Managed Funds

Glossary

Property has been a popular route to wealth for many Australians for many years. Buying their own home is often the first investment many people make; purchasing another property may well be the second even before shares and other assets.

But your first investment in property neednt be your home. Indeed, buying a small apartment to rent out can be a good way to accumulate funds so you can eventually buy your own place, in an area where you want to live.

Increasing numbers of young Australians are choosing this route, buying in one suburb while renting in a more desirable and expensive area or living at home for a while longer.

Still others are diversifying into non-residential property via property trusts and syndicates.

Sensible investments in property have many attractions. Property can be less volatile than shares though not always and it tends to be regarded as a safe haven when other assets are declining in value.

It has the potential to generate capital growth (an increase in the value of your asset) as well as rental income. Then theres the tax advantages associated with negative gearing (more about that later).

However, as with any investment, there are no guarantees. Property prices go down, as well as up, and sometimes tenants are hard to find especially good ones who pay on time and take care of your investment.

Investors need to have a keen awareness of the interest rate environment how higher rates might affect their expected net return and the market for their property should they wish to sell. They also need to make sure the return or yield from their property stands up against the return they might have achieved had they invested in shares, for example.

Of course, you dont have to make a direct investment in property. Pooling your funds with other investors in managed funds with a property focus, listed property trusts or property syndicates provides exposure to a broader range of property including commercial, industrial and retail as well as residential often with a smaller investment required.

Many financial advisers would argue that too many Australians let direct investment in residential property dominate their portfolios. In theory and this is far from reality for most people property should account for perhaps 10 per cent of an investment portfolio.

Capital growth

Capital growth is the increase in the value of your property over time and is one of the main reasons people invest in residential real estate.

Historically, Australian residential property has experienced strong capital growth the long-term average annual growth rate for property is about 9 per cent but periods of stagnation and even decline are also part of the picture. The nature of the property cycle means real estate should probably be thought of as an investment with a 10-year horizon.

Take the experience in recent years. In 2003, Australian house prices were rising at a rate of about 20 per cent, but since then prices have come to a virtual standstill in many areas and have gone backwards fast in some of the hot spots.

Your best chance of achieving capital growth is buying the right property, in the right place, and most importantly at the right price.

www.homepriceguide.com.au ). Talk to real estate agents and observe at auctions.

Rental income and yield

You should apply the same standards to a property investment as to any other investment, benchmarking the potential return against what you might achieve elsewhere.

An important measure is a propertys yield. That can be calculated by dividing the annual rent it generates by the price you paid for the property and multiplying that by 100 to get a percentage figure.

Lets say you bought a unit for $400,000 and rented it out for $350 a week (or $18,200 a year). Thats a yield of 4.5 per cent. That might compare with a dividend yield of, say, 7 per cent had you invested in a particular companys stock.

But lets say you bought a workers cottage in a mining town where prices are low but the rental income as good as in the big city. Pay $350,000 and rent the property out for $600 a week and youll achieve a yield of 9 per cent.

Remember, yields fall as house prices rise (if rent doesnt rise commensurably).

Keep an eye on vacancy rates the proportion of properties sitting empty out of the total rental supply.

If landlords have to fight for tenants, they wont have much pricing power with regard to rent. However, if the rental market is tight, and tenants are competing for properties, theyll be prepared to pay a bit more to get in the door.

A vacancy rate above 3 per cent is a warning sign, and it may pay to be wary of areas where theres going to be a big increase in the supply of apartments.

In any case, build into your calculations of your likely return periods when youll be in between tenants.

Tax

The tax advantages of property investing are a big attraction for some investors, and many people invest in property with the aim of taking advantage of Australias negative gearing rules.

Negative gearing

Gearing basically means borrowing to invest. Negative gearing is when the costs of investing are higher than the return you achieve. With an investment property, thats when the annual net rental income is less than the loan interest plus the deductible expenses associated with maintaining the property (such as property management fees and repairs).

When youre negatively geared you can deduct the costs of owning your investment property from your overall income reducing your tax bill. High-income earners benefit the most, because theyre in the top tax bracket.

In addition, while you record a loss on the income from the property, in theory capital gains in the value of your property should make the investment worthwhile.

But dont over-commit to property just to get a tax deduction. Those tax benefits generally dont come until the end of the financial year and you have to make your mortgage payments in the meantime.

That said, you can apply to have less tax deducted from your pay to take into account the impact on your overall income of expected losses on an investment property.

