Desperate to Buy Your First Rental?

9 April 2018

 

Desperate to Buy Your First Rental?

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John and Lisa are desperate to buy their first rental and jump up the property ladder.  They purchased an average first home in 2011 for $340,000 (around the NZ median at the time).  They started with around a $270,000 mortgage, which they have managed to get down slightly to $240,000.  John earns $90,000 per annum, and Lisa earns $30,000.

They are good with money, have no HP’s, and no outstanding credit card debt.  John and Lisa want to get ahead and have just changed their loan so that it will be paid off over 10 years.

At the start of 2017, their property has jumped in value and is now worth $490,000 (around the NZ median at the time).  They can now borrow 80% ($392,000), or an extra $152,000 towards an investment property.

They initially look at buying a normal rental, but with only 60% lending at the time through banks, it seems too hard and their price range seems too low.  They could only buy something for $380,000.

They talk to an investment property company, who convinces them to buy new, as the banks will now lend them 80%!  John and Lisa buy an investment property for $599,000 with a furniture package, and rented for $570 per week.

The rental would have a cash deficit of around $5,100, but after large chattels depreciation on a new property, the tax refund should be around $3,600 if structured in the best way.  So’ overall’ a cash loss of $1,500 per year.

They earn $120,000 per year combined;

Less Tax $24,890

Less Personal House mortgage $29,568

Less rental shortfall $1,500

$64,042 remaining for everything else.

 

One year later – 2018

The tenant has moved out.  The market has changed slightly and there are no longer tenants for fully furnished.  So, John and Lisa rent for $490 per week without the furniture.  They are lucky that they have a shed they can store the furniture in.

The rental cash deficit has increased to $8,700, and after-tax refund of $4,500, the cash shortfall is $4,200 approximately.

The property market has been reasonably flat, and John and Lisa purchased quite high through the property investment company, so their rental is still only worth $599,000, if they are lucky.

 

Another year later – 2019

Labour and IRD have ring fenced property losses (expectation at 8/4/18).  The rental is now a cash deficit of $8,700, but no tax refund.  So it is costing them $167 per week to top up the rental.

The property market has been reasonably flat, and John and Lisa purchased quite high through the property investment company, so their rental is still only worth $599,000, if they are lucky.

 

They still earn $120,000 per year combined;

Less Tax $24,890

Less Personal House mortgage $29,568

Less rental shortfall $8,700

$56,842 remaining for everything else.

 

HOW DOES THIS STORY END?

There are multiple possible endings, and you can choose your own ending!

1)  Property prices jump in value. John and Lisa’s personal house has jumped to $790,000 value.  Their rental has jumped to $700,000 value.  John and Lisa are extremely happy and looking to buy more rentals.

 

2)  Interest rates go up 1%:

a.  John and Lisa’s personal house payment goes up $1,404 for the year

b.  The rental cost goes up to $14,700 per year or $282 per week.

c. Their remaining cash for other costs is down to $49,438 per year.

 

3)  Property prices remain flat for 5 years:

a.  John and Lisa have put $32,000 approximately of their own funds (after tax refunds) in the rental to top it up.

b.  The rental is still worth $599,000 on a good day and the mortgage is $599,000. So, no equity.

 

4)  Property Prices have fallen over 5 years:

a.  $32,000 top up

b.  The rental is worth $549,000, and the mortgage is $599,000, so negative $50,000 equity.

 

5)  John gets cancer and can’t work …

 

The one good thing that is happening in all options, is that John and Lisa are quickly paying off their personal house.  So, if they can get through 10 years, and have paid off their personal house, then they will have surplus cash that could pay off the rental.  They also have a reasonable household surplus, so can perhaps afford to tighten their belts a little and push through harder times.

I don’t have the perfect answer how this will end either.  In my opinion, this isn’t a great situation to be in.  John and Lisa are stuck and really reliant on capital gains.  They will struggle to buy more rentals until their current properties have jumped in value.  Ideally, I think they should be saving a little harder and paying principal on the rental to create a buffer in case something goes wrong.  And obviously point 5) highlights that they should discuss their affairs with a risk broker and maybe have some income protection insurance, trauma or life insurance.

I hope this has got you thinking a little bit?  What is your goal, and if you are buying a rental, will the rental actually help to achieve your goals?

I think the simple goals for most people are a debt free personal home and passive income!

Kind regards

Ross

 
 
 
 

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