Warren Buffett, the internationally recognised investor, defines investment ‘as putting away a small amount of money today to make more money tomorrow’.
Many investors put their money into residential real estate because they believe it’s an investment that will make them more money tomorrow. But how good an investment is it?
Reasons to buy residential property
Investors usually buy residential property for three reasons:
- to have an asset that increases in value (i.e. capital gain)
- to rent it out and get an income (i.e. yield)
- to deduct the investment costs from income and save tax (i.e. negative gearing).
A recent Australian Bureau of Statistics study found that one-third of residential property investors get a positive cash return from their investment, while one-third are running at a loss and one-third are breaking even.
So the motivations of residential property investors are varied and so are the results.
Capital gain
Traditionally, residential property has been a long-term asset. However, these days, some buyers buy, renovate and sell the property immediately to achieve a capital gain. This is called a ‘flip’.
All these gains are taxable unless the property is the investor’s own home.
However, if investors hold for the longer term, they will pay less tax. After 12 months, only 50% of the net capital gain (i.e. the profit) is taxable.
Yield
If you buy a property for cash, rent it out, and pay for council and water rates and repairs, your ‘net income’ is your rental income minus all those expenses.
If you divide that net income by the original purchase price, you get the ‘net yield’.
Here’s an example:
Purchase price: $500,000
Rental income: $500 per week x 52 weeks = $26,000 per year
Expenses:
Council rates: $2000
Water rates: $1000
Land tax: $1000
Repairs: $2000
Sundries: $4000
Total expenses: $10,000
So your net income is $26,000 – $10,000 = $16,000
And your net yield is $16,000 ÷ $500,000 = 3.2%
When investors are struggling to get 1% return on cash this is starting to look very attractive. Add to this the capital gain and it makes good sense to invest.
Additionally, if the property increases in value by 5%, the property’s total return is 8.2%.
Tax deductibility
About 25–30% of investors buy property and borrow around 50% of the purchase price. Often their investment runs at a loss after costs and interest rate payments. This isn’t not necessarily a bad thing and, in fact, can be a deliberate strategy.
If an investment property has a principal-and-interest loan, the principal repayments are not tax deductible, but the interest component is.
This deduction can be offset against the investor’s income, which reduces their taxable income and the amount of tax they pay.
If the residential property increases in value and saves the investor tax, it can be attractive to many investors.
Summary
Residential real estate offers a range of options for investors and has been the foundation of financial wellbeing for thousands of Australians.
This investment is tangible, durable and easy to understand. No wonder it’s the investment vehicle of choice for so many investors!
If you have any queries or would like advice on purchasing a residential investment property, contact Alan Bourke or anyone from Bourkes on (08) 9474 2000.
