Real estate

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Investing 7Australians love their real estate.  In this we’re not really alone, most country’s people have a desire to own their own slice of earth, for example, the Americans with their dream of the ranch style house and the white picket fence.

But Australians have taken it to another level.  Housing gradually seems to have become more than a place that provides shelter and a place to live to an entire investment class.

They’re convinced they can become wealthy just through owning some real estate and by selling houses to each other.  And this may be possible, but it needs some qualification.

You can’t just go out and buy any old house or apartment or even a bunch of them, and expect to sit back and retire wealthy.

You need a plan and an end goal, and your real estate strategy must fit in with this plan.  Do you want to give up work and replace your income with rent?  Do you want to pay off your property/ies and then live off the rent when you retire?  Do you want to sell your property/ies when you retire and use the cash from the sale?  It all depends on you and your plan.  This will be different for everyone.

Once upon a time, landlords made money through renting their properties.  However, a recent trend has been to purchase real estate in anticipation of capital gain.

I find this a fairly risky undertaking.  In a normal and properly performing economic climate, housing should only ever increase in price in line with inflation.

In Australia, house prices mostly remained constant from 1880 until the 1970s, when adjusted for inflation.  However from the 1970s onward, economies were distorted as currencies became fiat, in that they were no longer backed by a solid asset, such as a precious metal, and instead became backed by debt.

This had the effect of pushing up house and other asset prices over and above the inflation rate.  Thus was born the idea that wealth could be created in real estate through capital gain.

This allowed something called negative gearing to come into existence.  What negative gearing means is that the outgoings for holding your investment property/ies is greater than what you earn from your properties.

The tax office allows very generous tax breaks on negative gearing.  Australia is one of only a very small handful of countries that allows tax breaks on negative gearing, and is by far the most generous.  It is seen to offset the fact that expenses on your primary place of residence (PPR or PPOR) are not tax deductable in Australia.  Unfortunately, this has taken on a life of its own.

This idea works as long as people believe that prices will always go up above the rate of inflation, as it assumes there will always be someone to come along to pay a higher price for your property than you paid for it.  Some refer to this as the greater fool theory, you are relying on a greater fool to come along and buy your asset for more than you paid.

Now you may ask why, as an investor, you would be willing to keep an “asset” that is costing you money every week, month and year in spite of the tax “breaks” (spending $1 to make 30c or 40c sounds like a good deal to me, NOT)?

For some people this may be a strategy that works for them because they have a very high income and can afford to wait until the property appreciates in value or starts either earning an income or is cash flow neutral (outgoings equal income).

However, I call this the BHP factor, which stands for Buy, Hold and Pray that the asset price appreciates.

Where this comes unstuck, and where I think the biggest risk lies, is when property prices DON’T go up, they flatten or go backwards.

And even if your property value appreciates, the amount you gain has to be offset against the interest you’ve paid, rates and water charges, land tax, repairs and maintenance and any other cost associated with owning and renting that property.

If you were to add up all those expenses in the time you’ve owned the property and add those costs to the initial purchase price and even allowing for the rent received, have you really made that much of a gain on your investment?  Or have you only broken even?  Or worse, actually spent more than you’ve received?

Remember, real wealth is measured by your net worth, and not necessarily the size of your property portfolio.

Let me clarify this with an explanation.  Say, for example, you have a million dollar property portfolio.

If the debt secured against these properties is $900,000, then your net worth is $100,000.

1,000,000 – 900,000 = 100,000.

The lower the debt against your properties the higher your net worth.  But what if housing prices have dropped or slumped for whatever reason?

Say your million dollar property portfolio has in fact $1,100,000 worth of debt against it.  Then your net worth is in fact minus $100,000.

1,000,000 – 1,100,000 = MINUS 100,000.

What this means is that you actually owe more to the bank than the value of the assets secured against the loan.

This becomes a further problem in good times when house and asset prices are rising, the bank is willing to lend you more money on the increased equity in your assets.

However, should the economy turn against you, the banks are equally quick to have you redress the imbalance by topping up your equity.

This could mean you may have to sell one or more or maybe even your entire property portfolio to satisfy the bank requirements.  And then you might still end up owing money to the bank.

To me, a much better option is to actually earn income from your property.  To make it into another stream of income for you.  If you are making more money every week, month and year than you spend on your property, you won’t really care if the price of your asset appreciates or not.  You’re making money from it (which is of course, like any other income, subject to tax) and any capital gain is a bonus.

Now, it is important at this stage to identify and note the differences between a positively geared property and a positive cash flow property.

A positively geared property is one that earns you more in income than the expenses against it before any tax breaks and deductions.

A positive cash flow property earns you more income than the expenses against it after you have claimed all your allowable deductions.  This is usually achieved through depreciation and it is important therefore, to engage the services of a good quantity surveyor to do a depreciation schedule on your property when you purchase it, and also before you renovate it.

Another option is to find a property that might initially be negatively geared, but that you can quickly turn either positively geared or cash flow positive by adding value, for example through renovating, adding an extra bedroom, garage, carport or shed, furnishing it etc.

If you are able to purchase your property/ies at a discount, ie. below the market value of the property, then you have already made some instant equity, providing that property prices are stable or rising.  Of course in a falling market a discount won’t count for much.

Ensure you do your sums carefully though to make sure your return will be worth it and make sure, if making structural changes for example, you have the plans drawn up by a proper architect, work done by a licensed builder and have all the approvals in place.

So, the bottom line is that real estate is a good investment vehicle, but only if you are able to derive an income from it or you are able to leverage from your portfolio in a timely manner.

Once again, it all comes back to your plan and what you would like to achieve in your financial plan.  It will be difficult to retire with a multi million dollar property portfolio, but one which is costing you every week, month and year, forcing you to keep working to maintain them.

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