot borrow funds to acquire a property, or having acquired it, borrow against the property.
In this section, the focus is upon creative strategies to overcome the funding requirement in acquiring a property.
Acquiring a property with no external finance
Acquiring a property with no external finance (no borrowings) is a strategy employed for property acquired to derive income for a super fund to during the pension phase.
If an individual does not wish to borrow, they choose a partner to buy the property with. Super funds can do likewise – by investing with others jointly in a property.
These strategies can be used for property purchases with no external finance.
[list]* Tenants in common purchase:
A property may be purchased in two or more names jointly. Joint purchases may take two forms.
- Joint tenants When the family home is purchased, the relationship between the two spouses or partners is designated as ‘joint tenants’. This designation means that on the death of one of them, their interest passes automatically to the other, regardless of the provisions of a will.
- Tenants in common When an investment property is purchased, the relationship between the two investors is designated as ‘tenants in common’. This designation means that their interest remains separate, unaffected by death, of if they are corporate, unaffected by liquidation. Also, when purchasing as tenants in common, it is possible to specify unequal shares, so that for example, one purchaser may acquire a one-third share and a co-purchaser a two-thirds share.
A property may be purchased by a super fund, as tenants in common with an individual, company or trust. Each makes a cash contribution to purchase their share in the property.
Illustration: A property is purchased for $300,000. The super fund contributes $100,000 towards the price, while the individual or their entity contributes $200,000. The individual uses their own funds, which may for instance be drawn from a home equity loan on their family home. The ownership of the property is designated as: the super fund as a tenant in common as to a one-third share and the individual/entity as a tenant in common as to a two-thirds share.
The property purchased cannot be mortgaged or used as security for a loan. This applies both to the share of the super fund and the share of the individual.
* Units held in a unit trust:
A property can be purchased in the name of a company as the trustee of a unit trust. The super fund can invest in the property through the purchase of units in the unit trust. The units in a unit trust give an entitlement to a fixed share of the profits and assets of the trust.
The investment by the super fund in the property is indirect, that is, the super fund pays for an allotment and issue of the units in the trust, and the trust in turn purchases and owns the property.
If the property purchased in the unit trust is not geared, then it is perfectly acceptable for a super fund to make this kind of investment.
Illustration: A company (as trustee of a unit trust) proposes to purchase a property for $300,000. The super fund pays the company $100,000 and is allotted and issued 10 units in the trust. The individual pays the company $200,000 and is allotted and issued 20 units in the trust. The property is purchased using these funds. The super fund and the individual by virtue of their unit holdings indirectly own the property in the proportions of one-third to two-thirds. The property purchased is not mortgaged or used as security for a loan.
These comments apply equally to investment in shares in a company for the purchase of property. Refer ATO Superannuation Circular No. 2003/Draft for further comments.
Acquiring a property with external finance
If the super fund is in ‘wealth accumulation mode’, which is to say, is building assets for payment of retirement benefits at a future time, the super fund will often be looking for a gearing strategy to leverage the capital gain.
Because of the prohibition upon borrowing, super funds can only make a geared investment indirectly, where they do not exercise control over the investment and where the lender has no recourse against the assets of the super fund.
These strategies can be used for property purchases with external finance.
[list]* Unit holders in a geared unit trust created up to 1998:
Investments made by a super fund up to 1998 in a geared unit trust are ‘grandfathered’.
Up until around 1998, the commonly accepted means of purchasing a property for a super fund, with gearing, was for the fund to set up a unit trust, with a corporate trustee, and invest in the unit trust by taking an allotment and issue of units. As the super fund received cash contributions, the super fund would pay the cash into the trust and be issued more units. The trustee of the fund would then use the cash to pay down the loan.
Illustration: A property is to be purchased for $300,000 in the name of a unit trust. The super fund subscribes $100,000 and is allotted 10 units with entitlements to income. The unit trust borrows the balance price of $200,000 and the acquisition costs of $15,000. The property is cash flow neutral. After a year, contributions have flowed into the super fund, so that it has $20,000 to outlay for the issue of another unit. The funds are paid into the trust and $20,000 of the debt is retired. The super fund now has 11 units. And so it goes on until the debt is retired and the super fund holds 30 units.
* Unit holders in a geared unit trust created since 1998:
Since 1998, the super fund can make the investment in a unit trust used for the purchase of a geared property only if it meets the (lack of) control test.
