Investment property differs from your own home
Yield a good indicator of rent income potential.
RESIDENTIAL property investment remains a popular option for people looking to secure their financial futures.
However, many novice investors fall into the trap of choosing an investment property using the same criteria they would apply to choosing their own home.
Choosing a home is an affair of the heart as much of the head, because it’s often based on finding a property that will suit people’s lifestyles and aspirations as much as purely financial considerations.
But property investment is about maximising a future income stream. Whether that involves investing in a multimillion-dollar commercial property or a small home unit, the fundamentals are essentially the same.
In either case, the decisionmaking process is a numbers game and the most important number investors need to consider is a property’s yield.
HOW YIELD WORKS
Yield is a standard measure of a property’s income-earning potential. It’s the rent a property could provide during a year, expressed as a percentage of its purchase price.
Say a property cost $250,000 and was expected to be rented for $300 a week. To get the yield figure you would multiply $300 by 52 to get the annual rent of $15,600, which is 6.25 per cent of the purchase price. So the yield is 6.25 per cent. Expressed another way, if you paid $300,000 of your own cash for the property, the rent of $300 a week would give you a gross return of 6.25 per cent.
It is a theoretical number, because it makes no allowances for likely periods of vacancy, or for expenses a landlord will face such as insurance, rates, repairs and maintenance. And it doesn’t take into account any debt funding used to acquire a property.
However, the yield is useful as a standard measure to compare the income-earning potential of properties.
Experienced investors are concerned less about a property’s price than its yield. Whether it costs $200,000 or $600,000, the yield signals how well it might stack up as an investment.
Most investors will have a target yield they will want to achieve. If a property has an acceptable yield, they can prepare a cashflow forecast and look at potential risks. If the yield’s not acceptable, it’s probably not worth wasting time on the property.
So the yield is a useful starting point for sorting out the wheat from the chaff.
One of the most common mistakes inexperienced investors make is overcapitalising on a property. That is, the money they spend on a property is not justified by the rental income it can produce.
GOOD SUBURB, BAD YIELD
It’s a general rule of thumb that cheaper residential properties provide a better return than more expensive homes. So an investor would probably make more money from owning three units in Sydenham, Porirua or Otara, than they would from investing the same amount in a single house in Merivale, Karori or Epsom.
The effect of this phenomenon can be seen in the accompanying table. It compares median selling prices with average rents in several suburbs in Christchurch, Wellington, Hamilton and Auckland. That enables an indicative yield figure to be worked out for each suburb.
The figures are not perfect because in most cases the median sale price and average rent figures will relate to two sets of properties. But they show the general trend and that is that the yields are much higher in the cheaper suburbs than moreexpensive ones.
So, in the traditionally working-class Christchurch suburb of Linwood, the indicative yield is 7.7 per cent, while in the rarefied airs of Cashmere it is 4.8 per cent.
That would make a substantial difference to an investor who was relying on a rental property for an income. On $400,000 of property investments, it could be the difference between receiving $30,800 or $19,200 in gross income every year.
So, although yields are a theoretical figure, getting them right can have a big impact on an investor’s income.
APARTMENT OPTION
The other figures in the accompanying table worth noting are the yields on CBD apartments in Auckland and Wellington, the only cities in this country with apartment markets of any significant depth.
However, there are major differences between the two markets. Overall, apartments in Wellington are more expensive and their yields are lower, while in Auckland the reverse is true and prices are lower and yields are higher.
That is because of differences in the way each market developed.
The Auckland apartment market was driven largely by investors and the apartments that were developed for them were usually smaller and often catered to students. That produced large blocks of what are often referred to as shoebox apartments because of their small size.
And they are owned by investors from all over New Zealand and even overseas, who were attracted by the fact that although they may not be flash, they provide a high yield, which in turn gives the investors a good income.
In Wellington, owner-occupiers are a bigger part of the market, so many of the apartments are larger and built to a higher standard than those in Auckland.
That means indicative yields on Wellington apartments are closer to those in the city’s general housing market.
If investors are prepared to consider buying a property outside their home town to get a good return, then apartments can be a good option.
One of the major drawbacks of an out-of-town property investment is that it can be difficult for an owner to keep an eye on and deal with any issues.
On the other hand, apartments lend themselves more readily to being managed by a third party.
The larger complexes will usually have a resident manager to deal with daily issues and keep an eye on tenants who may cause problems. And there will be a body corporate structure in place to deal with more-important issues such as building maintenance.
Because these items are budgeted for and usually professionally managed, that can also give individual landlords in a complex more certainty about their costs than they may have with a standalone property.
BOOSTING THE YIELD
Some investors will seek out lowyield properties that have a potential for improvement.
Take the example given above of a property that cost $250,000 and could be rented out at $300 a week, giving a yield of 6.25 per cent. If the landlord could increase the rent to $375 a week by spending $50,000 on refurbishment, it would increase the yield to 6.5 per cent as well as lifting the capital value of the property, so it would probably be money well spent.
However, that should be an option only where the investor is prepared to carry the development risks involved.
If investors put yield at the top of their list of things to think about when considering investing in a property, they will be far less likely to make a bad decision.