Property risks and rewards

Property investors need to consider what would happen to their finances if the market were to drop or interest rates go up. PHOTO / GETTY

Although the level of activity by property investors is more subdued than it was a few months ago -- likely due to the Reserve Bank's requirement for a 40 per cent deposit -- there are still plenty of people keen to become landlords.

Unfortunately, some have little more idea about property investing than hearing that "there's money to be made".

The desire to buy investment property may be driven by seeing friends and family doing the same or thanks to a cold-call or investment seminar.

Investors' attention is often focused on the potential for tax savings from investment property. Investing for tax breaks is known as "negative gearing".

How it works is that the rent on negatively geared properties is less than the cost of the mortgage and other expenses. What this means is that the property investor is in effect making a loss month in month out. Those losses are then claimed against the investor's other income, in particular the tax paid on their day job.

Using negative gearing as a strategy is common in New Zealand. What negative geared investors like is that the "expenses" on a property include more than just mortgage interest, insurance, maintenance, and rates. Investors also claim all sorts of costs such as advertising for tenants, agents' fees and commission, loan fees, land tax and strata fees, pest control, gardening, and home office costs.

One particularly good deduction on the "income" from a property investment is depreciation. In New Zealand you can't claim depreciation on the structure of the building. But you can for "chattels", which includes everything from carpet that is tacked down to stoves, fridges, furniture, curtains, light fittings, dishwasher, waste disposers, Sky dishes, range hoods, burglar alarms, heated towel rails, garage door openers and heat pumps.

There is a fine line between chattels and fixtures. Claiming on the latter, which might be a carport, gazebo, bolted to the floor, an in-ground spa-pool and other items fixed to the property is a no-no.

It's important as well to realise that capital expenditure and maintenance fall into two separate buckets and only the latter is tax deductible. More than one investor has got him/herself in hot water with the Inland Revenue Department thanks to this.

Negative gearing can sometimes turn a loss-making property neutral or at least reduce the amount the owner needs to top up the mortgage each month.

None-the-less, negative gearing as an investment strategy does have its detractors. After all what's the point of losing a dollar to get 33c back in tax?

Serial property investor, author and educator Lisa Dudson, of Acumen, warns investors to make sure that negative gearing makes sense for them before using it as a strategy.

"Negative gearing is fine but focusing on tax losses is not the greatest way to start building a successful portfolio," says Dudson. "The object is to make money so look at any tax rebates as a bonus and as part of your overall numbers."

Another issue with negative gearing is that it makes expanding a property portfolio with new investments more difficult. This could also prove problematic if you want to borrow against your own home for renovations or to move to a more expensive property.

In the banks' eyes, ownership of negatively geared properties may mean that you can't afford to service other loans. If this happens you're going to need to increase your cash flow or stop buying property.

What's more, you could get into trouble financially if interest rates rise, rents fall, or you're without a tenant for an extended period of time.

Property investment companies often encourage their clients to go interest-only on their investment mortgages as well says mortgage broker Geoff Bawden, of Bawden Consulting. He argues the reverse.

"If you are buying investment property because it is part of your long-term strategy, you are going to have to start paying it off sooner or later, so why not start from the beginning."

Dudson says she's focused on the balance sheet when investing.

"On one side is the equity I will make and on the other, the cash flow. Too many people buy property and cross their fingers thinking it will make money. When I buy a property I think, 'What will it add to my financial position today?'. I want to know what the downside is going to be."

Investors need to:

?Be clear about their long-term goals

?Do the numbers

?Look at the risk factors

?Get their ownership structures right

?Run their rental properties as a business

?Understand the difference between gross and net yield

?Not buy on emotion.

Finally, if you are being encouraged to invest for tax breaks, do a worst-case.

Assume your tax break will disappear at some point and ask yourself what's in it for you if that happens. If you buy at the peak of the market and the value of the investment drops on a property that's costing you money week in week out, it could hurt financially.