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What Savings Do I Need to Buy an Investment Property & What Return Should I Expect?

There are a few reasons you may want to buy a rental property; being either for investment purposes or for lifestyle reasons - or both - should you wish you or your family to move into that property in the future.

What can I afford to buy?

This depends on two things - how much do you have saved away for a deposit and how much risk are you prepared to take…

To work out how much you can afford - you need to first work out how much risk you are prepared to take. The more debt you take on over the property value - the more risk - which is why the banks charge Lender’s Mortgage Insurance (LMI). There is more risk because if something happens to the market prices or if interest rates go up - you could find yourself in a world of strife. To get out of paying LMI & to reduce your risk down, you need to come up with a 20% of the purchase cost plus extra costs including stamp duty, legals and pest/building inspection.

How much debt to equity ratio you intend to borrow on. If you borrow 90% debt to equity on a $400,000 home, this means you essentially borrow $360,000 and require a deposit of $40,000 before other cost like stamp duty. As your debt to equity ratio would be greater than 80%, you have to will have to pay for LMI.

To calculate your LMI - Click Here

The other major cost to take into account are Stamp Duty which varies state to state. Some buyers may be eligible for first home buyers grants which may mean that you get out of paying Stamp duty completely as well as being offered a cash bonus to help make the purchase more affordable. It’s worth contacting your state government authority to check if you are eligible for first home buyers grant before purchasing your property. Other fees which are generally quite small are the transfer fees to transfer the title over to the new owner & the mortgage establishment fee.

 

To calculate your approximate Stamp duty, transfer fee & mortgage establishment fee - Click Here

Here is an example to demonstrate how much cash you need to purchase a property:

Purchase Price

$400,000
Lean Amount (90%)

$360,000

Deposit

$40,000

Lenders Mortgage Insurance (LMI)

$6,336

Morgate Registration Fee (NSW)

$136
Transfer Fee (NSW)

$136

Stamp Duty on Property (NSW)

$13,490

Total Cash Required

$60,099

The other purchase costs that it is worth leaving an allowance for is for pre-purchase pest and building inspections and for conveyancing of the contract of sale. This is just part of doing your due-diligence into the property to make sure there isn’t any hidden nasties and this can always be done within the cooling off period after exchanging contracts if you are in a rush to snap the property up before other buyers. If you find anything that could be costly to repair or devalues the home - then you have the chance to pull out without any significant financial burden - only a small 0.25% of the purchase price.

What returns are normal and how can I calculate the returns?

If you are buying a property as an investment here are some resources that will help you figure out if the return is adequate. The average rental return that can be expected across capital cities of Australia is around 4% gross ROI in 2016 (RP Data, 2016). However, it is possible to achieve much higher returns with the right rental strategy up to 10% gross ROI or more.

How do I Calculate my Gross Return?

Gross rental yield % = Annual rental income (rent per week x 52) / market value x 100 

For example:

Purchase Price

$ 400,000

Rent (per week)

$ 400

Rent (per year)

$ 20,800

Gross ROI

5%

NOTE: Gross ROI is a dumb calculation and does not take into account the expenses, so this return does not give you any accurate indication of actual returns.

How do I Estimate Expenses and Calculate Net ROI?

It is beneficial to also estimate the Net Profit and subsequent Net Return on Investment (ROI) by estimating the approximate expenses as this is what you see hit your bank account each year. Costs here may vary state-to-state, however here is a list of things it’s worth making allowances for:

  • Capital and Interest repayments on the Loan
  • Council Rates
  • Insurance
  • Water Service & Sewer Fees
  • Pest Inspections
  • Maintenance allowance
  • Agent fees (if applicable)
  • Any STRATA levies/fees
  • Land tax (if applicable)

An Example of a standard Torrens Title home in the Suburbs

purchased by a first time investor (with agents put in to manage the property):

Council Rates

$ 1,500

Insurance

$ 1,000

Water Service & Sewer Fees

$ 400

Pest Inspections

$ 300

Maintenance allowance

$ 1,000

Agent Fees (7% + 2 week rent letting fee - NSW)

$ 3,600

Any STRATA levies/fees

$ -

Land tax (if applicable - NSW is only payable over $549,000 land value)

