Mike
Reply: 1.1.1.1.1.1.1.1.1.1
From: Mike .
THE ANSWER
From: Mike
Date: 20 Feb 2001
Time: 17:10:42
Hi Newbies,
Wow, what a great response! Excuse me, while I get back off the floor. Part of the fun of the forum is posting something interesting enough to get some responses from jaded forum addicts. My last one, "Negotiating Online", went down quicker than the Hindenberg. This one's made up for that in spades.
I've placed the actual answer at the end of this post, so you have the choice of reading my 2 cents worth first or skip my crap and scroll to the bottom of the post to see (drumroll) 'The Answer' (cymbal). By the way, The Answer sounds like it was written by someone with more letters after their name than The Wife MuMMY EXTOd AIRE. Property BYER, Bus. OWNER, VIC NSW Qld ACt.
I'm not going to comment on your individual answers since I'm no guru and self-examination is the best teacher,anyway.
Just a small observation, though: I noticed nobody did any number crunching to backup their advice. Perhaps you thought the financial benefit of your particular strategy was so obvious that numbers weren't an issue. Something to think about. I wonder whether the Investment Institute would have us number crunch the various scenarios?
If we were to number crunch a scenario, then we would need to arbitrarily assign figures to the financial variables, such as: equity, rent return, resale value, proposed cost of renovations to IP. The couple's financials, such as: current rent, combined income, lifestyle issues (eg, children?).
I've decided to have a go at this and have some fun with it. First, I'll flesh out this couple a bit, make them more real, there might be emotional issues to consider in the decision-making process. You guys and gals came at it from a purely financial perspective. Some of you will make great hard-nosed investors someday, to rival Rivkin. For this exercise I'm going to be the hapless friend who has been put on the spot at a restaurant dinner after a few drinks too many. Tough assignment.
About this couple: I see this couple as Gen-xers. Met through work, became an item after a wild Xmas party, married, delayed family to establish career. Renting 2 bedder close to work. Saved small deposit and paid LMI to buy IP with a P&I loan. IP is 20 years old and needs a facelift. Because it is a long distance from work, couple wouldn't consider moving into it, even if renovated. IP was bought to minimise tax and build equity (they had to get advice for that move, as well). Couple, now in early thirties, see their friends with children and want to do the family thing, as well.
They're looking at low maintenance, 3br townhouses in their area less than 10 years old at approx $350,000. The resale value of their 2br IP, as is, would be $200,000. They have 75% equity in it, ie, $150,000. Their IP rents for $10,000 per year. They pay rent of $12,500.
After clearing the fishbone from my throat, I ask across the dinner table if they would consider continuing renting in a larger place while using equity to purchase further IP's to improve their tax position. In unison, they launch into me. They're fed up with crappy kitchens with bench space designed for ants to crawl on and colour schemes that would pacify a pro wrestler.
After a few shooshes from nearby tables we mellow out with another round of drinks. I forget who raised the issue of renovations but it wasn't me, I promise. They twisted my arm for an opinion so, reluctantly, I point out the danger of overcapitalising if selling immediately. What about renovate to keep? Can't some costs be returned through depreciations and a rent increase? Yes, but to buy home using equity in IP, interest on loan would not be tax deductible. (awkward silence) Pulling out my pocket calculator, I crunch the numbers:
Current cashflow: Outgoings are repayments on IP @ $3,500 pa and couple's rent @ $12,500. Total is $16,000. Incoming is rent from IP @$10,000 and tax credit is a big fat zero. Balance is negative $6,000.
First scenario of renovating the IP to hold and taking out a loan against it to buy home, cashflow would be: Outgoings are repayments on $160,000 home loan @7% are $11,200, and repayments on IP @ $3,500. Total is $14,700. ($10,000 of renos makes IP $210,000) Incoming is rent from IP @ $10,500 and tax credit is $1,000. Balance is negative $3,200. LVR is 71%.
Second scenario of selling IP, as is, buying home with large deposit, then borrowing against equity to buy IP. Assuming deposit on home after sale of IP is $140,000, purchase price of home is $350,000, and loan for new IP is $200,000, then cashflow would be: Outgoings are home repayments of $14,700. Incomings are rent from IP @ $10,000 and tax credit is $5,000. Balance is positive $300. LVR is 75%.
Putting my calculator away, I explain that, with the second option, they are $6,300 better off compared to their current situation. I add that the last option reqires no rebudgeting and the extra cashflow will pay for all baby food and disposable diapers.
The couple look at each other in amazement. In gratitude, they pay for my meal and promise to name their first child after me. If it's a girl, they'll call her Michelle. (Well, I deserve to end the story with a bit of ego massage after writing such a long-winded post) Now, check below for The (actual) Answer.
THE ANSWER:
A. If you have reasonable equity in the investment property and you borrow against it to buy a home you could end up with a large (non-deductible) home loan and a smaller investment loan, which some investment advisors, would argue is the wrong way around. The most financially effective cause of action would be to sell the investment property, buy home using all available cash, then use equity to re-invest. Yes, you have to live with the transaction costs, but at least your borrowings are then properly structured and servicing your home loan is not chewing up your cash-flow so you can move on to do more with your resources!
