Investors have surged in the Sydney and Melbourne property markets at record levels over the past few years, with many amassing significant property portfolios. Many Gen Y investors have made headlines for having a large number of investments to their name, often worth millions of dollars.
But are they really as wealthy as they appear?
Answering this question is about understanding how they have managed to buy properties in the first place.
The first property
Getting the first property is widely described as the “hardest” for investors and first-home buyers alike.
At this stage, saving up a significant cash deposit – or using a parental guarantee to top up a deposit – is the most typical buying approach. Without any assistance, most investors and first-home buyers do have to do the hard yards to save funds, let’s say $100,000 plus costs.
But for those buying an investment property rather than a home, there is a difference worth noting.
While investment loans are typically now subject to higher interest rates, in many situations investors are seen as more serviceable – meaning they can borrow more – than home buyers on the same income. This is for one simple reason: having a tenant in the property is considered to be income.
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Research undertaken by Macquarie analysts in 2016 found someone earning $105,000 a year could borrow $813,000 as an investor, compared to $588,389 as a home buyer.
If a first time property investor is keeping down their living costs by renting somewhere cheap, living in a sharehouse, or staying at home for longer, they have a much higher ability to borrow.
In addition to this increased ability to borrow, they can also get on the ladder earlier by buying wherever they can afford and think there will be good growth – compared to first-home buyers who are restrained by where they are able to live and work.
Investors are also frequently more able to buy in more affordable areas – where deposits are already cheaper – such as regional locations or the outskirts of major cities. By buying cheaper properties, it means they may be able to buy more real estate in the future.
Every investor has a different approach. But let’s assume our investor bought two apartments five years ago in an investor favourite area, such as Sydney’s western suburbs, for $250,000 each – prices that were achievable in 2012.
The next properties
For investors, the fastest way to get a deposit for the next property is not to save again – but to use equity in their home or other properties as it becomes available.
This could require waiting and hoping for the market to increase in value, doing a renovation or paying down the loan.
Here is how it works.
Home equity is the amount left over when you take away what is owed on a home loan from the current value of the property. With our investor’s two $250,000 apartments, the revaluation is likely $350,000 today ($700,000 in total) – to be conservative.
In this situation, our investor initially paid $50,000 in a deposit for each home – meaning her loan was $200,000 per property ($400,000 in total).
Even without paying any additional funds into paying off the homes, she has turned her $100,000 worth of deposits (two x $50,000) into a total of $300,000 because she has, in theory, gained an extra $200,000 from the revaluations. This means the portfolio would be worth $700,000. The debt remaining would be $400,000.
In this situation, it would be possible for the investor to pull equity out of these properties to cover more deposits plus costs. This approach could be used multiple times to ramp up a portfolio above the 10-property mark, provided they don’t hit a “serviceability wall” where the bank will no longer lend.
Mortgage Choice’s 2017 Investor Survey found 22.2 per cent of investors borrowed the full purchase price of an investment property using the equity in their current home as security and another 29.6 per cent borrowed some of the purchase price with this method.
Based on this data, more than half of Australian property investors rely on equity to build their portfolio.
If our example investor decided to buy a $500,000 investment property using her equity – she could push her portfolio up to home number three. Her portfolio value at this point would be $1.2 million.
But if our investor sold her portfolio at this point – she wouldn’t walk away with $1.2 million. In fact, she is far from a “property millionaire” and would be unlikely to even walk away with $300,000 – the equity plus initial deposits.
When capital gains tax and selling costs are considered, this can quickly erode the leftover value. Add to this costs incurred by holding the property – including any shortfalls between the rent and mortgage repayments, improvements to the property, insurances and other outgoings, and it doesn’t look as attractive as the initial one-off figure.
Many investors would not be selling at this point – in fact many are willing to lose money in the short term, by paying more to hold an investment property than it makes in rent, in the hopes of future gains.
The 2016 PIPA Annual Investor Sentiment Survey found 64 per cent of respondents had bought for “long-term” growth. Growth of 10 per cent on our example portfolio would be an additional $120,000 in equity.
If this growth didn’t occur, they could be losing money due to the holding costs.
And if values fell, it is entirely possible these investors could end up with mortgages costing more than the properties are worth.
What to ask when determining the success of an investor
- What is the value of the portfolio? (Are the valuations conservative and where have they come from?)
- Does anyone else share ownership over the portfolio?
- How much has been spent on the portfolio in terms of deposits?
- How much is left owing on the mortgages (this will determine how much of the principal has been paid down)? How much has been paid in interest?
- If they sold today, how much would they be left with before and after costs? (Consider stamp duty, agent fees, capital gains tax and marketing costs.)
- How much has the investor spent improving and renovating the properties? Take this cost away from the dollar figure above.
- What is the investor’s cash flow – that is, how much are they paying out each month to make up the difference between the rent and the mortgage repayments? If this figure is a positive – that is, the rent is more than the mortgage repayments – the investor is described as “positively geared” or “cash flow-positive”.
- What are their monthly outgoings on their portfolio, including insurances, property management costs, council rates, taxes and maintenance fees? Subtract this figure from the cash flow amount.
- How does depreciation and negative gearing affect their annual cash flow position?
- How long does the investor intend to hold their portfolio for? As the value increases in the properties, or decreases, these balances will change significantly.