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Low interest rates opening property investment door to more Australians

November 13, 2013

A 2.5 per cent cash rate. Get comfortable with that number because it’s not changing one way or another any time soon, if my reading of the Reserve Bank’s recent pronouncements is correct.  The Board sees an economy operating at a steady-though-cautious pace. And it is signalling that conditions don’t look like they will alter enough for the case for raising rates or dropping rates having sufficient momentum in coming months to break that inertia.

With this becalmed outlook, property investors may want to weigh up the case for switching some or all of their borrowings to a fixed interest mortgage. Although experience shows that many people choose the wrong time in the interest rate cycle to fix rates (i.e. they tend to fix rates when they are near the top of cycle), we may be at one of those points where you might just ‘beat the bank’ by fixing for 3 years and, even if you lose the bet (because variable rates continue to fall), the cost is likely to be limited because the RBA is unlikely to cut much more.

One of the attractions of fixing is a marked reduction in uncertainty when it comes to projecting the cash flow incomings and outgoings of your investment. That certainly makes it easier for the prospective investor to determine what sort of monthly budget they will need to purchase in their ear-marked price range; or, to put it another way, establish how much property their spare cash flow could finance.

Let’s try to shed light on those cash flow considerations using some hypothetical examples. Today, an investor should be able to secure a three-year fixed loan for 5.5 per cent or better.  There are three other main variables we need to fill in or model. The first is the expected rental yield of an investment property. Now it’s possible to purchase residential property that yields ten percent plus. Happy days? No. Avoid them. High percentage rental yields are synonymous with poor quality properties that will not deliver sufficient capital growth to justify their inclusion in your portfolio. Blue chip, capital growth orientated property assets currently yield somewhere between 3.5 per cent and 5 per cent in our capital cities, together with capital growth that significantly outpaces inflation.

The next variable is the management and maintenance cost of your property. Budget for 25 per cent of your rental income to be consumed by property management fees and maintenance. Some investors try to keep these costs lower by managing the property themselves or by scrimping on maintenance but that usually turns out to be a mistake.

The third important variable is your marginal tax rate.  It will determine how much of your expenses you can reclaim from the ATO as a tax deduction. The higher your marginal tax rate, the higher the proportion of your holding costs you can claim.

The following table illustrates the cash flow required to buy a $400,000 property, a $700,000 property and a $1 million property for top marginal taxpayers (46.5 per cent including the Medicare Levy) and those on the second highest marginal tax rate (38.5 per cent including the Medicare Levy). For simplicity it assumes a 100% mortgage for the cost of the property, but that all other initial transaction costs - stamp duty, legal and solicitor & loan fees – are paid up front with cash.

 

$400,000 property

$700,000 property

$1 million property

Marginal tax rate (+ Medicare levy)

Top

(46.5%)

Second tier

(38.5%)

Top rate

Second tier

Top rate

Second tier

Gross annual rental income @ 3.5%

14,000

24,500

35,000

Management and other ongoing costs (25% of rental income)

3,500

6,125

8,750

Net annual rental income

10,500

18,375

26,250

Annual borrowing costs @ 5.5% interest only

22,000

38,500

55,000

Funding difference per annum before tax

11,500

20,125

28,750

Funding difference per annum after tax

6,152.50

7,072.50

10,766.87

12,376.88

15,381.25

17,681.25

Monthly cost after tax

$512.71

$589.38

$897.24

$1,031.41

$1,281.77

$1,473.44

 

Many people are pleasantly surprised at the relatively modest cash requirements to invest in entry level blue-chip property.  As you can see, based on conservative assumptions for rental yield and management and maintenance costs, a $400,000 property – a good one-bedroom apartment in most capital cities – will require a little under $600 a month to fund for a second tier marginal tax payer. With an impost to the family budget of less than $150 a week, property investment is not the preserve of the wealthy or those on top incomes.

Photo: Stuart Miles