Margaret Lomas
May 2008 - Issue 2
Margaret Lomas discusses whether you should buy your own home or rent and become a landlord, considering the next 12 to 18 months will offer up some property bargains
I am often asked by potential property investors considering buying a home of their own whether they should buy an owner-occupied or an investment property first.
With interest rates rising and rental yields still relatively low, it is important property buyers consider the answer to this question considering two major issues – the emotional one and the financial.
For many people, the need to own a home in which they can freely bang nails into the wall, paint the bedroom orange or have all manner of wild parties, is very strong.
Raised by parents whose own parents taught them to save hard and, at all costs, access the great Australian dream, the Y and Zen generation have been instilled with a notion that, unless you can own your own home, you are not financially secure.
For baby boomers like me, the ability to get into our first home as soon as we were married was relatively easy. With plenty of land available for release by the land commission and builders offering small, but cheap, project homes, it was a natural progression to include, as part of our wedding plans, the purchase or building of a new home.
While finance may have been difficult to access, it certainly wasn’t impossible for those willing to crawl on their hands and knees to the bank and offer the soul of their first born in return for a loan at an undisclosed interest rate.
We then built our homes, amazingly held on to them while interest rates peaked at 18 per cent, then enjoyed an investing freedom that the increased equity brought to us during the past 15 years of economic abundance.
Now things are not so clear cut.
Interest rates are rocky and the price of homes is startlingly high. The difference in value between properties at the lower end and those at the higher end is greater than ever before, with growth remaining strong in pockets while it disappears altogether in other areas.
It is little wonder then, that those yet to enter the market are confused as to exactly how to do so, and are probably also not convinced that they should do so at all.
To make the decision, potential buyers must consider two main things:
The emotional argument
Are you prepared to live in property where you are restricted as to exactly what you can do?
Do you feel comfortable knowing that you do not necessarily have tenure, and at the end of each lease period you may be at risk of eviction, or of a rental increase which may be more than you can afford?
Most states do have laws which prevent landlords from increasing rents between lease periods by an unreasonable amount. The problem is, however, in the current market, it is difficult to establish what reasonable is.
With high demand for rentals in many areas, landlords have been enjoying the ability to ask top dollar, with some reports recounting bidding wars and rental auctions for scarce property.
If you are not prepared to be a part of this and you have established, after reading the next section, that financially you are in a position to buy your own home, then you may wish to do so in the coming months.
The greatest opportunity for property bargains will be seen in the next 12 to 18 months, peaking around the nine-month mark when mortgage-stressed vendors realise they can’t wait any longer and drop their asking price.
However, before making this decision it is crucial that you fully explore the financial impact.
The financial argument
A number of reasons, such as work or family, could dictate a desire to live in a particular area. The area, however, you have chosen in which to buy your home is prohibitive from a financial point of view.
When I was first buying, the cost to rent was very similar to the cost to buy. Mortgage repayments pretty much matched rent payments and, rather than help an investor to own more property by paying his or her mortgage, we would be far better to dig deep for a deposit and use our weekly commitment to repay our own mortgages.
These days, this doesn’t really apply. Some areas with high price tags have relatively low rental yields, making the option to rent most probably a better one.
It is common for some areas in the western suburbs of Sydney, for example, to have rental yields of around 5.5 per cent, while some areas in the eastern suburbs are sitting at around 3 per cent.
With interest rates currently around 9 per cent, buyers must consider whether the renting option may be more financially sound than the buying one.
EXAMPLE ONE
Kaye and Mark really want to live in Avalon. They have a deposit of $200,000. The average house price is $1,085,000. They have found a suitable four-bedroom property that they can buy for $980,000.
The interest repayments on the loan of $830,000 ($980,000 purchase price plus $50,000 costs and stamp duties, less deposit of $200,000) at 8.61 per cent will be $1374 per week, or $71, 462 per annum.
While past growth rates are never an indication of future growth rates, if we considered that the reported past trend for growth in Avalon has been 7.3 per cent, we might assume that, after 10 years, the property may be worth $1,847,665 ($867,665 increase).
