Calculating the return
The rent return is often referred to as ‘yield’, and it is calculated by dividing the annual rent through the value of the property. For instance, a property with a market value of $500,000 that can be rented for $485 weekly - or about $25,220 annually, would have a gross (before expenses) rental yield of around 5% ($25,000divided through $500,000, then multiplied by 100). It is useful to know a property’s yield as it lets you compare the rent return between properties, and against other types of investments.
(Annual rent/Market Value) x 100 = Rental Yield
(25,200 /500,000) x 100 = 5%
Yield focused strategy
A focus on yield can be useful if you don’t want to borrow heavily, or if you are seeking a source of additional income to live on. In some regional areas, rental yields can be as high as 10%, which is an exceptional return. On the flipside the long term price appreciation is unlikely to be as strong as a metropolitan property. It is even possible to find ‘positively geared’ properties where the rent covers all the expenses of the property with some extra income left over for you.
By contrast metropolitan areas, especially state and territory capitals, tend to earn a rental yield in the order of 4% to 5%. This compares favourably with many cash based investments, but remember you will also get the benefit of long term capital growth that adds to your total returns on the property.
Aiming for capital growth
The right property, in the right location at the right price has the potential to deliver very rewarding rates of capital growth over time.
If you are aiming for capital growth it is vital that you can afford to hold onto the property until you see a substantial rise in the investment’s value. For some investors this is not a problem because of the tax relief that comes with negative gearing but do the sums to see if this applies to you.
Depreciation is a valuable tax advantage of property investment. Unlike many of the costs relating to your rental property, which require you to spend cash to secure a deduction, depreciation can be claimed with no cash outlay. Benefits of depreciation are best seen from as new or new builds, but benefits are seen to all property types.
Two main types of depreciation can be claimed. The first applies to fittings and fixtures like stoves, hot water heaters, light fittings and carpets. The second relates to depreciation of the building itself. If your property was constructed between 1985 and 1987 the building cost can be depreciated by 4% annually. Those built after 1987 can be depreciated at 2.5% each year. Have a look at www.ato.gov.au for a list of rates and effective life of depreciable items.
Depreciation is an area where it pays to get professional assistance. A quantity surveyor can inspect your rental property and draft a complete depreciation schedule that ensures you are neither missing out on depreciation deductions nor overstating your claim (which could result in tax penalties). Trying to estimate your own depreciation charge could leave you facing tax penalties if you get the figures wrong.
When it comes to investing, the term ‘gearing’ refers to borrowing to buy an asset. Most investors use some gearing – in the form of their mortgage, to fund their rental property. The loan interest is often a major expense associated with owning the property but it can be claimed as a tax deduction when the property is tenanted or available to let, and this can significantly reduce the cost of the loan.
Negative gearing occurs when the cost of owning a rental property outweighs the income it generates each year. This creates a taxable loss, which can normally be offset against other income including your wage or salary, to provide tax savings.
Let’s say for example that Bill owns a rental property generating $25,000 in rent each year. The costs of holding the property, including mortgage interest, come to $30,000. This gives Bill a taxable loss of $5,000, which he can use to reduce the tax payable on his salary.
If you know in advance that your investment will record a loss over the financial year, you can apply to the Tax Office to reduce the amount of tax taken out of your salary. This is called PAYG Withholding Variation and it can provide a real boost to your personal cash flow. Speak to your tax advisor or accountant for more details.
That said, a loss is still a loss, and the whole point of investing is to make money at some stage. This can happen when the loan is finally paid off and the rent returns are no longer reduced by loan repayments, or when you sell the property, hopefully at a profit.
When looking at purchasing an investment property, a very common strategy is to purchase a property with an older home on a large block of land, rent out the property in the short term with the plan of knocking it down and sub dividing the block to build two new homes. When looking at these types of properties, there are a few things which need to be considered as mentioned below.
Zoning: The zoning of the land refers to how the local council has zoned the property, such as whether it's intended for residential, commercial or business use. This will influence your ability to subdivide the property. Once you’ve found out which zone the property is in, you’ll need to access the relevant information from your local council about whether or not you need a development approval (DA). You can also speak to a qualified surveyor to find out whether you can subdivide the lot.
Land size: As a rule of thumb, the land size should be at least 700 square metres of “usable land” to meet local authority regulations, but this will vary from council to council.
Land layout: Ideally, the property should have a good layout with enough area to install a driveway that’s 2.5-3.5 metres
Land gradient: A relatively flat block of land is easier and cheaper to work with for a subdivision project compared to a sloping block that may require you to cut or fill the ground with retaining walls to level it out.