Understanding the Real Income Return on Property Investment
Investing in Australian residential property is an aspiration for many. APC recognises the diversification benefit of owning an investment property in your financial asset portfolio. As it is unlisted, this asset class behaves differently to listed assets such as shares. This is what is called ‘correlation benefit’ meaning that as assets move in value (up or down) they do so at different times resulting in a smoother rate of return over time.
However it is our experience that investors do not always take into account the risks associated with owning residential investment property. Some of these include;
- Illiquidity risk
- Single asset risk
- High transaction costs to both purchase and sell
- High carrying costs
Over many years of assessing the rate of return of investment property, it is our experience that the actual return on investment (ROI) is often far lower than many owners actually believe it to be.
This article deals with understanding what the actual expenses are in owning an investment property so that you can accurately assess (hopefully before purchasing an investment property) what the likely ROI – return on investment – will be. By doing so, you can compare that ROI with other potential investment assets to ultimately determine the best investment decisions for you.
Quoted Income ROI Figures – Gross or Net?
Generally speaking, an investor in Australian residential property has – or should have – a long term investment time horizon.
We often see rental income ROI figures quoted by agents that on the face of it look quite attractive. However when you scratch beneath the surface all is not as it seems. The following example illustrates some of the costs you should be well aware of;
Melbourne apartment – $600,000 with an income yield of 3.75%
However, the quoted purchase price does not include costs associated with the purchase itself such as stamp duty, agent and conveyancing costs.
So the actual purchase price is $634,070 and therefore the rental yield is 3.55%.
However, this also is not the full story as to produce the ongoing rental income, there are likely other expenses that are incurred. These include agency fees, rates, body corporate fees, insurance and a provision for maintenance or a sinking fund. The sinking fund is to cover the costs of ‘plant & equipment’ that over time will fail and need to be replaced. This does not include the sinking fund for ‘Capital Works’ that a body corporate may also have if the investment property is an apartment.
So, what started as an income ROI of 3.75% has now become 1.53%!
For some investors, another cost which is not included in this example is land tax. In Victoria, land tax is payable on taxable land you own over the value of $250,000. The rate of tax increases as the value of taxable land you own increases. Your home is not included as a taxable land value.
If you owe land tax then this cost also should be included in the ongoing costs of owning a residential investment property.
An important tax deduction available for residential property investors is depreciation. This deduction improves the after tax return of a property asset. From July 1st, 2017 there were important changes to what depreciation on ‘plant & equipment’ such as dishwashers, carpets, hot water systems etc can be claimed.
Essentially, if you purchased an investment property after May 20th, 2017 and the ‘plant & equipment’ in that property had already been ‘used’ at that date, you cannot claim any depreciation deduction on that asset. If however you then purchase a new asset (say a dishwasher) then a depreciation expense can be claimed.
So, if you are considering purchasing a residential investment property only ‘new’ plant & equipment may be depreciated and that value used as a tax deduction.
Also May 20th, 2017, you cannot claim any travel expenses related to that residential investment property.
Ultimately, the ‘after tax’ income ROI on an investment property will include other factors such as;
- The owner’s marginal rate of income tax
- The amount borrowed to purchase the asset
- The interest rate on the loan
- The legitimate depreciation claimed
- Prevailing rate of inflation over the measure time period
Just ensure that you are incorporating all the associated costs of the property to ensure that you understand what the accurate income ROI actually is. Once you know this you can then more easily understand what the ‘break even’ rate of capital return needs to be.
With these two important pieces of analysis you are in a position to know if you should (a) hold an existing property asset or (b) purchase one.
As always, if you wish discuss this article with APC please contact any member of our advice team.