Otago Property Investors Association Inc

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14-10-2007

How does your rental rate?

Sunday Star Times journalist, Greg Ninness, lists some of the key indicators that could be pointers to an investment property's performance.

These are graded from strongly positive to strongly negative, and each grading carries a score either positive, negative or neutral, depending on how much of an impact they are likely to have on future investment performance.

When these numbers are added together they produce an overall score which can point to the likelihood of an investment property being a goldmine or a millstone.

It gives an indication, but don’t take it too literally: Stuff.co.nz: Are you as safe as houses?

Are you as safe as houses

Investing in rental property may seem a sure bet, but you can still get burnt. Use our simple guide to assess your risk profile. By Greg Ninness.

Residential real estate has been a hugely popular choice for many investors over the past few years. Strongly rising property prices accompanied by good demand for housing from tenants, easy finance and generous tax treatments have encouraged many people to invest their savings or borrow against the equity in their home to purchase one or more investment properties.

But the market is changing.

To help investors decide whether their property is a ladder to riches or a hole in the ground we have listed some of the key indicators that could be pointers to an investment property's performance.

These are graded from strongly positive to strongly negative, and each grading carries a score either positive, negative or neutral, depending on how much of an impact they are likely to have on future investment performance.

When these numbers are added together they produce an overall score which can point to the likelihood of an investment property being a goldmine or a millstone.

YIELD

This is one of the most important measures of an investment property's performance. Yield is the amount of annual income it produces as a percentage of its capital value. So a property worth $250,000 rented for $320 a week ($16,640 a year) would provide a gross yield of 6.7%.

From the rental income the landlord must deduct expenses such as rates, insurance, repairs and maintenance. If these were, say, $2000 a year, it would reduce the remaining income to $14,640 a year and the net yield would drop to 5.9%.

But what sort of yields should property investors be aiming for? If the money invested in a property was put in the bank instead, it could earn 8.5% and be virtually risk-free. Property investment carries more risk than a bank deposit and can involve a lot of work as well.

But interest rates are more volatile than rents and are currently unusually high. A better comparison might be listed property trusts, most of which offer yields of around 6.5%.

So on our scale, a property producing a net yield of 6.1% to 7.0% is rated as holding its own. The better the yield is, the more points it receives. The further the yield drops below 6%, the more points are deducted.

YIELD:

9.1% and above = +3
8.1% - 9.0% = +2
7.1% - 8.0% = +1
6.1% - 7.0% = 0
5.1% - 6.0% = -1
4.1 - 5.0% = -2
4% or less = -3

EQUITY

The amount of equity an investor has in a property will affect its viability.

Because property prices do not always rise, investors with high levels of debt are taking on significantly more risk. If the amount of equity in an investment is less than 10% (90% debt) the investor could face a loss from even a small decline in prices after selling expenses were deducted from the proceeds. The more equity there is in a property, the more options that are open if the market becomes difficult.

We have set the base level for equity at 20.1% to 25%, (neutral) which allows for a useful level of debt while still giving the investor some room to move if things turn to custard.

EQUITY:

35.1% plus = +3
30.1% - 35% = +2
25.1% - 30% = +1
20.1% - 25% = 0s
15.1% - 20% = -1t
10.1% - 15% = -2
10% or less = -3

LOCATION

The ideal location will appeal to highest number of potential tenants.

Generally this means it should be in the suburbs where there will usually be a good pool of prospective tenants.

Other locations such as the CBDs of larger towns and cities are less attractive because they appeal to a narrower range of prospective tenants and are likely to be more severely affected by market changes, such as a reduction in the number of overseas students coming here to study. Rural properties will also appeal to a more limited number of potential tenants and buyers.

LOCATION:

Suburban = +1
Rural = -1
CBD = -1

TITLE

Freehold titles are the most desirable, and variants such as cross-leases and freehold strata titles usually present few problems.

But leasehold developments are starting to become more common and these can present problems for investors.

This is because a leasehold property is structured to provide the owner of the underlying freehold title, who collects the ground rent, with a substantial share of any capital gains, significantly reducing the opportunity for the leasehold investor to make money.

Many modern leases have ground rent reviews every five to seven years and if the rent increase is substantial the investor can be hit with a double whammy, a sharp increase in their outgoings which usually also makes the property harder to sell and can reduce its capital value.

For these reasons, leasehold properties are often more suited to owner-occupiers rather than investors.

TENURE OF TITLE:

Freehold = 0
Leasehold = -1

IMPROVABILITY

The ability to improve a property can have a big effect on the rental it produces and its capital value.

This can take the form of something straightforward such as new wall and floor coverings, to more complex jobs such as adding an extra bedroom or subdividing a large section.

But like owner-occupiers, investors must be careful not to over-capitalise.

IMPROVEMENT POTENTIAL:

No ability to increase rental income through improvements = 0 points
Modest improvement potential = +1
Significant improvement potential = +2

SOURCE OF PROPERTY

Investors often get the biggest headaches from properties bought off the plans (before they were built).

These can be promoted through slick marketing seminars where investors were provided with financial projections which turned out to be overly optimistic.

Each month many such properties are sold at prices well below what they were purchased for "off the plans".

OFF THE PLANS:

If the property was purchased before it was built, or through a marketing seminar = -2

RENTAL GUARANTEE

Many developers or property promoters will sell investment packages with a rental guarantee in place.

This guarantees a minimum rental income for a fixed period of time, often about two years.

Unfortunately, when the guarantee expires many investors find the actual rental income is well below the guaranteed amount.

In such cases it is likely that the developer has subsidised the rental income to help make a sale and added the cost of this to the purchase price.

RENTAL GUARANTEE PROVIDED:

= -1

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