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.

Share purchase plan's - When things don't go to plan

In a previous post I outlined the benefit of share purchase plans and how they were often a great way to make 'free' money.

The example I used was the SPP that I was then participating in - the QBE SPP. This particular plan allowed you to apply for more than your proportionate share and as the price of the share was trading above the SPP price it was as guaranteed a profit as one could normally get.

However where the above conditions exist almost all investors will see the same thing and I'm fairly sure most applied for over allocations. The result was a scale back which I expected however QBE scaled back allocations to such an extent that it was possible to actually lose money in the process (which I did). A summary is shown below:

Original expectations

• Shares originally held: 32


• Shares applied for: 1,401 ($15,000 worth)


• Expected profit on SPP shares: ~$2,400

Actual outcome

• Shares actually allocated: 3 ($32.10 worth)


• Cash refunded: $14,967.9


• Gross profit on SPP shares: $6.90


• Days cash held by company: 17


• Lost earnings on cash (@7% p.a.) = ~$49


• Actual loss: $42.10

While the loss was annoying and not substantial, compared with the expected profit it was quite a big variance. I did a bit of research and such a big scale back is almost unheard of so I was a bit unlucky with this one. The rationale for investing in SPP's still holds however the lesson from my experience here is that you should always keep in mind that a massive scale back like this can result in a loss for the investor.

Investing in Real Estate: House hunting

This is the fourth part of my Investing in Real Estate series and the focus of this post will be how to effectively house hunt. At the broadest level investors only really have 2 concerns:

• What budget do I have for this investment?


• What yield am I looking to get?

Unfortunately this can make house hunting a nightmare as these can yield several suburbs / towns or even cities which conform to the minimum requirements that you seek. Further it is rarely possible to run a screening tool either from real estate listings as each area has it's own rental market (i.e. within the same city you may have some areas which are currently strong for rental properties while others are very weak)

I have put together a checklist of questions / suggestions that an investor should look at before looking at any properties or calling an agent:

1. What is the amount that I can afford to invest in this one investment? (note that this is very rarely the maximum you can afford). Once you have this price get rid of all areas with a median price above your price point. I don't necessarily believe that you should buy around the median like some authors teach but simply that you're more likely to waste your time on properties that are out of your price range.


2. Am I more interested in capital growth or yield? This is an especially important question in countries which allow negative gearing (such as Australia). There is often (though not always) an inverse relationship between the two in property markets. This will dictate whether you look at inner city house / land type properties (high cap growth / low yield) or whether you look at outer suburbs or inner city apartments (high yield / lower cap growth)


3. How good am I at doing repairs / maintenance and do I want to do this? Quite simply if you are not a very handy person or you tend to pay others to do your repairs etc don't bother looking at properties that require a lot of work. They may look cheap but unless you can do a lot of the work yourself you may just end up in the same spot as you were before


4. Try and target renters areas. There are some areas that are typically inhabited by renters and have a high number of rental properties. This is a good thing! Areas such as those around colleges / universities or even those which tend to have yuppies or young families tend to have a constant level of demand.


5. Once you have answered the above questions limit yourself to 3 or 4 suburbs which are around each other. This saves on travel when you are searching but also means that you will narrow your prospects quite quickly. You will also get a feel for the area and what is good and bad in the area (especially those streets that are good or not so good)


6. Figure out what the specifications are of the property you want. Be really specific and once you set this you can be flexible but it will focus your search. Also real estate agents are typically more likely to be helpful if you say you want a 3 - 4 bedroom, 1 bath, low maintenance with access to schools etc rather than saying 'I'm looking for an investment property'. You'll actually find you get shown properties before they are even advertised


7. Call every agent in the area and let them know what you are looking for. Also tell them that you are not interested in anything that doesn't fit your criteria. They will get the idea that your a serious and experienced investor (even if your not) and you'll only get shown relevant properties.


8. Go and look at every property which fits all of the above requirements. You're now at a stage where it is not wasting time any more to look at every property because you know exactly what you want and you know what is good and what is not.

If you follow the above 8 steps it will save you a lot of hassle in the property search process. You may not get the perfect property even if it is for sale because there are always going to be people that will pay more / too much.

In my next post I will outline the negotiation process.

Alternative Investments: Initial Thoughts

Over the Easter long weekend I had the chance to sit back and think about my investment strategy generally. I believe that while it is good to have a plan and to stick to it - it is equally as important to assess this plan as time goes on (my inability to stick to my personal expenditure cap is a good example of a plan that isn't working)

The question I pondered was whether I was limiting myself to too narrow a field of investments (that is stocks, property and fixed interest securities). Nearly every general investment book I have ever read has a chapter on what they call 'alternative' investments which tend to include things like:

• Coins


• Paintings / art


• Stamps and other collectibles


• Gold and other precious metals

While I do possess some of these (such as a stamp collection I inherited from my great grandfather) it has never been for an investment type purpose. The more I thought about these types of investments the more I became convinced that although you may get good returns on them they were inherently risky for several reasons.

1. The return on an 'alternative' investment is totally dependent on the supply and demand situation for that product in the future. There is simply no other way of making money out of these investments. This is not the case with traditional investments - for example on a stock or property while the value in 10 years time is important, in most cases you should be receiving some sort of income (e.g. rent / dividends) in the meantime


2. If you are investing in these items you have to be doing so full time. While I (and I imagine most people) would like to think that we are are good at appreciating a piece of art I have no special knowledge about what the demand for such a product may be in the future or where tastes are trending. Some people are blindly willing to trust valuers of reports which say what is going to be in vogue in the future but that is much like blindly trusting a broker report or hearing stock tips on the street. I have said it before but you should fully understand every investment you own.


