Rental property can be winner or loser

By MARY HOLM

Q.Has anyone ever laid out for you the figures for residential property investment in a simple manner?

Try this:

Buy $100,000

Deposit $20,000

Borrow $80,000

Interest Rate 7%

House Inflation rate 3%


Expenses:

Interest $5600

Rates and Insurance $2000

Maintenance $1000 $8600
Rent @ 7% = $7000

Loss = $1600

Tax rebate on loss $600 (for convenience a round number)

Net loss = $1000

Capital gain = $3000

Net gain = $2000


= 10% tax paid, a damn good return

All of the figures are conservative.

Average house price inflation is typically more than 3 per cent, and any increase would give a large boost to the percentage return, notwithstanding a small bit out of it due to higher interest rates in a more buoyant market.

Residential property investment of this geared type relies on house price inflation, no capital gains tax and a bit of bravery in dealing with the tenants market and fluctuating house values.

But the returns are usually very good.

If you secure property on your family home you can borrow 100 per cent, which drives up your risk but means your returns appear to be on zero investment, which makes percentage returns bigger than the universe.

I don't think your column has ever clearly presented this point of view in the few years I have been reading it.

A. Well, now it has! And, generally, your example seems reasonable to me.

You're right that house price inflation has been more than 3 per cent.

From December 1989 to last September - the latest data available from Quotable Value NZ - New Zealand prices have risen 3.7 per cent a year, and Auckland prices 4.3 per cent.

If we plugged in those numbers, the net gain would be somewhat bigger.

It's not logical, though, to say that if you borrow 100 per cent, using your home as security, your returns are infinite.

When you look at your total assets, they are reduced by the amount of the mortgage on the family home. If you sold your home, you would have to repay the bank.

It doesn't matter what you use for mortgage security. The loan is still a negative on your balance sheet.

You should also look at what's called the opportunity cost.

If you're willing to raise a mortgage on your home to buy a rental property, you could also raise a mortgage to invest in a share fund. You'd be much better diversified and, over the years, it's quite likely you would end up better off.

But not many people are willing to borrow for share investment. It's rather risky.

What they don't realise, though, is that highly geared rental property is also risky.

Let's play around with your numbers.

* Interest rates could rise. If they hit 10 per cent, total expenses would be $11,000, the net loss before capital gain would be $2680 (at 33 per cent tax), and the gain would be $320, or a pathetic 1.6 per cent.

* Rates, insurance and maintenance could go up. Maintenance, in particular, can far exceed $1000 if you suddenly find the roof needs replacing or wiring or plumbing need a major overhaul.

* Rent might drop - perhaps because of a glut of rental properties, or because your place ends up being vacant for several weeks. If it fell to 4 per cent, you would make a small loss in your example.

* If house prices don't rise, or even fall, it all goes to hell in a hand basket.

The value of the median house sold in Auckland dropped more than 5 per cent from December 1997 to September 2001.

That's not just a blip. Prices went down over almost four years.

When property investors are told that, they simply say they wouldn't sell when prices were low.

But people don't always get the choice, especially if the rent doesn't cover ongoing expenses.

I've heard of people who have been forced to sell rental properties for less than the mortgage, and have lost their deposits.

But we could also go through your numbers and lower the expenses and raise house inflation and rental income.

You could come out making considerably more than 10 per cent a year. And people have done that, too.

Rental property can be a good investment. But it's also risky.

And we haven't even looked at risks such as getting bad tenants.

* Got a question about money?

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