Many Australian’s purchase an investment property with the intention of achieving a strong passive income stream from the outset.
In reality, Australian residential property generally offers consistent capital growth returns over the medium to long term and relatively low yield returns when purchasing the asset.
With time in the market, and depending on the loan repayment schedule, an investor’s loan-to-value-ratio (LVR) may decrease over time as the property appreciates in value. Subsequently, this will likely result in an improvement in the overall cash flow of the property, however, this takes time and patience.
To truly build a property portfolio which generates a passive income, a key focus for asset selection should always be centred on strong capital growth prospects, in conjunction with a healthy cash flow.
Cash Flow is KEY
An investor should always know how much the property will cost on a weekly, monthly and yearly basis. It’s best to sit down and conduct a cash flow analysis before purchasing an investment property.
This will minimise risk and ensure that you can hold the property for the medium to long term without the property costing too much, whilst reaping the potential capital growth returns.
There are other key elements to consider when assessing your investment cash flow, besides the weekly income (rent) and ongoing costs.
Below are five key areas that must be considered when looking to purchase an investment property.
1. Tax deductions for rental properties
As a property investor, you can claim a variety of expenses relating to your rental property as tax deductions, improving the overall after tax cash flow.
You can potentially claim a wide range of running and management expenses against your investment property’s income, including:
Real Estate management fees
Council and water rates
Advertising for tenants
Insurance
Interest on your investment loan
Renovation costs
Depreciation on assets like whitegoods and air conditioners
Regulations and policy change to tax laws can take place, so it’s best to contact your accountant prior to purchasing an investment property and understanding exactly what can and can’t be claimed come tax time.
You can also check out the list at the ATO website [1].
2. Depreciation
Just as you can claim wear and tear on a car purchased for income-producing purposes, you can also claim the depreciation of your investment property against your taxable income.
Under Australian tax laws, it allows owners of investment producing properties to claim an offset for the decline in value of the asset due to wear and tear.
Furthermore, Australian law allows investors to claim tax deductions on both the decline in value of the building’s structure/capital works (Division 43). Also plant and equipment assets, which can be easily removed from the property; more commonly known as “fixtures and fittings” (Division 40).
To claim depreciation against your property income, it’s advisable to obtain a tax depreciation schedule from a licensed quantity surveyor.
For properties that were acquired before 9 May 2017 (including contracts entered into before that date), and plant and equipment that form part of the property, investors can claim depreciation based on a surveyor’s assessment of the asset’s remaining life and value.
New changes to depreciation:
For properties acquired after 9 May 2017, depreciation only applies for:
Costs on plant and equipment you paid for (e.g. new carpets or fridge); or
Plant and equipment included as part of the new property.
This means that owners of the property won’t be able to claim deductions for plant and equipment bought by the property’s previous owner.
3. Interest Rates
One of the biggest cash flow expenses as a property investor will be the interest you pay on your mortgage.
While rates are currently at historic lows (January 2020), it is impossible to foretell how long these conditions will remain.
When conducting a cash flow analysis for your first or next investment property and working out the potential ongoing costs, it’s a good idea to prepare a couple different cash flows with a higher interest rate.
This will illustrate if interest rates were to rise, how much it will actually cost you and if you can handle the potential repayments.
It is also best to set aside a financial buffer to handle unexpected expenses or the extra cost of increased interest rates.
4. Purchase and Settlement Costs
Ideally, you will have your mortgage broker outline all the associated costs for your potential investment property. This will allow you to budget accordingly.
Depending on your borrowing capacity, the initial deposit may vary and generally will be between 10-20% of the property purchase price.
You will also need to allow for all the settlement costs of purchasing and the upfront costs.
Settlement and upfront costs include:
Initial deposit
Legal fees
Loan costs - including potential Lenders Mortgage insurance (LMI)
Valuation fees
Landlord Insurance
Potential depreciation schedule
Property Management ongoing and letting fees
Stamp duty
It is best to factor in and budget any potential costs also such as ongoing repairs, and vacancy periods and always ensure a cash buffer is in place for these unforeseen ongoing costs.
5. Vacancies and Property Management
Even with detailed due diligence, investors must understand that their property may not be occupied all the time.
It is advisable to assume that your property will be vacant for at least two or three weeks each year and a cash buffer should be saved accordingly.
To help minimise the risk of potential vacancy, it would be ideal to seek the support from an experienced Property Manager.
Fees vary from manager-to-manager and you shouldn’t choose your manager based on the cheapest rate being offered. Good service comes with a fair price.
Do your own research when looking to secure a property manager, check testimonials, ask for a rental appraisal along with potential costs upfront.
It would also benefit talking to friends and family who have utilised certain Property Managers previously and if they have had a good experience.
Summary
As you can see there are a number of areas to consider when budgeting and working out the potential cash flow for an investment property.
Once again it is good practice to seek the support of a qualified Mortgage Broker and revisit your cash flow each year and discuss ways to improve and reduce your cash flow from one year to the next.
Jarryd Gauci – Property Investment Consultant
P: (02) 9939 3249
References
[1] ATO Rental Expenses You Can Claim - https://www.ato.gov.au/General/Property/Residential-rental-properties/Rental-expenses-to-claim/