Say you earn $45,000 a year, gross, in your day job but you can reliably estimate that youll make a $15,000 loss on an investment property. You can apply to have your tax payments calculated on an income of $30,000 rather than $45,000 giving you more cash in hand now, rather than a refund at the end of the year. Get your sums wrong, though, and youll owe the tax man money at the end of the year.

See www.ato.gov.au for information about pay-as-you-go (PAYG) withholding payments

Remember, too, that a capital gain which will be taxed is never assured. Whats more, the benefits of negative gearing are smaller when interest rates and inflation are low and can be offset by charges such as the land tax levied in NSW (see www.osr.nsw.gov.au ).

Depreciation

The owners of investment properties can also claim depreciation of items such as stoves, refrigerators and furniture. That involves writing off the cost of the item over a set number of years the effective life of the asset.

The ATO sets out what it considers to be appropriate periods. The cost of a cooktop, for instance, is generally written off over 12 years you claim one-twelfth of its cost as an expense each year.

There are two different types of depreciation an allowance for assets such as the cooktop, and an allowance for capital works, such as the cost of construction.

Its a good idea to talk to a quantity surveyor or other depreciation specialist right from the start, so you make full and correct use of the available depreciation allowances.

The higher the depreciation bill, the higher the amount to offset against income when youre negative gearing.

Capital gains tax

Capital gains tax (CGT) is the tax charged on capital gains that arise from the disposal of an asset including investment property, but not your place of residence acquired after September 19, 1985.

Youre liable for CGT if your capital gains exceed your capital losses in an income year. (If youre smart, youll time asset disposals so that if you really must take a capital loss itll be at a time when it can offset a capital gain).

The capital gain on an investment property acquired on or after October 1, 1999, and held for at least a year, is taxed at only half the rate otherwise. This means a maximum rate of 24.25 per cent if youre in the highest tax bracket.

The capital gain is the profit youve made over and above the cost base the purchase price plus capital expenses such as subsequent renovations. Make sure you keep good records of these sorts of expenses.

Capital gains tax is a complex area, so it pays to get specific advice about how it applies in your individual circumstances.

Where to buy

Having worked through the financial considerations, and bearing in mind that youre not actually going to live in the property, you should be able to make a fairly rational decision about where and what to buy.

Youll want to benefit from as much capital growth as possible, so the first rule is to buy in a growth area.

That might be a suburb located within 10 kilometres of the city centre, or a suburb with special attractions such as a beach or trendy caf strip. Proximity to a hot suburb could mean your suburb will be next to rise in value.

It could even be a regional town supporting a booming industry.

Narrow your search down even further by looking at a propertys access to transport, shops and leisure facilities and its appeal to your market whether theyre young professionals or blue-collar workers.

What to buy

House or unit? Old or new? Units usually are a much better proposition for landlords. Theyre easier to rent out and easier to maintain: theres no lawn to mow, and when things go wrong in the building the expense is shared with the other owners.

Properties with a view are always more desirable than those without, and tenants like facilities such as balconies, internal laundries, undercover parking and security.

These sorts of facilities may not be available in an older property, which may have to compete with a new apartment building down the road with all the mod-cons.

If the property youre interested in is already rented, ask about its history of tenancy. Have there been periods when it hasnt been occupied? If so, find out why. You dont want to inherit those problems.

The bottom line: balance what you can afford to buy with the rent youll be able to charge. Theres no point buying a waterfront property if you cant find tenants happy to pay the sort of rent youll need to make the exercise worthwhile.

Once youve found the right property, the actual mechanics of buying it will be the same as if you were buying a home to live in. See our guide to buying a home for what happens next.

Finance

There are few differences between borrowing for a home and borrowing for an investment property.

Some lenders charge a higher interest rate for investment properties because they say their risk is higher, but shop around and you should be able to get a rate thats the same as for an owner-occupied property.

See our guide to buying a home for a run-down of lenders and the types of loan available.

Interest-only loans

One option for investors is the interest-only loan, where you dont pay off any of the principal, only the interest.

Such a loan can make it easier to estimate the true returns from a property. A tax advantage is that interest payments for investment properties are tax deductible, while payments off the principal are not.

Interest-only loans

One option for investors is the interest-only loan, where you dont pay off any of the principal, only the interest.

Such a loan can make it easier to estimate the true returns from a property. A tax advantage is that interest payments for investment properties are tax deductible, while payments off the principal are not.

