Nila Sweeney

Building property riches from scratch can be daunting, yet it need not remain an elusive dream. Iain Hopkins looks at how to develop an investment strategy and how to obtain finance for that crucial first investment purchase.

Why do today what you can put off until tomorrow? If every residential property investor lived by that mantra they would likely still be enviously looking on from the sidelines as their friends and relatives jumped on the investment bandwagon. Perhaps that’s what you’re doing right now – because there’s always something else to save for, a better paid job to land, and of course, interest rates could always be more favourable…

Just like anything new, kicking off an investment portfolio can be scary. However, with the right strategy and diligent research comes confidence; and with confidence anything is possible. But where does a first-time property investor start?

Early lessons
Jo Chivers, director of Property Bloom, says there are two lessons she learnt early in her investing career, both of which have shaped her investment strategy ever since. First, investing in property is a long-term strategy.

“When you take into consideration the high purchase costs such as stamp duty, legal and loan costs, then you really need to be holding for over five years, depending on where we are in the property cycle. My strategy now is to hold property long term, or at least 10 years to benefit from a complete property cycle,” she says.

Secondly, since buying her first investment property in 2000, Chivers has read countless books and magazine articles and completed an intensive property investment course, educating herself to become more financially literate and understand all the strategies that can be used when investing in property. “I suggest first-time investors educate themselves before purchasing,” she advises.

Part of this education is being clear on what you are trying to achieve. Pino Tedesco, the director of Capital Property Advisory, says that without a plan it’s almost impossible to get to the goals you’re trying to achieve. “Different investors have different goals and different constraints. Those will govern what sort of structures you put in place, or finance strategies you may employ. Once you put your plan together you should be able to see yourself reaching your short, medium and long-term goals,” he says.

Developing an initial strategy
An initial strategy should be treated like a blueprint for all future investments. It can also provide certain steps that must be considered for each investment. Tedesco outlines the key questions to ask:
  • How do I structure my investment?
  • Do I buy in my own name?
  • Do I buy in a trust?
  • Do I use my super or ask parents to help with a deposit?
  • In regards to finance, which products do I use?
  • Which banks?
  • Before I buy, if renovating is part of my strategy, what are the costs in doing so?

Taking into consideration the goals and constraints of the investor, a risk profile should also be developed. This will weigh the pros and cons of various ways of investing. “Some people buy and hold; some people buy, renovate and hold; some buy, renovate and sell. That could be for existing stock out in the market, or it could be for new stock just built, or possibly even off the plan. Different strategies have different risks. That’s why it’s very important in your initial strategy to review your risk profile. Find out which is the most appropriate approach for you,” Tedesco suggests.

Developing a structure 
There are countless structures available to investors when buying a property. These can include trusts, such as a unit trust, discretionary trust, family trust or hybrid trust. In recent years investors have set up self-managed super funds and they may use instruments like property warrants to try to leverage further into property.

The type of structure chosen will depend on the investors’ risk profile, what they’re trying to achieve, whether they’re buying solely for themselves or with family, or buying with unrelated parties.

A winning team
No man is an island, and no investor knows everything. To create action plans to move the strategy into reality, Chivers recommends investors talk to experienced investors and then create an investment ‘team’. “Start by finding a good property-specific accountant who will be able to advise you on the best structure for purchasing with, look at your financial situation, and help you analyse potential property purchases. You will need this advice before you exchange on a property,” she says.

Next on the list is a good solicitor. Choose someone who has invested in property themselves. “Don’t be shy about interviewing them,” says Chivers. “This is important for all the people you surround yourself with as the more property transactions they have handled the more experienced they’ll be. This may be your first investment but hopefully it will lead to many more property purchases for you – so the time you take now to set up your team will be rewarded.”

Given the changes seen in the finance arena since the GFC, Chivers also recommends the services of a finance or mortgage broker. “You need a good broker with strong, established relationships within the banks.

“Once you give your broker information such as what you are earning and what other debts you have, they will be able to tell you what size loan you can service and how much deposit you will need,” she says.

Initial steps
Fiona Herbert, an accredited mortgage consultant with Leap Frog Loans, recommends investors get a copy of their credit file so they know what’s on it and that it is actually correct. This is cheap or free if investors are prepared to wait a few days to obtain it, but it can be an important document to hand to a broker (see www.mycreditfile.com.au). “It gives the borrower and the broker confidence that your credit record is clear. Even a mobile phone debt that you forgot about three years ago can cause problems if it’s not declared upfront,” she says.