The ‘control test’, as applied by the Australian Tax Office (the ‘ATO”),, is that the beneficiaries of the super fund cannot also control the unit trust which owns a geared property. And so, the unit trust must be at arms length.
The control test is satisfied for investment in a publicly listed unit. , The control test is significant when the unit trust is private. The definition of ‘control’ for these purposes is technical, and its examination is outside the scope of this article, suffice to say that the beneficiaries of the super fund should not constitute 50% or more of the directors of the trustee company and the super fund should not hold 50% or more of the units in the unit trust.
This restriction will exclude a super fund from investing through a unit trust which is related, in a geared property. A trustee of a super fund is therefore restricted to investment in publicly listed property trusts and private property trusts over which it has no control.
* A participant in a property syndicate:
Property syndicates are property partnerships created for the purchase of particular property. Instead of the property purchase being made in the name of the syndicate members, the purchase is made in the name of a nominee company.
Even though the nominee company finances the purchase of the property with external finance, and the guarantees of the syndicate members are not required by the financier, the sole recourse for the financier being against the property.
Provided that the super fund satisfies the ‘control test’ as defined above, it can participate in the property syndicate.
Acquiring the property with vendor finance - transfers between related parties
Vendor finance, in terms of the vendor permitting the purchaser to pay the purchase price of the property over time, is thought of as ‘finance’ in the broad sense of the word, but does not necessarily constitute a loan. If interest is not payable, then it is merely the payment of the price by agreed instalments.
It is therefore available as a technique to transfer property, particularly between related parties.
Illustration: A property is sold for $300,000. Assume that the vendor agrees that the price is be paid over 5 years, by 60 monthly instalments of $5,000 each. The instalments do not carry interest, because the vendor is selling the property at a premium of $60,000, with the current market value $240,000. The premium of $60,000 could be viewed as capitalised interest. It is equally feasible not to add in a premium, so long as the sale price is at market value.
By this means, a super fund could purchase a property, subject to a market valuation to support the price. Provided that the instalments add up to the price and no interest is charged, then a transfer by this means appears not to breach the prohibition on borrowings by a super fund. Refer www.ato.gov.au / Superannuation Circular 2003/1 – valuation of assets, for comments on market valuations.
Restriction on in-house transfers
There are restrictions in super funds purchasing from related parties. Section 66(1) of the Superannuation Industry (Supervision) Act 1993 prohibits regulated superannuation funds from intentionally acquiring assets from related parties of the fund, with some exceptions, one of which is business real property. The prohibition extends to leasing properties owned by a super fund to related parties, unless it is business real property.
Residential property will generally not satisfy the business use exception – renting out one or two residential properties is not considered the carrying on of a business, but renting out a number of properties may be.
Refer further ATO Superannuation Circular No. 2003/Draft for comment – business real property at http://www.ato.gov.au / Superannuation Circular No. 2003/ Draft.
Some aspects of terms finance
The form of vendor finance described is a sale by instalments, which is also known as terms finance. In sales by instalments, the title to the property is not transferred until completion, that is, until the final instalment is paid. The documentation is a Contract for the sale of land. The Contract specifies that the price is payable by instalments.
Because there is no transfer of tile until the price is paid in full, there is no mortgage or external finance required by the purchaser. On the other hand, the vendor can retain their existing mortgage over the property until the final instalment is paid and the title to the property is to be transferred.
The vendor, if it is a related party, should obtain appropriate tax advice to defer payment of capital gains tax until the price instalments are received. Refer: www.ato.gov.au /Legal database / ID 2004/407.
The vendor may allow the purchaser to take the benefit of possession, on the entry of the Contract. If the property is rented out, this would mean that the super fund would be entitled to the rentals and could apply rentals from the property towards payment of the price instalments.
Further illustration: In the illustration above the monthly instalments were $5,000. If the property rents for $2,000 per month, then the rent plus cash contributed to the fund of $3,000 per month could fund the instalment payments.
Transfers of property into a super fund are fully liable for Transfer Duty (Stamp Duty) calculated on the value of the property transferred.
In South Australia, legislation applies to limit the number of instalments to 4. In Queensland, legislation applies to require the title of the property to be transferred once one third of the price has been paid. The other states have no such limitations.
Suitable property for a Super Fund
The property must be suitable for the super fund to acquire as an investment. This is a subjective, rather than a legal requirement.
The property must be suitable in terms of a high capital growth or rental return, and have low outgoings and maintenance, so that it can provide the capital gain or the income stream desired.
