STRATEGY: GOOD YIELD AND STEADY GROWTH

She’s a 30-year-old single who is renting and earning $65,000 a year. Currently her yearly bills, including rent, and lifestyle expenses are $23,000 and $15,000 respectively. For Rachel to invest in property, it’s important to preserve her monthly cash flow based on her income so the strategy here is to look to buy her a higher-yielding property for $300,000 with a capital growth target of 4.5% a year and a gross yield of 5.5%.

Rachel has saved $15,000, which is not sufficient to get into property. However, her parents are prepared to go security guarantor so that she can borrow the full amount plus the additional 6% acquisition costs, thereby avoiding mortgage insurance and also allowing her to get interestonly lending.

The table shows that for the first eight years Rachel will rely on negative gearing as her pre-tax cash flow will be negative. But in year nine it will turn positive and instead of receiving a tax benefit from negative-gearing benefits she will be contributing to the tax revenue. Therefore, the tax outcome will shift from negative gearing to positive gearing and she will use the post-tax surplus to further reduce the debt.

For Rachel, investing in this property will contribute to her overall wealth the longer she holds it, as after 20 years it has a net cash flow position of $17,964 and her wealth has increased modestly (see table).

Why invest in property?

But despite these speed bumps, investing in property remains an attractive proposition for building real wealth in the long term. There are many reasons but here are a few to remind ourselves why:

Big market – according to CoreLogic, Australian residential real estate is valued at $7.3 trillion, with over 9.8 million dwellings, an LVR of 23.4% with outstanding mortgage debt of $1.66 trillion. The opportunities to build wealth in this market are substantial with a very strong secondary market given it forms an essential human need. To put its size in context, Australian super is next biggest with $2.3 trillion and Australian listed stocks at $1.8 trillion.

Self-funded retirement – the growing awareness that superannuation alone will not be enough and the constant changes to the rules. As well, the uncertainty around the amount of government pension that will be available and the desire to be less reliant on the government makes it attractive to create a self-funded retirement through property.

Leverage – this is very appealing for a property investor, as the ability to control a larger asset and get the compounding benefits of the larger value is the single reason why we choose property over any other asset class. Combine leverage and compounding with an investment-grade property and the results are life-changing.

Low volatility – particularly in the capital cities and surrounding areas where the demand exceeds supply. While property performance is never consistent and linear, investment grade property rarely loses value quickly or in high proportions.

Simplicity – it’s tangible and easy to understand. After all, it’s an essential need: shelter.

Control – unlike other investments, you’re in full control of your property investment; you can make all the decisions and have control over all your returns. You can add value to your investment without having to seek approval from a large company or fund manager.

Government backed – let’s be honest, the collapse of the housing market would be a disaster for the government of the day at the ballot box, so protecting this very important asset class is not only in the national interest but politically underpinned.

Alternatives – they often appear harder to understand, are riskier or are perceived as a poorer return on investment. An investment-grade property offers better performance than money in the bank.

The fundamentals

To build a portfolio that weathers any storm, it’s important to ensure that you get the fundamentals right from the beginning. This enables you to positively plan your financial future while creating a safety net to defend your portfolio from external factors outside your control.

The first fundamental for any property investor is asset selection. Picking a poorly performing asset whose value doesn’t grow or, worse, falls is by far the biggest derailer to any portfolio. So it’s important to know that not all property makes for a great investment. Therefore, knowing the difference between investment-grade property versus investment stock is a priority. This point alone is what determines your ultimate success or failure as a property investor, as mistakes are often hard to recover from. I see too many investors who think it’s simply about putting their name on a title and magically it will go up in value. The law of supply and demand exists in the property market as it does in any market, so ignore this fundamental at your peril.

The second fundamental is to correctly finance the property. I mentioned earlier that property investing is a game of finance so getting a borrowing capacity is simply not enough. You must get a borrowing strategy that takes into account not only the current purchase but also planning for any future purchases. Providing a buffer as well as ensuring that the banks are not dictating the terms through crossing the security will give you the agility to navigate whatever the market throws at you.

Third, investing in property is all about time in the market. Savvy property investors see short term as being 10 years and long term as being 20-plus years. The power of compounding is brilliant but only if you give it time to work its magic.

The most successful investors we’ve ever interviewed on our podcast or met in person are those who have been investing for more than 20 years and navigated through many cycles, and their portfolio size reflects the patience they’ve shown to accumulate. The interest on the original purchase price is now equivalent to their kids’ lunch money! If you hold for the long term, your reliance on the negative-gearing benefits well and truly diminish over time.

And, finally, to the common question of “When should I buy my next investment property?” The answer is the same no matter what the market sentiment is. Assuming you’re a long-term investor (not a speculator) then it’s simply “when your cash flows allow”. If you have planned your cash flows appropriately, taking into consideration your medium-term needs (growing family, changing jobs, 12-month sabbaticals, job security), not just the here and now, then if you have surplus cash flow above your needs then you should consider adding a property to your portfolio. It’s as simple as that.

The growth of median house prices in the capital cities for the past 35 years has not been a straight line – and in some cases it goes down – but the overall trend is up and this further reinforces the benefits of playing the long game.

OK, let’s see all of this put into action with two case studies: Rachel on the previous page and Matt and Jayne on the following page.

If you hold for the long term, the interest on the original purchase price is equivalent to the kids’ lunch money