Looking to buy a rental property in 2018? 8 Key Tips
24 January 2018
Looking to buy a rental property in 2018? 8 Key Tips.
Is your next rental property purchase just a gamble on capital gains? Here are some tips to help you get ahead with rental properties!
1. Buy a property where you can add value.
Too many investors just buy a standard property, in a standard area, at fair value, with no opportunity to add value in the future.
- The easiest opportunity is where the property is under-rented. For commercial properties, the higher the rent, the higher the value. So, if you can find property that is partially empty or rented below market value, then it can be quite easy to increase your equity and cash flow. For residential, higher rent doesn't necessarily mean higher value, but it will improve cash flow.
- Simple renovations and improvements are my second favourite - Use a good property manager and discuss options with them:
- If you add a heat pump, how much extra rent will you get?
- If you add new carpet, how much extra rent will you get?
- What else could you do to make the property better for tenants? How much extra rent will you get for these improvements?
It is normally pretty easy to get a 10% return on your investment for simple renovations. But, realistically, if you are smart and work in with your property manager, you can probably get 20%.
- Rent by room or rent fully furnished? Be careful with these options, but it can be a way for you to add value and improve cash flow.
- Add a bedroom - For residential, more bedrooms equals more rent and more value.
- Add a minor dwelling.
- Subdivide - For commercial, you might not be able to subdivide, but you might be able to split one bigger tenancy that is hard to rent into smaller tenancies that are easier to rent, and rent for a higher value overall. For residential, a subdivision can often easily add $100,000 in equity, plus give you the opportunity to have a new rental, with good tenants and low maintenance.
- Buy at a true discount. This generally means buying privately!
2. Work out the cash flow!
Ideally you want a residential property where the rent pays for all the expenses. Even more ideal would be if the rent can pay for all the expenses and some principal, so that you pay the rental off over 20-30 years.
NOTE: This means all expenses, so allow for fair repairs, rates, insurance, travel, accounting fees, etc.
If you are a Coombe Smith client, make sure you have our simple Rental Spreadsheet that helps you see the cash flow now, and over the next 10 years.
For commercial - watch the principal requirements. For example, your commercial property might be making $10,000 taxable profit. But your bank might require $15,000 principal repayments, plus $3,300 of tax = overall negative cash flow of $8,300.
3. Check the area.
- I google the population as a starting point for any area I am thinking of buying in. If the population is decreasing, I would be very careful buying. More people means more possible buyers and more possible tenants. Good population growth is likely to lead to rent increases, which is essential for cash flow!
- This is a great article on property values versus household income. If household incomes are too low compared to house values, you might struggle to get higher rent in future: https://www.interest.co.nz/property/house-price-income-multiples
- Look for recent articles and information, such as "100 jobs to go" - http://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=11980396.
- If you are not from the area or buying without seeing, be careful that there is nothing in the area that affects your purchase. A property investor once purchased a rental in a different island, sight unseen. Unfortunately, it was right next to the sewerage works!
4. High Gross Yield doesn't necessarily equal positive cash flow
You might find a property in a small town. $120,000 cost and $275 rent per week. Based on 52 weeks (I probably wouldn't use 52 weeks in my real calculation), this is an 11.9% Gross Yield. But rates are $4,500, insurance might still be $1,200, interest might be at 4.5%, so $5,400. Property Management is often a higher percentage (might be 9.5% plus GST). Repairs can be the killer, as it often costs the same to repair in a small town as it does in a city. Suddenly, with low interest rates, this property is still making a cash loss of $1,298 using those figures, some accounting and bank fees and travel.
5. Don't believe developers.
Property is advertised as $600 per week rent – don’t believe it and get an independent rental appraisal.
Property is worth $700,000 – don’t believe it and either do your own research or get an independent valuation.
Property will give a 10% Gross Yield – is it too good to be true? What is the catch? Make sure you do your own research and if rent by room, or fully furnished, check with an independent property manager to make sure sustainable. You don’t want to rely on $600 per week, when realistically it might have to drop to $500 as no demand for rent by room (for example).
6. Have a plan and a goal - If the property you are looking to buy doesn't help you to achieve your goal, then why are you buying it?
7. Plan for change
- Interest rates may go up. I like to have some long term loan terms to protect against interest rate rises.
- Tax refunds might disappear.
- Better heating and conditions might become a requirement. Take this as a positive and think of Item 1 above, as you are likely to get a good return on these items, especially if the Government helps pay for them.