Indeed, it’s crucial that borrowers get their own financial situation under control and understood. Having credit card statements, any additional loan information, the last couple of payslips, PAYG group certificates and other documents close to hand will assist the process. “When a client comes to me with all that information sorted it’s a good sign that they’ll probably be a good investor – because investing is a business. It’s not a game, it’s not a hobby. You’re in it to make money,” says Herbert.

Undertaking that step will also help you see where you stand. “You’ll be able to look at your bank statements and say, ‘I have this much cash’. From there you can get an idea of cash flow and budgeting. How much can you afford or are you willing to invest on a monthly basis in your investing plans?” says Herbert.

Getting financed
Although almost anyone can get into property investing, it does require that you at least have some money or assets to get you enough credit with a lender.

For some people, like middle aged or elderly couples, this can be easier as they probably own their own home. That equity can be used towards borrowing for a purchase, as can any savings they’ve accumulated.

For buyers starting out without any property already in their name, and limited savings, it’s a little trickier, but far from impossible.

“The banks have been reducing the LVRs pretty steadily over the past few years, and 100% loans and even 95% loans are hard to find,” says Herbert. “For first-time investors they would need a minimum 10% deposit.”

A lot depends on the bank, the timing, and who you talk to – but in the majority of cases it comes back to how your case is presented. “They’re after very strong applications so ensure you have everything ready to go,” Herbert suggests.

Most investment experts agree there is little point in even looking for a property without knowing what your borrowing capabilities are, or getting some assurances from a lender. Tedesco recommends having a finance strategy in place before looking to buy property. “I’ve heard many times people buying a property at auction, then going to their banks and trying to get finance, and not being able to. The costs involved are quite high if you back out. You could be up for the 10% deposit and the agency fees, which could be 2–3% of the property purchase price. Plus you could be up for legal fees, so on a $600,000 property that could be $60,000– 100,000 of extra costs,” he says.

There is some limited preparation that investors can do prior to approaching a broker. Online calculators can provide clues as to borrowing capabilities, but Herbert notes that these should be used as simple guides only. “For some people they are extremely misleading, in both directions – they can be too conservative or they can be far too generous. That’s because people aren’t all the same. The bank’s primary market is for the very conservative, standard PAYG earner. There are many people who don’t fall into that basket. For example, what you consider to be income and actually is cash in your pocket, such as commission or overtime payments, aren’t always acceptable as income to a bank for their servicing models.”

Pre-approval from a bank must also be taken with a pinch of salt as it’s no guarantee you’ll get the loan. Different lenders will undertake different amounts of scrutiny on the documentation. “If you’re dealing with a lender who will give the approval in principal, which means the assessor has actually looked at the file and checked the documentation, then that’s worth a little bit more in the sense that it’s actually been looked at. They’ve not just looked at the electronic loan application,” says Herbert.

Regardless, Herbert adds it can be a useful step to take, if only to get the borrower organised with the right documentation.

It’s also important to note that the total transaction costs can add an additional 11% to the purchase cost. Make sure you include those added extras when buying a property – like legal fees, research and mortgage insurance. Stamp duty, while not strictly speaking a ‘finance cost’, is a property transaction cost regardless of whether you borrow or not.

Also find out about ongoing costs such as council fees, strata fees, body corporate expenses and property management fees. An accountant can help you determine negative gearing and capital gains tax.

From there, you should consider how you want to structure your mortgage. “The type of finance product you choose may depend on your strategy,” says Tedesco. “For example, if you were to buy, renovate and try to add value and increase your equity component in that property, then look to refinance, extract the equity and move on to the next one. To increase your buffer position for holding costs moving forward, certain finance products may suit you better than others. Others may have break costs or refinancing costs, or hefty legal fees moving forward. So seek finance that meets your initial objectives.”

One option is an interest-only loan, to maximise available cash. Herbert is an advocate of interest-only loans because they can maximise cash flow and also represent the lowest ‘personal commitment’ a borrower has with the lender. “Personally I like to have my contract with the lender be the minimum it can be, which is interest-only,” she says. “That does not stop me making extra repayments – and that’s important – but it means that contractually my obligations are as low as they can possibly be. So if things do go pear shaped and you hit a GFC or whatever, you know that’s the bottom line that you need to meet to keep everything clean.”