$  -

TOTAL EXPENSES

$ 7,800

Loan Repayments ($360,000 at 5.3%) per year

$ 24,000

TOTAL EXPENSES WITH LOAN REPAYMENT

$ 31,800


This bring the following approximate returns to:

Purchase Price

$ 400,000

Rent (per week)

$ 400

Rent (per year)

$ 20,800

GROSS ROI

5%

Net Income (Cash Flow without Loan Repayment)

$ 13,000

NET ROI

3%

NET Passive Income (Cash Flow with Loan Repayment)

-$11,000


Note that when calculating the Net ROI, this is worked out independant on how you plan to finance the investment, so your loan repayment expenses including both capital and interest don't come into it. In this sense Net ROI is a good indication of the return when you have no debt left on the property, once you pay out the loan completely. 

After looking at the figures, and noting that although it appears like an OK investment with 5% Gross ROI and 3% Net ROI, this is still a standard rental property that ends up costing the owner over $10,000 per year which makes it more difficult to save and progress up the property ladder. It takes away from your lifestyle and puts strain on you rather than adding to your life while you own this property. Most people live in hope that the property will go up in value, and I hope it does, however unfortunately this isn’t always guaranteed due to unforeseen market forces. It's like gambling as you can't predict what the market will do.

Although it is important to note that when you make such a loss on an investment property - due to negative gearing rules, you may be able to get half this amount back in your tax return as tax deductions - however you still will find yourself over $5000 out of pocket each year!

An Example of a standard Torrens Title home in the Suburbs converted into a 4 Bedroom Sharehouse

To bring in that extra bit of rental income you may need to be creative and use one or more strategies to improve your returns. It's important to note that you may need to speak to your local council for legal compliance around Share-Style or Boarding House style Accommodation - and you may need to gain council approval to avoid severe legal repercussions. If you have set up a rooming/boarding house or share-style accommodation there are also some other costs to consider also factoring into the rent you charge:

  • Electricity/Gas bills
  • Water Usage
  • Phone/Internet
  • Cleaning
  • Lawn maintenance

To give you an idea, an estimate of extra costs are shown below (which is factored into the rent at around $30 per week per person of included bills) & if you self-manage the property (don’t use agents*) NOTE: *If you use agents - you could expect to pay a higher agent commission at 10% or more for the small amount of extra work of managing extra tenants.

Internet

$ 800

Electricity

$ 1,600

Water

$ 600

Cleaning

$ 2,000

Lawn Maint

$ 1,000

EXTRAS

$ 6,000

TOTAL

$ 10,200

TOTAL EXPENSES WITH LOAN REPAYMENT

$ 34,200


This brings the approximate total return for the share-style rental strategy to:

Rent (per week)

$ 740

Rent (per year)

$ 38,440

GROSS ROI

10%

Net Income (Cash Flow without Loan Repayment)

$ 28,280

NET ROI

7%

NET PASSIVE INCOME (Cash Flow with Loan Repayment)

$ 4,280

This option give you a much healthier return of 10% net and 7% gross, which is what I beleive we should all be aiming for with the use of some creative strategies. If you choose to use agents to manage your share/boarding house, you will come out around cash flow neutral instead of having your rental property potentially costing you over $5,000 per year if you were to rent out the traditional way. Much better to have your rental property cash flow neutral than to cost you money each week! If you want to give self-management a go, this could be the difference between having a passive income which gives you a step up to progress your savings to move onto bigger and better things! You can see with these numbers that it is possible to replace your income with passive streams of investments such as through property - by using some creative strategies and squeezing as much out as possible.

Although the property is only making you just over $4,000 per year back into your pocket - after the loan has been repaid - this amount goes up to the full $28,280, and over time will probably increase as your rents improve and as you reap the benefits of rising capital in your home value. 

The trick is to not be so focussed on the money, and make sure you provide quality accommodation that suits a specific, genuine market need for that accommodation. If you have happy customers (tenants) then this will ensure your long term success. 

Disclaimer:

As Jade Hamilton does not know your individual circumstance and is NOT qualified as a financial adviser, accountant or solicitor, this blog contains information and opinion only. Jade is speaking only as a Real Estate Agent and Investor from her own Personal Experiences, and recommends you seek your own personalised advice from a suitably qualified person.