- Regular rent reviews.
8. Balanced Portfolio
An old saying was to have five cash flow positive properties to support your one capital gain property. This kind of portfolio should give you stable cash flow and stop you being so reliant on capital gains. Also, try not to have too many of the same thing. For example, if you have 20 rentals at Auckland university, what happens if the university suddenly closes down, or its student numbers drop by half? Having some newer properties also helps to balance the portfolio, as these will have less maintenance in the future.
a. If you already have two rentals, each running $5,000 negative cash flow per year. Then, if you purchase another, I would want it to be positive.
b. If you have five older rentals in Tokoroa, which have great cash flow, but you think no capital gain potential. Then you might buy the next one in Hamilton to have a more stable tenant base, maybe less repairs and less hassle, but higher chance of increase in rent and value.
I hope you enjoyed reading this.
If you're not already a client of Coombe Smith, but want some help, we have 3 free telephone chat spots available this week for 5-10 minutes. These are no-obligation free telephone chats with me. Please email Mareese RIGHT NOW to book yours in, as mentioned, this is OBLIGATION FREE.
Kind regards
Ross Barnett
Common Restructure to Become More Tax Effective (Personal Home becoming a Rental)
9 January 2018
Common Restructure to Become More Tax Effective (Personal Home becoming a Rental)
Are you trying to get ahead on the property ladder by converting your current personal home into a rental, and then buying a new personal house?
This is an example of poor advice that I have recently seen, followed by a common restructure that makes the overall situation more tax effective.
Poor advice and current situation
Jack and Jill own a personal house (House A), worth $500,000 with $50,000 of debt in their personal names.
Jack and Jill have been advised to keep House A in their personal names.
They have purchased a new personal house (House B) for $600,000 with a $600,000 mortgage.
Outcome – Unfortunately with this structure, none of the interest on the $600,000 loan is deductible. Only the interest on the $50,000 loan on House A will be deductible. At say 5% interest, this would be a $2,500 deduction, reducing tax by $825 (if at 33% tax rate).
Restructure
A common restructure is to sell House A to a Look Through Company (LTC) at fair market value. The LTC would then borrow 100% (can do with one or two banks!) being $500,000. The interest on the $500,000 is deductible as it is being used to buy a rental property. At say 5% interest, this would be a $25,000 deduction, reducing tax by $8,250 (if at 33% tax rate).
Jack and Jill would then receive the $500,000, pay off the $50,000 current debt, and use the $450,000 cash towards House B purchase. This way there would only be $150,000 personal debt left, where the interest is not deductible.
This creates a tax advantage of $7,425 per year!
For any restructure, it is important to look at the cost versus the benefit. There can be catches such as depreciation recovery, tainting and the Brightline test to consider. Also, whether there is a commercial reason for the transaction. So it is important to get expert advice. QB 12/11 from the IRD gives some great information on this type of transaction as well, and confirms that this type of restructure is not tax avoidance, but it does depend on the exact circumstances!
The information below is from my 14/07/17 blog. It is important reading if you are thinking of converting your current personal house to a rental:
Convert Your Current Personal House to a Rental?
When trying to get ahead on the property ladder, a lot of people move to a new personal home and convert their existing house to a rental. Unfortunately, this is often done for emotional reasons!
If you are thinking about doing this:
1) Is your existing house a good rental?
Is there high tenant demand in the area? Look at population figures for the area and talk to a local property manager.
Will you be able to attract a good tenant?
Is the property easy care and low maintenance?
Is there an opportunity to add value in the future? For example, subdivide or add a minor dwelling.
2) What is the cash flow?
As a starting point, I would work out the Gross Yield. This is 50 weeks rent divided by the property value *100. For example, $400 per week * 50 = $20,000 divided by value of $400,000 would give 5% Gross Yield.
The Gross Yield gives an indication of the cash flow:
5% or under is going to be quite negative cash flow based on 100% mortgage.
7% or better should break even or be positive cash flow.
Between 5% and 7% is still likely to be negative cash flow, but a smaller, more manageable amount.
Review the income less the full expenses. The example below shows a $8,784 loss expected each year before tax. After tax refunds, this drops to $4,914 per year or $94.50 per week.
3) What happens if interest rates go up?
At 6.5% interest, the loss after tax refunds increases to $9,950 per year or $191 per week.
4) Can you afford the cash flow losses?
