So, you’ve probably read the NZ Herald and Stuff articles on property. The classic story of an ‘investor’ goes something like this
‘Mr. x has bought this property and then sold it on a week later for $200,000 more!!!’
Well, it’s sensational, jealousy inducing, it grabs eyeballs and yes, it makes us all salivate just a little bit. So how do you find a property like this?
The answer – you don’t.
Much like everything on the news and TV, it’s a facade and a rather thin one at that. Not to say each individual instance isn’t true but the idea that every investor goes out and buys something and just flicks it on for huge gain simply isn’t true. That sort of speculation (and it is speculation, not investment – see this lovely chart if you’re not sure on the difference) is fraught with risk. That’s also not to say that no one makes a living out of it, some do, but equally some people make a living out of poker or craps and you certainly wont find many competent investors in those areas. The issue is that you’re only hearing about the winners, not the losers. Survivorship bias for those into their psychology.
So if you’re a bit more like me, a bit more thoughtful in your investments, you like making a good income and growing your capital but not risking everything you’ve got and being able to PLAN for your retirement, not simply hope. If this sounds good then I might have something for you.
Some people have preconceived ideas about property relating to how to make money. So I’d like to kindly ask you to drop those and in it’s place I will use the metaphor of the box. Thanks for that. What we are investing in now is a box, a bland plain box that’s only purpose is to make money for you. A box you need to watch, nurture and take care of.
There’s many ways to skin a cat and our boxes are no different, I’ll guide you through the principles only and we can look at the more interesting techniques and ideas in future.
Let’s say we see a box for sale. This box is $100. Is this a good price? Is it a good investment? How do we know with some back of the envelope calculations whether it makes sense?
Test 1 – Cashflow
You’re going to rent out this box to someone.
Cashflow is an oft misused term so lets define it here. The amount of profit or loss you make over a given time, simple. We will use the annual amount.
Positive Cashflow – Profit and good times
Neutral Cashflow – You might have to try not to fall asleep in your investment. You’re not losing anything but you’re not really gaining anything either.
Negative Cashflow – You’re making a loss. You’re paying for someone else to borrow your box. Why?
If we borrow the whole $100 (always calculate the full amount, any investment can be shoehorned into looking good with a large deposit), the bank says this will cost us $5 per year in interest.
Our other costs (box insurance, box maintenance, box management etc) come to $2 per year.
We find out from local box rental companies that they can rent this box out for $10 per year.
So $10 – $5 – $2 = $3 profit.
Fantastic, it’s passed test 1, it’s profitable on a cashflow basis. This is extremely important to the stability of your investment. You never know what’s around the corner, borrowing costs can rise, rents can drop, your tenants could leave and you might not be able to fill it, you could lose your job and so much more. A profit means this place holds it’s own and pays for itself.
If it’s zero or less, find a new box and try again.
Test 2 – Capital Value
So to borrow on your first box you’ll need a 20% deposit.
n.b. I’m going to use 20% deposit as the current 40% LVR restrictions are temporary and will likely be repealed once the excrement hits the fan which is also likely to be when you’ll get the best deals. It can also be done now through non-bank lenders and other means. Come to your own conclusions but I feel this explains the principals better, especially with confusion between owner occupied, rentals, holiday homes, eurgh. 20% ok? ok.
Let’s say you’ve got $20 saved up for your first box. Well done you! You could afford this box and be making a tidy $3 per year. A great investment, yes?
Well it’s a good investment but it might not necessarily be a great investment. It depends on how much other peoples boxes are worth.
The local box sales suggest boxes similar to the ones you’re looking at buying are worth $110. With some cosmetic repairs, a better example might go for $125.
If you were to buy this box today, you would have an extra $10. What’s not to like? If you sell it tomorrow you’ve already made a profit (not that we’re going to sell).
This is a great investment. It has both Cashflow and Capital requirements sorted. Not to say there’s no risks but you’ve greatly reduced any potential pitfalls in future.