The following are criteria for suitability:
[list]* Maximising income – land content:
When considering whether a property is suitable for purchase in a super fund, the emphasis should be upon maximising income, rather than maximising capital gains.
Is there a rule of thumb criterion that could be applied? Yes. The simple rule of thumb is land content.
Income will be maximised when the land content is low relative to the value of the improvements, while income will be minimised when the land content is high and the value of the improvements is low.
Examples of low land content relative to improvements include home units, villas, terrace houses, shops and offices.
Examples of high land content include detached houses, vacant land and hobby farms.
Illustration: Assume that a two bedroom dwelling will rent for $250 per week, and a two bedroom unit for $220 per week, next door to each other.
For the two bedroom house, the value of the house improvements might be $200,000 and the land value might be $150,000, being a total of $350,000. The gross rental return will be 3.7% (i.e. $250 x 52 = $13,000 ÷ $350,000).
For the two bedroom home unit, the value of the unit improvements might be $175,000 and the land value might be $75,000. The gross rental return will be 4.6% (i.e. $220 x 52 = $11,440 ÷ $250,000).
The differential in net rental returns will be greater in that outgoings such as council rates and water rates, and repairs and maintenance will be higher for a two bedroom house, than a two bedroom unit, because they are based on land value.
* Maximising income – more than one rental source:
It may be possible to derive more than one rental from a property, by separately renting out parts. The classic example is a shop, with a residence upstairs. Each is separately rented. Perhaps there is a garage at the rear which is also separately rented. Another example is a split level house, where the flat underneath is separately rented. My personal favourite is to build a studio/garage, which consists of a garage underneath, and a studio above, which can be rented out as a whole, separately from the house / terrace at the street front of the land.
* Minimising maintenance - low maintenance buildings:
Experienced investors will purchase property which does not have large or difficult to maintain exteriors. Investors will purchase a block of flats, home units, a row of villas or terraces where there are common walls or where it is all ‘under the same roof’.
My father always pointed out that if you buy a house you have four external walls and one roof; if you buy a block of flats you have four walls and one roof; BUT you have 4, 6 or more rentals from a block of flats, compared with 1 rental from a house, and almost the same external repair requirements in both.
Experienced investors will purchase property where the building, the fit out and the appliances are in good condition and where their useful life can be extended by repair, rather than by replacement.
Buildings which are built with low maintenance materials should be favoured. Examples are:
- Exposed brick is always lower maintenance than painted cement render. Most exposed brick is found externally. Sometimes the exposed brick is internal; where it matters less if it is painted as it is not exposed to the weather.
- Tiled roofs maintain their appearance long after colorbond, or worse still, galvanised iron or alcenite roofs deteriorate. Skylights are more long lasting if they are glass rather than a polymer.
- Aluminium powder coated external windows, door frames and screens require less maintenance than wooden widows and frames in terms of painting.
- Tiled floors in kitchens and dining areas are easier to maintain and last longer than linoleum.
- Wall tiling floor to ceiling in bathrooms takes away the need to repaint walls.
- Polished floorboards are usually more durable than carpet, particularly if the floorboards are polished professionally or the carpet is low quality.
- Minimising maintenance - low maintenance locations:
Experienced investors will avoid purchasing property in high maintenance locations. They avoid seaside locations where the salt spray and the salt air will accelerate the deterioration of the exteriors – particularly windows. They will also avoid locations near heavy industry or mining where ‘acid rain’ will accelerate the deterioration of roofing and guttering. - Low maintenance landscaping:
Tenants do not look after large gardens or properties. They do not mow large areas of lawn, do not keep plants and bushes trimmed, do not keep fences in good repair. At the end of the tenancy, the cost of bringing the grounds up to an acceptable state will often fall upon the landlord, as it is difficult to satisfactorily cover the care and maintenance of the grounds in a lease. The solution is small yards, easy to maintain garden areas, and extensive paved areas, which can easily be cleaned up at the end of the tenancy.
Disclaimer: The information and advice contained in this article is: (a) general in nature; (b) intended to draw attention to certain items to be discussed with a professional adviser; (c) not intended to provide specific advice; (d) takes no account of particular facts and circumstances; and (e) is not to be relied upon for any purpose. The author and publisher disclaim all liability and responsibility to the fullest extent available at law. Liability limited by a scheme approved under Professional Standards Legislation