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One of the main problems Australians face in investing is not having a clear understanding of what they’re trying to achieve.
Do you want to reach your goal quickly and retire early or do you want to take it slow so you’re financially independent by the time your retire?
Once you define your goals, you’ll then be able to choose one of two strategies that form the basis of making a profit from real estate: rental income or capital growth.
Each method has its own pros and cons so let’s break it down.
What’s the benefit of generating rental income?
The main benefit of rental income is generating a steady cash flow.
If the rental income from a property exceeds its costs, the remaining rent is your profit. These types of property investments are known as cash flow positive or positively geared.
With interest currently hovering between 4.50% to 5.00%, positively geared properties usually have a gross rental yield of 7% or above.
What does yield mean?
Yield is basically the profit you earn from rental income you earn as a percentage of the market value of the property minus your mortgage repayments and other expenses.
For example, if you bought an investment property that was worth $420,000 and you receive $580 in rent, you would have a rental yield of 7.18%.
Of course, this is a gross figure with profit only being realised in the future once you’ve paid down the home loan.
The great thing is that, home loan interest aside, when you get approved for an investment loan, you’re borrowing a fixed amount. That means any increase in the value to the property translates to pure profit for you.
Use the investment property cash flow calculator to estimate the weekly cash flow position of your next investment property.
What are some of the drawbacks of rental income?
Not all properties will produce a positive cash flow from the outset so the trick with this type of strategy is to identify this real estate.
The kind of properties that support this strategy are those found in regional areas or mining towns.
For investors who have little to no equity or on an average income, these types of markets tend to have lower entry points in relation to purchase price as well as stamp duty and land tax.
With positive cash flow, you can use those funds to pay down the principal of your loan in order to build equity for future investment.
The problem with regional areas and mining towns is that growth tends to be slow and measured compared to city and inner city suburbs.
On top that, you may have trouble getting approved for a home loan because these locations can be sensitive to economic cycles, particularly mining areas, and banks are always concerned with reducing their risk in case you default on your mortgage.
Not sure if a bank will view the location of a property you’ve found as a high risk? The postcode location calculator will give you a pretty good idea.
Of course, one of the biggest thorns of being cash flow positive is that you’ll be taxed on this extra income, a major obstacle if you’re ultimate goal is to become financially independent.
What are the pros of capital growth?
What are the benefits of a capital growth strategy?
Home buyers or owner-occupiers generally take the long view when it comes to purchasing a home, that is, they’re not planning on selling the property in less than, say, 10 years.
Obviously, holding onto property for longer means you’re likely to see significant increases in value but savvy investors who do their research on a property and, in particular, its location, have the potential to make comparatively larger gains in a shorter amount of time.
When you’re doing this research though, you should be wary of so-called average annual growth figures or annualised 10 year growth figures touted by real estate agents and other “experts”. The reason is that they can be misleading.
For example, if you were to look at two suburbs, suburb A with a 7 per cent annualised growth rate, and suburb B with a 2 per cent annualised growth rate, you’d logically say that suburb A has a strong track record and therefore is a better location to put your cash to work.
However, when you consider which suburb has more room to grow in terms of generating capital growth, suburb B would probably be a better decision.
Of course, you shouldn’t rely on this measurement alone. There are other factors that indicate the growth potential of a particular property.
For example, inner-city locations tend generate higher and more consistent capital growth over the long term, generally speaking.
The cons of pursuing capital growth
You’ll not only be required to outlay a significant amount of money to buy the property but pay more compared to buying a positively geared property.
Well, rent is unlikely to cover your mortgage, particularly if the home loan is for 90% or more of the value of the property (Loan To Value Ratio).
The reason is that these types of properties tend to be prime real estate and carry a price tag, not to mention the cost of stamp duty and land tax, making it hard for first-time investors without equity in an existing property or a substantial deposit to employ the capital growth strategy. Negative cash flow is common.
Luckily, tax benefits like negative gearing and depreciation make it a little more attractive to pursue this strategy. Use the negative gearing calculator to work out the profit or loss from your investment property as well as your tax refund from negative gearing.
LMI is a one off fee payable when borrowing more than 80% of the purchase price so by capitalising, you can avoid this cost upfront, freeing up your cash flow.
You can even avoid LMI altogether and borrow up to 105% of the purchase price with a guarantor.
Fill in our free assessment form to discover how our mortgage brokers can help you achieve your investment goals with an investment loan that fits your strategy.
Here’s a little tip
Although there is no guarantee in the short term that there will be capital growth every year on the property you purchase, you may be able to spur on capital growth by improving the property with renovation work.
This may be as simple laying down some new carpet, replacing old/faulty appliances and adding a fresh coat of paint, to renovating a bathroom or kitchen.
This can not only increase the resale value of the property but it can make the property more enticing to renters and potentially increase cash-flow. Of course, it’s essential to calculate the cost of renovating in relation to the potential return on investment.
Check out this client story about how Nick turned a real dump in Marrickville around and made about $100,000 in profit with just some new paint and carpet.
Should you wait to pay off your mortgage before investing?
You have two choices when it comes to investing: you can either save up a deposit and buy an investment property as your first home or by buying an owner-occupied property, build up your equity and then use that equity as a deposit to invest in the future.
Many potential investors wait until after they’ve paid their home loan before pursuing plans to invest in property but the problem with this strategy is that you can potentially miss out on opportunity after opportunity. Time is not on your side when it comes getting into prime real estate.
The fact is, the fear of taking the leap will always be there, no matter whether it’s your first time around the block or you’re a seasoned real estate wizz.
Build up your confidence and knowledge about the Australian property market by learning as much as possible by following reputable experts like Terry Ryder at hotspotting.com.au and Todd Hunter from wHeregroup.
In addition, Australian Property Monitors (APM) have plenty of free reports and release house price data every quarter.
Interest rates are low and it’s an investors market at the moment but the best thing you can do is speak to a financial adviser about your financial goals and see a mortgage broker who can find you a home loan with the right lender in order to support your investment plans.
Call us on 1300 889 743 today or complete our free assessment form.