5) Do you want to gamble that the property will go up more than the cash loss?
6) Or do you have a plan to change the cash flow?
- Minor dwelling to increase rent
- Subdivide long term and sell section, or build second rental on section
- Inheritance coming that can reduce the rental debt. NOTE: you are likely to pay off any personal debt first.
Often I find that personal homes are not great rentals and that it is better to sell the existing personal house and buy a specific rental, with better cash flow or better long term options.
I hope you have found this topic of interest.
Kind regards
Ross Barnett
Low Hanging Fruit - 6 Easy Opportunities to make more from Property
12 January 2018
Low Hanging Fruit - 6 Easy Opportunities to make more from property
A great way to get ahead with property is to concentrate on some easy ideas that you can get done immediately. I posted this live video on our Facebook page yesterday and it has had a really good response, so I thought you might be interested to watch it too.
Click here to view the video.
Feel free to share the video link with friends and family.
What is happening in 2018?
- Simple property seminars in Hamilton, starting late February. Over the next few months we will be covering:
Property Basics
Cashflow
Structures
Trading.
- Simple property webinars on the same topics, most likely starting in March.
- Video copies of the webinar available to Coombe Smith clients.
- We are investigating monthly fees, so watch this space if you would prefer to pay monthly.
- We will be offering discounted meetings with 2018 financial statements and tax returns, to help you plan for the future, focus on cashflow, and make sure you are in the best position once Labour’s changes come through.
If you have a topic that you feel would be good for a newsletter/blog, please email me at ross@cswaikato.co.nz and I might be able to do a future newsletter/blog on that topic.
Kind regards
Ross Barnett
Do you want to buy and sell properties for profit?
21 December 2017
Do you want to buy and sell properties for profit?
GST and Zero Rating
If you trade residential properties, then you will have to register for GST once you have a continuous taxable activity. This means that you can claim GST on purchase costs that have GST but you also have to pay GST on the sale.
If you do a one-off trade, then this is often not a continuous taxable activity. Therefore you would not be required to register for GST. But there can be a fine line, and it is often difficult to determine, if the trade will be a one-off or if you are likely to do numerous property trades, thus becoming continuous. I suggest seeking professional advice from a property accountant on this subject and the best approach is to be honest. If you trade further properties, then you will most likely be required to GST register.
For long term residential property investors, there is no GST, so the above comments are just for property traders.
Zero rating – Over the last year we have heard about a lot of mistakes around the Compulsory Zero Rating (CZR). Real Estate agents commonly get this wrong and a few recent forum posts on www.propertytalk.com even show lawyers and non property accountants getting this wrong. If both the vendor and purchaser are GST registered, then the sale will be zero rated for GST. Therefore if you are a GST registered purchaser and the vendor is GST registered, you should be making any offer for the GST exclusive amount, plus GST (if any).
So for example, you are GST registered and purchasing a section from a developer. The developer is advertising the section for $240,000. You want to offer $230,000. You would therefore work out the GST exclusive value $200,000 ($230,000 / 1.15) and offer on the contract $200,000 plus GST (if any). As the developer will be GST registered, the sale is then Zero Rated, so you would pay $200,000 but can’t claim back the GST, and the vendor would receive $200,000 but have no GST to pay to IRD.
Following the example above, some recent mistakes I have heard of are the contract being written at $230,000 inclusive of GST. This sale would still be Zero Rated, and Zero Rated at the $230,000. So the purchaser would effectively be paying $230,000 + GST, or $264,500. This would be a $30,000 mistake and this can often be the difference between a good , profitable trade and a bad one.
Therefore it is very important to ensure you know whether a vendor is GST registered or not when you are buying trading properties. I recommend that you talk to your lawyer about inserting a clause in the sale and purchase agreement to ensure that the vendor is unable to change their GST status once the contract is signed. Many traders and educators use a standard clause that your lawyer should be able to provide you.
Second hand goods claim – If you are buying from a vendor who is not GST registered (this will often be the case, as they are just personal house owners), then as a GST registered trader you will be able to make a second hand goods claim. You can only do this on the payments basis for GST (i.e. claim the GST once you pay for it). The property trader would then claim the GST back in the next GST period and get the GST back as a refund. This is the purchase price divided by 23 * 3, so for example if a trader purchased a property for $230,000, they would get $30,000 GST back. IRD will generally audit large GST refunds, so we often get clients to just claim the land/building purchase in that GST period, to keep the GST return very simple for the IRD audit.