Considering total interest payments of $714,620, the net gain for Kaye and Mark after committing the original $200,000 and the interest repayments is $153,045.
EXAMPLE TWO
Vince and Stephanie also really want to live in Avalon, as this is where Vince’s family live and he works nearby. They decide to rent and use their $200,000 to become landlords.
They find a four-bedroom home in Avalon which rents for $700 a week, or $36,400 per annum. With the $200,000 deposit they have, they buy property in:
Elizabeth, SA - $185,000 purchase price (total $195,000 with costs)
- $190 per week rent return ($9880 per annum)
- Yearly costs $3000
- Growth trend 11.3 per cent
Woodridge, QLD - $190,000 purchase price (total $200,000 with costs)
- $210 per week rent return ($10,920 per annum)
- Yearly costs $3,000
- Growth trend 10 per cent
Mildura, Vic - $175,000 purchase price (total $182,000 with costs)
- $190 per week rent return ($9880 per annum)
- Yearly costs $2,500
- Growth trend 8.5 per cent
Melton, Vic - $185,000 purchase price (total $195,000 with costs)
- $195 per week rent return ($10,140 per annum)
- Yearly costs $2500
- Growth trend 8.3 per cent
Liverpool, NSW - $180,000 purchase price (total $190,000 with costs)
- $190 per week rent return ($9880 per annum)
- Yearly costs $3000
- Growth trend 7.8 per cent
NB: All costs are estimates. Growth trends supplied by Australian Property Monitors. Properties and rental returns are from properties found on
www.realestate.com.au). Interest rate 8.61 per cent.
The total spent on these properties was $962,000, making a total loan after deposit of $762,000. The total interest repayment is $62,179 and the total other costs are $14,000, totaling $76,179.
As the total income will be $50,700 per annum, Vince and Stephanie, who are in the 30 per cent tax bracket, will receive a tax refund, on the loss, of $7,643, leaving them to meet the shortfall of $17,836 from their own funds.
In reality, they probably would have depreciation benefits on all of these properties, which would boost their tax refund, but for this example let’s just assume they have no additional benefits.
The ability to spread the investments over many different markets has meant that they have accessed differing growth rates and minimised some risk of vacancy by having several cheaper properties rather than one more expensive.
After 10 years:
According to the reported growth trends, the total property value will be $2,048,467, which represents a total gain of $1,133,467.
Total cost of holding these investments has been $178,360. In addition they have had to pay rent of $364,000.
In total, they have paid out $542,360, giving them a net gain of $591,107.
If we evened this up a little more and only applied growth rates to the entire portfolio of 7.3 per cent (as in Avalon), Stephanie and Vince would reach the 10-year mark with $1,851,050 of property, for a net gain of $393,690.
This is more than 2.5 times the gain that Kaye and Mark would make by buying their own property.
And both couples have enjoyed living in Avalon.
Summary
The important thing that all property buyers must do is to establish the financial cost of their dreams and goals. Before deciding what you would like to do, remember these important points:
1. Depending on the cost of property in the area that you need to live, it may be more prudent to rent.
2. If you do rent, you must consider getting into the property market as a landlord. You need some type of investment strategy that will allow you to be using capital growth to accelerate your savings.
3. There is no sense saving on loan repayments by renting a cheaper rental if you are only going to spend what you save. If you think you will do this, then buying is the better option.
4. You must ascertain the actual true cost of home ownership to you. Can you afford the repayments or will you struggle when interest rates go up? As a landlord, at least you may have the option of increasing rents to help you pay for interest rate rises, and you also have a tax offset with each rise which reduces the actual cost of that rise. As a home owner, it is you who must meet the extra repayments.
5. If you don’t care where you live, some areas have a similar net cost to rent as it would to own. If this is the case, ownership may be the better option.
Approaching the issue using both your head and your heart may save you the pain of joining the ever increasing ranks of the mortgage stressed.
And remember, just because property in your area is now out of your reach, this does not mean you can’t enter the property market. We still have many affordable areas in Australia and becoming a landlord may be a very viable option.