3. Gold and precious metal investment is a field that is very hard to get ones head around as there are so many things that impact the price of these products. If I use the example of gold - it is so hard to forecast with any accuracy the type of return you can expect from an investment in gold. Not only is the supply side hard to forecast (i.e. how many more gold deposits are there to be found) but the demand side is impacted by so many different things such as the level of hedging (which itself is impacted by general sentiment, the value of the USD etc), the level of speculation in the commodity itself, the demand for jewelery (especially out of India) and a host of other factors.

The conclusion I came to was that I am not going to make investment in these products part of my investment portfolio as there is too much uncertainty and I do not believe it is possible to get the relevant level of knowledge to invest in these products. If I buy these products they will form part of my 'personal expenditure' on collectible items that I enjoy.

Expenditure Tracker - March 2012

Like February 2012, March was a terrible month for keeping up with my expenditure goals for the year. My personal expenditure was too high which meant that the amounts I could allocate to my different savings plans were too low.

A summary of my expenditure for the month is shown below:

• Share investments: $16,291 ($12,911 over)


• Home loan offset account: -$13,149 (14,749 under)


• Personal expenditure: $4,700 ($3,200 over)

On a cumulative basis (January - March 2012) the accounts are as follows

• Share investments: $22,416 ($12,516 over)


• Home loan offset account: -$10,523 ($15,352.78 under)


• Personal expenditure: $10,151 ($5,651 over)

The big redistribution into shares was from the QBE SPP which I have posted above previously and I do not expect to receive my full allocation so there will be a flow back into my home loan offset account in the next month. The rest of the under investment in the home loan offset account is explained by the over expenditure once again.

Next month will be particularly bad for personal expenditure as my credit card bill is very high and I have to pay for some airline tickets as I have booked a holiday for the end of the year. I'm trying to work out ways to increase my income. I will post any ideas or strategies that I have and the results from them.

Making money from Share Purchase Plans (SPPs)

A common way for companies to raise money in Australia (though I have heard it is not as common overseas) is via a non renounceable entitlement offer (often called a share purchase plan). I will go through an outline of what an SPP is and how you can profit from it as a retail shareholder

What is a share purchase plan?

A share purchase plan (or entitlement offer) is a right given to all existing shareholders in a company to purchase for a defined price extra shares in the company (normally at a significant discount to the current price). This is a cheap way for companies to raise funds from the market as it does often does not involve a full prospectus.

The entitlement offer is normally offered to both retail and institutional shareholders with the institutionals setting the price during the bookbuild period (1 - 2 days after the entitlement is announced) and the retail shareholders being offered this same price with more time to make the decision (up to a month later in a lot of cases)

Should you participate in a SPP?
In a word - yes as long as you have the money and you still believe in the company. This is because if you don't you will have your proportionate shareholding in the company diluted. If you take up your proportionate share at the lower price then you are just as well off.


How to make money from an SPP
However the real way to make money from SPP's is by buying in excess of your proportionate shareholding. I will use an example that recently applied to me. The company was QBE Insurance an ASX listed company:

• Original number of shares held: 32,


• Original purchase price: $33.00


• Original purchase value: $1,050


• Share price pre raising: $12.00


• Value of shares held (pre raising): $400


• Existing profit / loss: $(650)

As is pretty evident above this is one of my less successful investments and it was bought while I was university prior to the GFC. I kept it as a reminder to always do my research and also to remember that markets fluctuate a lot so even if you think you're making a good decision some returns will be out of your hands.

As luck would have it QBE recently decided to do an equity raising where a shareholder could subscribe for $1000, $2000, $5000, $10000 or $15000 worth of shares at a price of $10.70 subject to a scale back if there was an oversubscription.

As I outlined above the way to make money from these investments is to buy a greater than proportionate share of the investment as it will usually trade between the original price and the issue price. For QBE it was even better because post the institutional raising it was trading above the original $12 (it was trading around $13) which gave the investor certainty around profits.

So if I continue my example from above

• New shares bought ($15,000 @ $10.70) = 1,401


• Total shares now owned = 1,401 + 32 = 1,433


• Total amount invested = $15,000 + $1,050 = $16,050


• Average purchase price = $11.20


• Current share price = $13.00


• Total book profit = $2,579.40

Thus by getting my full allocation of shares and selling at market price I would change a $650 loss into a $2,600 profit. Note that any scale back of the investment would reduce this profit but even one share allocated to me would reduce the loss that I currently had.

The one big thing to note is that if you don't participate then you are providing the profits for others who do participate.

March 2012 net worth - $233,000 (+2%)

Assets: $588,000 (+1%)
Liabilities: $355,000 (-0.2%)
Net worth: $233,000 (+2%)

As expected, I did not have a significant increase in my March net worth primarily driven by high personal expenditure which meant that I could not allocate as much to my investments. The net worth this month was not driven so much by one or two items but rather several smaller movements including:

• An automatic increase in the cash allocated to my employee share investment plan


• A slightly lower credit card balance (as posted before my car service unexpectedly cost much more than budgeted for) - hopefully I will get some significant gains next month as this amount rolls off


• Share market returns were marginally positive

I looked back at my February 2012 net worth and noted that I had predicted negative returns due to my high personal expenditure and it certainly would have resulted in this had I noted had mandated savings / investment plans such as the government mandated superannuation scheme as well as my participation in my company's employee share investment plan.

For April I am predicted relatively flat returns once again. My credit card bill will continue to take significant amounts of cash and I have just booked an overseas holiday which I will need to pay for in April. Against this I am forecasting some strong returns from a share purchase plan which I participated in which I will outline in the coming days.