GST on rental income if trading properties
We have taken on a client in the past whose old accountant has returned GST on rental income for the last 6 years. The client owes or has paid around $12,000 in GST per year, totaling $70,000 approximately over the 6 years.
If you are trading properties and registered for GST, you should not be returning GST on rental income! For properties purchased before 1/04/11 it is best practice to use Lundy adjustments. For the client above, using the Lundy adjustments reduced the GST adjustment down to approximately $2,000 per year or $12,000 for the 6 years. Overall we hope to save at least $50,000 and are in the process of reassessing the old GST returns with IRD. Again, if you are involved in property transactions, it is essential that you use a specialist property accountant who is fully aware of property tips and tricks.
If the property was purchased after 1/04/11, new rules have come in that generally require more GST to be paid back to IRD. But the first adjustment required is not until 31 March of the year after. For example, if you purchased a section, built a house in May 2013 and tried to sell it, then couldn’t, so rented it out, the first adjustment period would be for May 2013 to 31/03/15, with the GST adjustment due in the 31/03/15 period.
Profit on Trading Property
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There are a lot of people looking at going full time into property trading to make a living and gain wealth.
My first comment is be very careful about quitting your day job.
- This job brings you day to day cash flow, which enables you and your family to live.
- Banks love a steady, solid income. So without one, you might find lending difficult.
Secondly, do the figures really stack up? In today’s market it is easy to buy, easy to renovate but the problem lies with selling. This can result in additional holding costs and also with a lower than expected selling price.
Here is an example of a Property Trade that I have heard an investor talk about.
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Example
Purchased for $275,000
Renovations cost $5,000
Could sell for $300,000
From a quick glance, a lot of people think “that’s not too bad” and it’s $20,000 profit. But, unfortunately, that is not the case. Below are the likely expenses and I have included commission because in today’s market, many sellers are needing to use an agent to get a good price.
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Incl GST
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Excl GST
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INCOME
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Sale of Property
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300,000
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Less GST - Divide by 23 * 3
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39,130
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260,870
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EXPENSES
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Purchase
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275,000
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Commission on sale
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10,350
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Legal - $1,000 to buy and $1,000 to sell
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2,000
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Accounting
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500
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Advertising - Agent or other
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1,500
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Insurance for 3 months
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200
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Rates - 3 Months
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500
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Renovations
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5,000
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Telephone
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25
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Travel - 86 cents per km * 300
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260
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Subtotal Expenses
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295,335
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Less GST
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38,522
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Subtotal Excluding GST
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256,813
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Less Loan Fee - NO GST
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1,000
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Less Interest 3 months @ 6%
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3,750
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TAXABLE PROFIT
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-693
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So based on the expenses included, the Trade would make a loss of $693. If commission is excluded the profit would be $8,307 before tax, or around $6,000 after tax at average tax rates.
This example shows how quickly a perceived profit can disappear. If the property was held for longer, then it is likely to make more of a loss.
There are a number of property investors getting tutored about property trading and my understanding is that there are around 90 such students targeting areas in South Auckland.
In my opinion this is too many traders concentrating in the one area. I would suggest being very careful about trying to trade in this area as it is likely there are too many other traders competing to sell their properties.
20% Rule
I always think that you need a $50,000 gap between the purchase and sale for a low value property, with limited renovation expenses. This equates to around 20% of purchase price. So for example, buy at $250,000, spend $5,000 on renovations and sell for $300,000. Based on the same kind of expenses including commission, the profit before tax would be approximately $20,000. If higher value, work on 20% of purchase price - so buy for $500,000, sell for $600,000 with limited renovation costs.
This level of profit gives the trader some room to move with either the selling price, or to hold the property for longer and to still make some kind of profit.
Overall
Property Trading is not easy and you need to ensure you have a market in which to sell your finished product. With Trading you need to keep your properties moving, so the idea is to do them as quickly as possible and then move onto the next one. Historically where I have seen Traders come undone is where they take too long or where they get too big too quick (i.e. have 2-3 or more on the go at once).
If you are thinking about trading properties, I suggest you organise a meeting with me to discuss the structures used and the implications of tainting. Ring Mareese on 839 2801 to organise a meeting or email mareese@cswaikato.co.nz. Please note: there will be a charge for this meeting, depending on the work and information required.
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Kind regards
Ross Barnett
