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…and why you should never believe everything you read in the newspaper - especially when it comes to investing in rent guaranteed investment property!

I didn't think I'd be angrily responding to a Sunday Star Times article for my first-ever blog post, but hey… life is full of surprises

I happened to be scanning through my RSS feeds from various news sources last-night when I came across an article in the Sunday Star Times entitled "Are You Safe As Houses?"

I read it with interest, hoping to find some new little gems of property investment wisdom that had previously eluded me.

To say I was 'disappointed' would be a gross understatement.

The author, Greg Ninness - normally a great financial writer and someone I have considerable time for - failed to portray an accurate picture of modern property investment techniques. He almost bordered upon "anti-property" with some of the less than half-truths he spewed out!

For instance, the article assumes that an investor would pay the entire purchase price for a property "IN CASH!" Who in their right mind does that these days? Or perhaps, more to the point…

…who has that much cash these days?

It doesn't pay to "pay cash-in-full" for an investment property

Here's why:

The net yield on a typical investment property these days is around 4%. The current fixed term deposit rate offered by most banks is around 8%. Even after you deduct two percentage points for withholding tax you're still left with a net yield of 6% - a full two percentage points higher than what you might expect from the rental yield on a typical investment property.

So, if you had $400,000 cash and you had two choices regarding where to invest it…

Option 1) Fixed Term Deposit at 8% pa (6% after tax)

Option 2) $400,000 investment property purchase

… the logical thing to do would be to opt for the higher yielding security offered by the fixed term deposit, wouldn't it?

NOT NECESSARILY!

You see, a property investment has a distinct advantage over a cash investment or an investment in the sharemarket , primarily due to the "power of leverage".

What does "leverage" mean in terms of property investing?

Perhaps the simplest way to describe "leverage" is to give you an example of how one of our clients at Compass Property Investments utilised it to his advantage recently.

"Steve's assets were comprised of the family home worth $500,000, plus around $30,000 in a savings account. To kick-start his investment property portfolio he decided to purchase two properties - a town house and a five-bedroom home. Total combined purchase price, $800,000.

Steve was earning a high salary, in excess of $140,000 pa. This also meant that he was forking out tens of thousands of dollars each year in income tax!

The bank had no problem approving Steve's loan for the full $800,000 plus start-up costs i.e. conveyancing costs, accountant, valuations, rates etc., because they could depend on two healthy rental income streams as well as use his family home in conjunction with the two new homes for security purposes.

Now before I go on, the important thing to remember with this example of "leverage and how it can massively boost your rental property profits" is that Steve only ever had $30,000 cash in the bank. In other words, he borrowed everything to purchase the two investment properties and left his cash untouched in an interest-bearing savings account.

Ok, moving right along…

You don't have to be a rocket scientist to figure out that Steve's monthly interest costs on an $800,000 mortgage were pretty darn high! However, once you took into account that he would be benefiting from…

- $3,100 per month in net rental income

- $2,200 per month in claw-backs from the IRD for depreciation and property expense claims

… even after you allow for Steve's trip to the accountant each year, and the rates and building insurance, the total shortfall between the total cost of ownership and the total income received amounted to just $10,000 pa!

Steve only needed to find the equivalent of a couple of hundred a week in order to control - and therefore benefit directly from - the increase in value (over time) of $800,000 worth of prime residential investment property!

If he really wanted to, he could choose to break his fixed term savings and drip-feed the $30,000 over the next 3 years or so, simply to cover the cost of the shortfall on the two investment properties.

Lets say he did that and after 3 years the two properties had shown an annualised capital gain of 5% each or $20,000 per property.

That would give Steve an unrealised profit of $120,000 at the end of the 3 years. This is a combined rate of return of $40,000 pa.

How much did Steve need to contribute in "hurt money" again? That's right… just $10,000 pa.

Do the maths…

In 3 years Steve has outlaid $30,000 of his own money in order to gain $120,000 in capital gain. Deduct the $30,000 from the $120,000 and you end up with $90,000 in net profit.

Ummm… so that means Steve's real rate of return over the 3 years in this example - using the power of leverage - is…

T-H-R-E-E   H-U-N-D-R-E-D   P-E-R-C-E-N-T   P-E-R   Y-E-A-R!

Now do you get it?

The fundamental difference between Steve forking out the full $800,000 in cash (of which he was $770,000 short and couldn't do that anyway!) for the properties versus leveraging off the equity in his own family home and "borrowing the lot from the bank" would be as follows:

Option A - $800,000 CASH-IN-FULL would give Steve a real rate of return of 5% pa in capital gain + an additional 4% in net rental yield, giving a combined total of 9% pa for 3 years.

Capital Gain over 3 years would equate to: $120,000

Rent at 4% net pa over 3 years would equate to: $96,000

Total Return: $216,000 after deducting his hypothetical $800,000 investment outlay.

Option B - BORROWING THE LOT by leveraging off the equity in his own family home would give Steve a real rate of return in capital gain of 300% pa for 3 years. NB: Because the properties are leveraged and therefore "negatively geared", the rental income does not give a positive cashflow - it instead helps to reduce the shortfall.

Total Return: $305,400 after deducting his $30,000 investment (shortfall top-up) outlay + adding on $5,400 in net interest earned on the $30,000 he left untouched in his savings account.

Property leverage in summary:

In the final analysis, I think it would be MORE than fair to say to Greg Ninness at the Sunday Star Times that a well-planned, fully leveraged, long-term investment in property is most definitely "AS SAFE AS HOUSES" - especially when the rental income in Steve's case is government guaranteed through Housing New Zealand!