Counting on a hot property

Bricks and mortar may be all the rage among investors, but you need to do your sums to avoid getting burned, says SHANE VULETICH.

Residential property investment has become increasingly popular in New Zealand over the past decade.

According to the 1991 Census, around 74 per cent of the country's 1.17 million households were owner-occupied, with the remaining 26 per cent tenanted.

By last year the number of households had risen to 1.34 million and the proportion occupied by their owners had fallen to less than 68 per cent, while the share of tenanted households increased to 32 per cent.

The trend has been most apparent in Auckland, where tenanted households have increased from 27 per cent of the housing stock in 1991 to almost 36 per cent last year.

A recent study conducted by Massey University concluded that the trend towards renting rather than owning is likely to continue.

The increase in demand for rental accommodation, and the subsequent rise in rental income, is likely to induce more investors into the residential property market. However, not all rental properties are good investments, and in fact those who don't buy wisely could lose money.

The key aim of property investment is to acquire an asset that generates income, at minimum personal cost.

Ideally, the tenant pays enough rent to cover the property's entire mortgage and operating expenses (excluding the initial deposit).

In that case, by the end of the mortgage term the investor would own a house that they had only contributed a small amount of money towards.

A property that generates enough income to meet all mortgage and operating expenses (apart from the deposit) is said to be "self-funding".

Once the mortgage is repaid, the owner has two options: keep renting the property, or sell it and invest elsewhere.

Unfortunately, self-funding properties are rare. Typically, property investors have to add some of their own money to the rental income to meet mortgage and operating expenses.

Yield vs capital gain

When choosing an investment property it is prudent to look at both the yield and the potential for capital gain.

The problem for the investor is that high-yielding properties generally offer low capital gains potential, and vice versa. The solution is a matter of balance - the investor must trade-off expected yield against expected capital gain.

Their choices range from a high-yielding, low capital gains property to a low-yielding, high capital gains property. What constitutes the right balance depends on the investor's objectives and their expectations for yield and capital gain.

Those expectations should be based on a comprehensive analysis of historical trends and educated forecasts of market growth and behaviour. It is not advisable to rely on "gut instinct" alone when dealing with such large sums of money.

Evaluating the financial return

The best way to assess the viability of a residential property is to estimate the likely financial return on the investment.

If the return meets the investor's financial expectations and it exceeds the returns that are available from other investment opportunities, the investment is considered to be a good one.

Evaluating the likely financial return on a residential property is quite complicated, because it involves a series of costs and revenues spread unevenly across the term of the investment.

To overcome this, investment returns are generally expressed in "present value" terms. Present value is a well-established method of expressing the future return on an investment in current (present value) dollar terms.

This concept is based on the idea that having $1 now is worth more than having $1 next year. After all, $1 now can be invested at today's interest rate and will be worth more than $1 in a year's time.

Reversing this logic, the present value of $1 payable next year is that amount which, if invested at the prevailing interest rate, would grow to be exactly $1 at the end of one year.

Choosing an investment property

Generally speaking, residential property is a good investment if the expected returns are higher than you could earn by depositing equivalent amounts of money in the bank (there are other investment mediums, but for comparison purposes it is useful to benchmark against the certain returns offered by commercial banks).

The table below ("Property v bank deposits") shows expected residential property returns after 10 years for various yield and capital gain scenarios, expressed in present value terms.

The returns are calculated as property return minus bank return; a negative number implies that it is more profitable to invest the money in the bank than it is to invest it in residential property.

The analysis is based on the following assumptions:

* Purchase price: $250,000

* Deposit: $50,000

* Term Deposit Rate: 6.3 per cent

* Interest rate: 7.5 per cent

* Mortgage Type: Table

* Annual Costs: $5000

* Tax Rate: 33 per cent.

The correct way to interpret the table is like this: at an interest rate of 7.5 per cent, a $250,000 residential property with a yield of 4 per cent and an expected capital gain of 2 per cent a year will return $24,700 less than a term deposit, in present value terms.

Moving further along the same row, a $250,000 residential property with a yield of 8 per cent and an expected capital gain of 2 per cent a year will return $40,800 more than a term deposit in present value terms.

The closer an investor gets to the lower right-hand corner of the table, the better their returns will be.

However, there aren't many residential properties with a 12 per cent yield, and even fewer demonstrating capital gains of 10 per cent a year.

In today's market the smart investor will seek properties that yield 8 per cent or more, in areas that are likely to experience capital gains.

If the long-term interest rate is expected to rise, the investor should seek properties with a yield of greater than or equal to the expected long-term interest rate plus 1 per cent.

This strategy ensures that, even in times of low capital gain, the return from the property exceeds the next-best (and safest) alternative, which is to put the money in the bank.

And in times of high capital gain, the returns increase markedly, resulting in a healthy profit for the investor.

Employing a low-yield/high capital gain strategy could produce similar returns, but capital gains are not guaranteed, and it is difficult to sustain high capital growth rates over long periods (the national average over the past 5 years is 2.8 per cent).

Conclusions

There are three morals to this story:

* Ensure that the property you're intending to invest in is going to generate sufficient returns to make it worthwhile. There are risks associated with property investment, so if the returns aren't high enough to justify the risk, leave your money in the bank.

* Give yourself the best chance of making capital gains by buying in the right areas, but don't rely on capital gains to make the investment profitable. Capital gains are unpredictable, and tend to fluctuate with the business cycle. Yield is a more stable and reliable indicator of investment return, and should be viewed as the cornerstone of any long-term property investment. Treat capital gain as icing on the cake.

* Invest in properties with yields of at least the expected long-term mortgage interest rate plus 1 per cent. This will ensure that your investment is profitable, even during periods of low capital gains.

* Shane Vuletich is a principal consultant with economists Covec Ltd. His full report is available on their website.

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