April 30, 2013 by Dymphna

Income Property Update: Stick to the Fundamentals!

After a few relaxing days in the Whitsunday islands, it’s good to be back at it again. Although, as you may be aware, I didn’t’ really stop everything while I was there; it was more just a change of scenery. Very beautiful scenery, I might add.

One thing that I kept thinking about was getting back to the basic income property investing strategies to help my newer students. I know that I cover everything about it my seminars and boot camps, but I also understand that we all learn differently.

Some people, for instance, take information in the minute they hear it. That’s fantastic if you’re one of those people. But others are more visually oriented (that’s about 75% of us, by the way) and need to see information in writing before they effectively take it on board. Some people require both. It’s not so much about being more or less smart, but much more about how each individual is wired.

And let’s admit it; sometimes we get caught up in the more sophisticated investing strategies and ideas that we forget about the fundamentals.  So today, let’s talk about the foundation of passive income—the fundamentals of analyzing an income property.

Price determines profitability

Even though you may have a rental property portfolio with great rents and a stable rental history with fantastic tenants, do you know what your true rental yield really is? It’s not a trick question. The one thing that rises above all others in maximizing return on your investment is this: “How much did you pay for the property?”

I’m not exaggerating. Your income property success depends most of all on the purchase price that you are able to negotiate with the seller. The higher the purchase, the lower your rental returns will be, and vice versa. Well that sounds simple enough, doesn’t it?

Ah, but how do you negotiate the best price? You do that by establishing a relationship with the seller (review my past blogs for more details on how to do that). Briefly, in many situations, the main issue for the seller isn’t price at all. It could other things like a long or short settlement, flexibility in terms, the sale of another property, and so forth. But you won’t know these things unless you ask, will you?

In most cases, the only chance you’ll have to ask is to work with the seller directly. This usually means not using a buyer’s agent–which also, by the way, saves you money on buyer’s agent fees. It may take a little extra time and effort on your part, but assuming you’re going to hold onto the property for long term income, the time and effort will be well worth it.

Know the real costs of the property!

As you know, the purchase price is just the beginning of the costs of a property. This is why you need to keep your wits about you and your emotions in check when deciding which income property to buy. You need to know the real costs of a property, not just the price.

The following are the main costs that you need to know before you make an offer on an income property:

  • Stamp duty (use a calculator–it varies for each state)
  • Loan establishment fees
  • Adjustment fees
  • Buyer’s Agent fees
  • Approvals on renos
  • Actual costs of renos

Other costs will include:

  • Council rates
  • Water rates
  • Insurances (asset protection)
  • Legal fees for trusts (asset protection)
  • Maintenance fees (3% of rental income)
  • Property Management fees (5% in metro areas up to 10% or more in more rural areas)

As a rule of thumb, for every $100,000 of purchase price, figure about 6% to pay for these costs. Calculate the costs on 100% of the purchase price, not just the loan amount. And remember to do your own due diligence; don’t rely on a buyer’s agent. They will likely not do the job as well as you will! Of course, all of these fees will come out of your rental income, so accuracy is very important.

True rents—Not what you need, but what you can get

That brings us to the rental part of the analysis. You need to view property from an operational basis. What does it cost to own and maintain the property? Bear in mind that those costs will likely never go away, or even go down. They will all probably go up over time, except for the loan balance, which should be decreasing over time.

Compare those costs you have tallied up with the actual rental income that the property will yield. You need to run your analysis from both a best and a worst-case scenario. What are the maximum rents in the area? What are the minimums? How soon can you get renters into place?

Do not think that your property will somehow capture the very top of the rent rate; be conservative and realistic.  Only after the rental income has covered all of the above expenses and there is still some money left over, can the property be considered positive cash flowing. Any other situation and you’re just fooling yourself into buying a negatively geared property!

Cash flow trumps value

Now, let’s talk a little bit about fluctuating property values. This is really quite simple. If you negotiated a good price for your income property, then it is a positive cash flowing property. You are earning passive income every week.

Should you be concerned about the value dropping? Not really. Property values will go up and down over time in response to all kinds of things that affect the market. Lower interest rates, for example, may result in high property prices; whilst a rise in the cost of funding may well push prices downward a bit.

If you already own positive cash flowing property, falling values should not concern you. Your main concern should be rental prices. That, after all, will affect your cash flow, won’t it? Fortunately, rents in Australia have a pretty solid history of going up, not down. Furthermore, there’s no reason to think that that will change any time soon.

Well, that’s it for today, except to remind to take care of the fundamentals and they’ll take care of you!