If there’s no ‘meat’ on it, negotiate the price lower or move on to the next one.
Test 3 – Preparing to buy more boxes
How would you buy your second box? Well you’d have to scrimp and save and get another $20 or so together.
There’s another way. If the bank gets a valuation for your box at $125 and the debt on box 1 is $80, then that’s your $20 deposit sorted for your next box. Crazy? Probably. Legal? Yes. Useful? Definitely. Let me explain.
So you buy the box, get your paint rollers out and make some repairs and get it professionally revalued at $125. You knew it would revalue around this amount because the valuer told you it should and your own comparisons with other boxes suggested they were correct.
Box 1 Value – $125
Debt on Box – $80
Your want to buy another one of these boxes and make another $3 per year. It’s logical, why not?
It looks like this – (125 x 0.8) – 80 = 20
Box Value – $125
Now take off 20% – (or x 0.8). This is taking off the deposit amount that you must keep in the property until you sell it. = $100 remaining
Now Take off the remaining debt – Remaining debt is $80, therefore $100 – 80 = $20.
$20 is the remaining value and the deposit on your next box. Honestly, I’m not making this up. Done right, you’ll only ever need to raise capital once to enter the this market. The rest remains on either good luck (values rising) or your ability to create capital value through improvements or otherwise.
Your ability to continue in your investment journey depends on how well you bought the last one.
Rinse and repeat, in no time you will have a strong cashflow income and a portfolio that is likely to grow well over time.
Replace the work ‘box’ with ‘property’ and add a few zeroes to the dollar amounts and you’ve got the basics of property investment. Well done.
Also note that we don’t rely on chance. The numbers we procure are all from reliable, qualified sources. Government websites, Definite sales figures, experienced estate agents with no conflicts of interest, not the one trying to sell you the box. No salesmen.
If the property goes down in value then guess what, it sucks – but here’s the key part – you’re still making a cashflow profit every week. How long can you keep that going? As long as you need to. If it was cashflow negative, you’d be forced to struggle, sell or to realise your loss.
If the property goes up in value, which isn’t guaranteed, then it’s a bonus and should be treated as such. It’s not because you’re a whizz kid investor and you know everything (yeah, that was me a few years back, sorry everyone), it’s because of good luck, things like government incentives to buy property, lower debt costs, higher wages or strong immigration. If you can control any of those things, then you can take credit for your fantastic knowledge and foresight, until then, it’s luck.
Be aware that this is using the principle of leverage, the bank multiplying your buying capacity by 5. This also increases your risk factor by roughly the same amount, there’s no such thing as a free lunch. If you win, you’ll win big, if you lose, you’ll lose bigger. Be careful and make your own judgement calls, these strategies are designed to ameliorate any risks, not remove them entirely.
Here’s some great places to find out different things
- Property values – https://www.trademe.co.nz/property/insights
Be honest and compare what you own or what you’re looking at owning against recent sales or similar properties. Similar being the key, a 4 bed 1900’s villa does not compare to a 4 bed luxury new build, even if it’s in the same neighbourhood. A fantastic tool and completely free
- Potential rents – https://www.tenancy.govt.nz/rent-bond-and-bills/market-rent/
Simply input your area and you’ll know exactly how much your property will rent for. Be careful that there enough bonds lodged for your type of property, anything with a low number of bonds held can be statistically off.
- Mortgage rates – The advertised (carded) rate is for suckers. Find out what people are really getting at property talk. Again, be aware that some will get better deals for having large amounts of debt with a bank, some will have long standing histories and some might be telling porky pies.
- Insurance – Try getting quotes from various providers
- Management costs – Usually around 6-8% of the rental intake
- Repair costs – if you’re not keen on doing them yourself, use the 3 quotes system. Get 3 quotes for what you need, go with the best one
- The library – One of the best sources for information on how to start, read every property book you can get your hands on