Friday, 13 April 2012

Investing in real estate: Is it a good deal at THAT price?

This is the fifth part in my Investing in Real Estate series. By now you are at the stage of weighing between several different options. This post attempts to outline how to work out if the property you are going for is a good deal / the right price.

Step 1: Find out what the gross rental return in your market is

Don't look at net returns. There is a remarkable amount you can control between gross and net. At the moment all you are looking for is the average rent in the area you are looking to purchase (remember from the last post we have narrowed down our search to a few surrounding suburbs) and the prices of those properties.

Take the rent on the type of property you are looking for and divide it by your property price to get your gross yield. A worked example below

  • Assume $400,000 property typically rents for $350 a week

  • $350*52 = $18,200 p.a.

  • 18,200 / 400,000 = gross yield of 4.55%
A big caveat in this step is not to be lazy. Don't just get the median house price and the median rent. If you are looking at 3 bedroom, 2 bath houses then get the rent for those houses (same goes for apartments etc).

Step 2: Estimate the capital growth in the area you are looking to buy

This is by far the hardest step. Historical growth rates typically mean very little and in all honesty you can be as analytical as you want but because growth in home prices are typically determined by sentiment (especially among home buyers who do not have return criteria) as well as things like government policy, incentives, job availability, gentrification etc it is really hard to get an accurate number for this.

You should remember some rules of thumb though which include

  • Inner city / 'popular' areas capital values grow faster than outer less popular areas

  • Access to amenities and jobs really do drive growth

  • Don't base your investment decision on what 'may' happen in an area because your investment is then predicated on that outcome and not on the inherent merits of the property

A growth rate of 4% - 5% p.a. is not outrageous and I use it for my calculations

Step 3: Work out what return you want and the time period you expect to hold it for

People have unrealistic returns for investments which is why they are surprised when they find they their 'high return' investments also have high risks attached to them. If you moderate your investment expectations you will find yourself making better investment decisions. For investment properties I want my return to be 8 - 10% net return.

I also use a 5 - 10 year time horizon (though in all reality I will probably hold for longer than that)

Step 4: Do the math

Find out what the typical costs are for an investment property of your type in your area. No rules of thumb here - you really need to be doing the work here. Don't listen to books that give you broad brush answers. ALSO do do this in excel - it's an iterative process and you will need to change the purchase price until it falls within your return!

Using the example above:

  • Assume that pre-interest costs are 25% of gross rent: $4,550

  • Income (pre-interest): $18,200 - $4,550 = $13,650

  • Assume you gear the property to 80% = $400,000 * 80% = $320,000 debt

  • Assume an interest rate of 7% = $320,000 * 7% = $22,400

  • Loss for the year = $8,750

  • If your jurisdiction allows negative gearing and you get ~30% back on tax then your actual loss for the year = $8,750 * 70% = $6,125

I realise that this is a long post to work out how much to pay but given the cash you are paying out it is work that you really should do

Continuing with the example above

  • Assuming we hold the property for 5 years

  • Property value increase = $400,000*(1.04^5) - $400,000 = $486,661 - $400,000 = $86,661

  • Selling costs assume 2.5% = $12,166

  • Capital return from property value increase: $74,495

  • Assuming rents increase by 3% p.a. you would get total rents of $96,626

  • Net rents (after costs but pre interest) = $93,184*75% = $72,470

  • Interest over the period would be a simple interest calc = $22,400 * 5 = $112,000

  • Loss after interest = $39,530

  • Tax adjusted loss (as outlined above) = $42,112 * 70% = $27,671

  • Take into account the income you could have made on this cash that you have lost over the years = $3,110

  • Net income loss over the 5 years = $30,781

  • Total gain / loss: $74,495 - $30,781 = $43,714

  • Return: $43,714 / $80,000 (originally invested) = 1.546419 ^ (1/5) -1 = 9.1%

Thus at this purchase price the investment is within the criteria. This is why doing it in excel is so important. If it did not fall within your criteria then you would need to adjust your purchase price until you got to a one in which it did. It is fairly easy to set up a basic excel file to do this. If there is sufficient interest (through comments etc) I will post one online so you can play around with the assumptions yourself.


  1. Am looking to get into property myself, am starting to do the preliminary research (whilst saving the deposit) and am finding it difficult to find realiable data out there, one thought that occurred to me would be to check the rental income, simply by searching 3 or 4 bedrooms in the suburbs then basing an average off this (given there will always be outliers)

    What are your thoughts on using a service such as RP Data or APM (waste or time or decent?)

    I have been going to open homes recently in my local area & although they say not to buy in your local area, I am thinking of buying a place with a granny flat or building a granny flat to reduce my costs (for rent) as I'd live in the flat & increase future rent potential, by having both the granny flat & house rented out after a few years..
    This probably isn't as simple as I'm making it sound however am looking to give it a try given that I am looking to generate income as well as growth..

    1. Hi Jef,

      Your first point is right on the money. Pick the suburb you are ACTUALLY looking at for the most accurate data point. Trust me when I say you cannot set your rent outside what is already being advertised - people will just not look)

      RP Data is quite expensive, especially for preliminary research and I'm not familiar with APM.

      I think buying in your local area is fine - you have intelligence and insights into your area that others don't have (as well as having a much keener understanding of the issues and what is coming and what is going)

      With the granny flat - I have no great insight into renovations and the pros and cons of this. The only thing that comes to mind is that renovations cost a lot and you need to think about whether you can afford to do them with no tenants paying the rent.

  2. Another thought I've had on this is what about Capital Gain Tax? I know there are ways to avoid this but assuming these are payable, this will erode net profit..
    Out of interest as well what would be an effective way to find out costs of investment property in the area, google or speaking with a real estate agent? (I am fortunate to have one as a family friend, not too sure how accomodating he will be though)

    1. CGT will absolutely erode your absolute net profit however real estate is NOT a short term investment and CGT is only payable on a sale so it is very much back ended. You need to make it part of your calculations but keep in mind that CGT is payable on ALL investments where the value of the asset has increased so in that sense property is no better or worse from that point of view.

      One thing that really bites with property is the stamp duty payable when you buy a property - that is just money down the drain.

      For costs of investment property use and find properties similar to what you are looking for. Keep in mind that many of these are advertised too low so you want to look at 'recently sold' properties for an idea of what they are going for.

      Using your family friend is a great idea - make use of whatever contacts you have when getting up the learning curve