Making your investment pay

If you hold your investment property for long enough, hopefully youll reach the stage where losses start turning into gains. The rent youre charging should have risen over time, and youll be steadily whittling away at the mortgage.

Once your rental income exceeds your mortgage repayments youll no longer be negatively geared, however. And no negative gearing means no tax advantages but that doesnt mean you should rush to sell.

Yes, youll have to pay more tax because the income youre making is more than your losses but the fact is youre making money, which is why you invested in the first place.

The temptation may be to take your profits and plough them into another property and that can be a perfectly reasonable strategy but dont lose track of the costs involved in selling. Stamp duty alone is a big disincentive.

Property management

Its possible to manage a rental property yourself, and in so doing save a management fee thats usually around 5 per cent of the rent. But it can be time-consuming and its hard to remain emotionally detached when you have tenants ringing up complaining about every little thing, or you personally have to deal with damage to your property.

The other option is to use the services of a professional property manager. Theyll have up-to-date information on whats happening in the market and what tenants are prepared to pay. Theyll have prospective tenants on their books, and experience vetting tenants. Because they manage many properties, theyll have access to reputable trades people at cheaper service fees.

And their fees are tax deductible.

Insurance

Managing your financial risk as a property investor also involves insuring yourself against a myriad of potential hazards.

Its up to your tenants to take out home contents insurance to cover their possessions, but youll need building insurance. Then theres landlord insurance, covering risks such as malicious or accidental damage to your property by a tenant, any legal liability should a tenant injure themselves, and lost rental income should tenants move out without paying.

Renovating

Be prudent about renovations. The colour palette of the kitchen in your investment unit may offend your sensibilities, but it only makes financial sense to replace it if a better kitchen will stop the unit sitting vacant or lift the rent you can charge.

Make a cost-benefit analysis of your renovations. If the kitchen is going to cost $10,000, and youll have to borrow the money and pay interest, but it will only add $10 a week to the rent, its probably better left alone.

Dont overcapitalise by spending too much on design, finishes and fittings.

Non-residential property

Of course, you dont have to restrict yourself to the residential property market.

Pooling your funds with other investors in vehicles such as property trusts and property syndicates provides exposure to a broader range of property including commercial, industrial and retail as well as residential often with a smaller investment required.

Youll be spreading your risk rather than being hostage to the ups and downs of the residential property cycle and youll still have access to tax advantages such as depreciation but you wont have to worry about kitchen colours and clumsy tenants.

Property trusts

Property trusts aim to generate rental income from a portfolio of professionally selected properties with good tenants on long leases, along with some capital growth in the value of those properties.

Property trusts can specialise in particular sectors such as retail or industrial property or they can be diversified, investing in various types of property.

They can be listed or unlisted. The advantage of investing in a trust listed on the stock exchange is that you should be able to sell part or all of your holding quickly something thats not so easy with your own bricks and mortar. But, like any investment, nothing is guaranteed.

Listed property trusts (LPTs) have blossomed in recent years and now account for something like 10 per cent of the Australian sharemarkets value. A recent development is a push by LPTs into property assets overseas.

Property securities funds

The growing popularity of LPTs, in turn, has led to the development of managed funds that specialise in investing in LPTs (as other funds do in shares or bonds). These are known as property securities funds.

Some of these funds also allocate a proportion of their money to unlisted property trusts as well as LPTs.

The theory is that property securities funds diversify your investments and reduce your risk even further.

Another variation on the theme is the geared property securities fund, where managers use borrowed funds as well as investors money to buy properties, with the aim of boosting returns to investors.

Property syndicates

Property syndicates are another growing area. These syndicates are unlisted and usually involve a restricted number of investors and a set amount of capital to be raised (making them closed-end rather than open-ended funds). They are built around a single property or a group of identifiable properties.

The Macquarie Martin Place Trust, for example, is based on a 50 per cent stake in the No. 1 Martin Place office tower in Sydney. In 2002, the trust sought $102 million from investors to fund part of the stake in the building (the rest being funded by debt).

Syndicates usually have a set life of around five to seven years, making them much less liquid than listed property trusts. However, some managers allow limited redemptions under prescribed circumstances in the intervening period.

Syndicates provide income during their life and, all things being equal, some capital gain at the end as well. Investments in property syndicates generally start at about $5000 to $10,000.

Look for syndicates that have been assessed by independent researchers and be aware that entry fees and ongoing management fees are higher than for ordinary managed funds.

Also consider the risk involved in being exposed to just one or two properties in a syndicate.