Herbert is also a fan of offset accounts. “They keep your money separate from the loan so you are never affecting the tax status of the loan. For example, people buying their first investment property will likely want to buy something down the track for themselves, so in my opinion they should be saving money in their offset account which gives them the benefit of reducing the interest cost of the investment and improving cash flow during that time, which then gives the investor more money to put into the offset. So they can invest and at the same time they are saving for their own home,” she says.

Finally, the question of whether to fix or go variable will need to be considered. Tedesco warns that this decision should be based on individual circumstances, your portfolio, costs, risk profile and what you’re trying to achieve. “As long as you factor in the end period of a fixed rate, and what it may fluctuate up or down to, then you can risk manage yourself moving forward,” he says. “If it’s variable upfront I always recommend that clients try to keep a 2–3% buffer either side of that variable rate. If you’re risk averse you may want to put 5–6% on top.”

Helping hands 
For young investors without reserves of savings, sometimes it’s up to parents to help out. This might entail lending a deposit, or using the equity in their home to secure a loan. Herbert warns that it’s not for everyone. “The advantage of tapping into parents’ equity is usually that it minimises the need for expensive mortgage insurance – and that’s a great idea. However, parents do need to be a little bit careful, particularly older parents who may be thinking about selling their house to move to a retirement village. The bank will want cash when they sell to cover that loan, unless the first property has gone up a sufficient amount to cover that loan. And there’s a certain amount of trust in the children to pay down the loan. In that situation, if it’s an investment property, I think the child has an obligation to their parents to reduce the loan to release the parents’ property as soon as possible.”

Parents, other relatives and friends might be able to assist by offering free accommodation or cheap rent as a temporary place of residence.

Regardless of age and experience, Chivers recommends investors use property investment analysis software to gain confidence. This software can produce calculations based on countless different scenarios, such as what happens if the property is vacant for a period of time, or what happens if the property needs to be painted and recarpeted in five years’ time.

“Paper trade a few investment options before buying,” says Chivers. “By this I mean get all the details of a property you like, ask for a copy of the contract, research with the agent regarding potential rental return and strata levies, council and water rates.

“You can purchase some good software to help you analyse the cash flow of a property. I personally use PIA – Property Investment Analysis by Somerset Financial Services [www. somersoft.com.au].”

Understanding cash flow is crucial and Chivers suggests your accountant can also help you with this. “Purchasing a cash-flow positive or positively geared first property will help you in being comfortable holding this property and allow you to keep moving forward. Negatively geared property is fine for high income earners, but you can really only go on to buy a few negative properties before you may find you can’t service any more loans,” she adds.

Tax and capital growth 
Tax should rarely be a major consideration for investors; in fact Herbert believes it’s “the icing on the cake”, but adds “you should never invest in something purely for tax reasons”. Tax benefits on a property can be beneficial and can certainly make the returns better, but doing research and due diligence upfront is crucial. Capital gains, land tax and possibly GST are all factors that need to be understood.

An important point to remember is you are only taxed on capital gains if you sell your property. Many high profile investors have achieved significant returns over the long term because they bought capital growth assets and held them for extended periods.

If you purchase high rental yield properties, however, you will be taxed on the rent. This option might depend on what your financial situation is. Those with a low wage and limited savings may need to sacrifice growth and go for yield, but the opposite is true for those with a high paying job.

Herbert notes that if you model two otherwise identical properties over 10–15 years – but one with a high rate of capital return, the other with a higher rental return – after that period the capital growth property can actually be earning more rent dollar for dollar than the other property, because the rent has gone up commensurate with the price of the property.

“It may still have a lower yield but in 10–15 years you’re going to be sitting on more hard cash in your pocket from the rental income. Property is not a ‘tomorrow’ investment; it’s a long-term investment,” she says.

Herbert adds that in her experience, the majority of quality properties have a slightly negative cash flow – which requires the long-term growth approach. “Unless you’re going to be absolutely adamant about positive cash flow you need to decide how much you’ll need to put into that investment every month, and how much you can afford to. If the investment is paying for itself you can afford to hold it for a longer time, although it may not be the best return on investment,” she says.

“If you don’t sleep at night there’s no point in investing. Mitigating risk is about doing your due diligence upfront. How do you decide between two properties? If it’s the colour of the paint you’re missing the point,” Herbert concludes.
Next issue we’ll look at the next steps required to start your property portfolio, by going into more detail on the strategies and decisions of how, when and where to make your first purchase.