House or granny flat
With skyrocketing capital city property prices resulting in more families housing multiple generations under one roof, it’s hardly surprising that granny flats are an increasingly common feature across our suburbs. But beyond family matters, the housing affordability crisis also creates opportunities for those wanting to leverage the dormant value in their backyard through a “secondary dwelling”.
With rental returns reducing as property prices increase, especially in Sydney and Melbourne, the argument for building granny flats has clearly gained traction. However, to establish whether building one in your backyard makes investment sense it means thinking through the complete picture properly, factoring in your personal financial situation and doing the all-important number crunching (see table “House v granny flat” on page 64).
For starters, any comparison between a granny flat and an investment property must recognise that while the former is typically a yield play, the latter has greater capital growth potential. Given its capacity to deliver both yield and capital growth, Gavin Hegney, of Hegney Property Group, suggests those with $100,000 to invest and access to bank finance should and would, in a perfect world, do better with an investment property. However, if you’ve only got $100,000 to invest, he says a granny flat could, under the right conditions, be a smart way to start an investment portfolio without having to borrow large amounts of money.
While it’s not investing per se, Steve Waters, of the Right Property Group, says owner-occupiers who borrow more to build a granny flat could use the extra (rental) cash flow to reduce their non-deductible debt a lot earlier.
He says the faster you pay down non-deductible debt, the sooner you can move forward financially, and for baby boomers this could mean passive retirement income. “If it’s costing you 5% to get a return of 10%plus, a granny flat can help you do this,” says Waters. “It also helps mitigate risk if you’re planning to go from two incomes to one.”
UNINTENDED CONSEQUENCES
Damian Collins, of Momentum Wealth, recommends that investors benchmark the yield from a granny flat against cash in the bank and fixed interest rates. Given that granny flats are not growth plays, he says
Weigh up today’s cash flow with future capital growth when comparing backyard granny flats with investment properties
Honestly assess how comfortable you would be sharing your backyard with strangers
investors need to receive a 7%-8% uplift in the yield – ideally 12%-plus – to compensate for potential lack of capital appreciation.
Based on a $120,000 investment, a 12% yield (about $300 in weekly rent) for a one-bedroom granny flat in a capital city looks highly achievable. Assuming you can command the yield you need, Collins urges investors to honestly assess why they’re attracted to a granny flat option; whether they can achieve/maintain the necessary uplift in yield; and, if they’re owner-occupiers, how comfortable they would be sharing their backyard with strangers.
Similarly, he says a granny flat may not be the best use of a backyard if your block has promising subdivision potential. “Remember, while the granny flat won’t be worth much after 30 or 40 years, it’s the land value that will deliver future capital growth,” says Collins.
While a return of 12%-plus may look compelling, Hegney also cautions against overcapitalising. For example, with valuers gun-shy of overvaluing properties these days, there’s greater investment risk if a $100,000 granny flat – which you’ve borrowed against equity in your home to build – only achieves $50,000 in additional value. “It’s important to remember that the
cost of a granny flat won’t automatically add significant value to the total value of your property,” says Hegney.
Adding further insult to a 50¢ return on every $1 invested, warns Waters, is when a clumsily conceived one-bedroom granny flat creates an eyesore in the backyard. This could impinge on the resale potential of your quality four-bedroom home.
Assuming the original house is also tenanted, you could also have to reduce the rent if you’re suddenly taking away half the backyard, warns Hegney.
To avoid these outcomes, Hegney says investors could contemplate buying a property with a granny flat or secondary dwelling that’s already been tastefully incorporated into it. If you are considering a property with a granny flat, he recommends looking for one on a corner block where both dwellings have separate street access.
Michael Yardney, director of Metropole Property Investment Strategists, says going into a granny flat investment with your eyes wide open means you have to be comfortable with running a mini-business. When crunching the numbers with your accountant, he says it’s also important to recognise that market conditions can turn quickly.
As well as dealing with tenants, he says investors should also allow for loss of income during vacancies, unexpected maintenance costs and the cost of hooking up the granny flat to utilities. “If you’ve got $100,000 to spend on a granny flat, you could generate a much better return by putting it towards an investment-grade property or asset,” says Yardney.
Similarly, while the granny flat will receive a depreciation deduction, Yardney reminds investors it will also incur capital gains tax (CGT) when the property is sold, and this is one of many factors to consider.
NEW HOUSE V GRANNY FLAT
To illustrate how the numbers might work in practice,
Money magazine has constructed a real-life example that compares building a new house for $550,000 versus a granny flat for $120,000 on an existing property as an investment (see table).
The investment house
Based on some preliminary research, within the area our fictitious investor is looking to buy, a new house will receive an annual income of $481 a week or $25,012 annually. BMT Tax Depreciation estimates the expenses for the house, including interest on the loan, council rates, insurance, repairs and maintenance, at a total $35,000 annually.
The granny flat
By comparison, the investor could expect to receive $350 a week in rent for a granny flat ($18,200 a year). As the borrowing amount on the granny flat is lower, estimated expenses for this property, based on BMT Tax Depreciation’s numbers, are expected to total $11,000 annually. The investor will be able to claim around $11,850 in depreciation deductions for the house or $5200 for the granny flat.
DEPRECIATION FACTOR
As our scenarios show, the investor’s tax situation will be quite different should they decide to build a granny flat compared with a new house. In both scenarios, claiming depreciation will boost weekly cash flow.
By claiming depreciation on the house, their weekly cost of holding the property is reduced from $121 to $37. In the granny flat scenario, the investor is able to reduce their taxable income and therefore the amount of tax they will need to pay on the property to just $740 for the year.
A weekly cash flow of $124 is therefore achieved for the granny flat. Based on these numbers, the investor will benefit from an additional $161 in cash flow by choosing to build a granny flat compared with a new house.
CASH FLOW RECIPE
In summary, the investor who opted for the new house is out of pocket $1908 annually, while the granny flat owner receives an after-tax cash flow of $6460 annually. That’s a good outcome, but Bradley Beer, with BMT, reminds investors that the capital growth on the future sale of the new house will invariably outperform the future sale of the property with the granny flat in the backyard.
Admittedly, the depreciation will maximise within the first five to seven years. But Beer also reminds investors that with deductions on the structural elements continuing for 40 years, the cash flow outcomes won’t change considerably.
But given that there are two sides to the cash flow recipe, Waters reminds investors that while a granny flat on the right property in the right area will contribute to capital growth, the opposite is also true. On the wrong property you could potentially be cutting out a percentage of your future market when it comes to selling.
“If you rely on depreciation to support this cash flow, you’re also rolling the dice if future tax laws change,” warns Waters. “That’s why you should always do your numbers on a cash-in cash-out basis, before-tax dollars, and allowing for a vacancy rate of 20% is also a good idea.”