Seeing around corners

Wouldn’t it be nice if we could see the future before making our investment decisions?

Last week I sat down with a client who recently built and rented out her first investment property. This young woman happened to come into some money and wanted to use it wisely by investing in, as she framed it, ‘something safe’.

The property she bought this time last year cost $450,000 and was going to rent for $390 per week, working out to a rental yield of 4.5 per cent.

Fast forward 12 months and the property is worth $500,000 and renting for $450 per week, working out to a rental yield of 5.2 per cent.

She did get lucky with her timing, it doesn’t always happen that quickly and she certainly didn’t expect it to either. You can do all the research on an investment and conclude a particular investment will grow in value, but you can never be certain of the timing.

As investors, we must think a little differently in a high inflation, high interest rate environment.

Let’s say you’re considering purchasing a $500,000 property today, with a rent return of 4.5 per cent.

Many people look at that, and their first question is, ‘what will it cost to hold that property’ It’s the right question to ask.

Let’s say you bought a $500,000 property and borrowed 80 per cent at an interest rate of 6 per cent.

The property will cost roughly $137 per week to hold (refer table 1 below).

Annual cost, $500,000 property, 4.5% rent yield, 80% LVR, 6% interest cost.

If you bought a new house with full depreciation benefits, and earn the average wage in Australia, the property would have a positive cash flow of $23 per week (refer table 2).

Annual cost, $500,000 property, 4.5% rent yield, 80% LVR, 6% interest cost, after tax deductions.

But it’s equally important to try and estimate the future by ‘seeing around corners’, as successful businesspeople and investors coin it.

What if rents go up by 10 per cent, like they are in nearly every capital city today? What if interest rates come down? What if, while rents increase and interest rates come down?

For those interested:

–        If rents went up by 10 per cent, the property in this case study would only cost $105 per week to hold before tax (refer table 3)

Annual cost, $500,000 property, 4.5% rent yield, 80% LVR, 6% interest cost, with 10 per cent rent increase.

–        If interest rates dropped by 1 per cent, the property in this case study would only cost $60 per week to hold before tax (refer table 4)

Annual cost, $500,000 property, 4.5% rent yield, 80% LVR, 6% interest cost.

–        If rents increased by 10 per cent and interest rates dropped by 1 per cent, the property in this case study would only cost $28 per week to hold.

Annual cost, $500,000 property, 4.5% rent yield, 80% LVR, 5% interest cost, with 10 per cent rent increase.

The point is this – don’t miss the forest for the trees.

If you want to get ahead, risk is unavoidable. It’s shouldn’t avoid risk altogether but rather manage it, by planning for the worst, hoping for the best and expecting to be surprised.

Planning for the worst means running the numbers for a worst case scenario to ensure you can afford a property (or any investment) before committing.

Hoping for the best involves considering the potential upsides. What could the rent and interest rates look like this time next year, the year after, and 10 years from now? Is it more likely the go up or down?

It’s clear as day to me that rents will increase in Australia for the foreseeable future. We’ve got record low vacancy rates, combined with a record high number of migrants and a record low number of new houses being built. We’re in the midst of a housing crisis and a roof over our head is our most fundamental need outside of food. People will sacrifice many other expenses before they touch their housing needs.

Interest rates go up and down. Today they are more than 3 per cent higher than they were this time last year. It wouldn’t surprise me if, based on history, this time next year, they’re at least 1 per cent lower than they are today.

Finally, expect to be surprised. It will happen quicker than we think and expect.

If it isn’t already.

House prices were up by between 1 per cent and 2 per cent in all five main capital cities during the month of May.