Is property back from the dead?

By GREG NINESS - Sunday Star Times

We've had the boom, the bust, supposedly the recovery and mortgagee sales are continuing at a great pace.

So with all that's happened in the housing market over the past few years, is it still possible to make money from residential investment properties (RIPs), or is it a case of R.I.P. for RIPs?

To find out what type of properties are available, how much they cost and how well they would be likely to perform for investors, the Sunday Star-Times has been window-shopping at a couple of regularly scheduled auctions which are usually happy hunting grounds for professional investors.

One was an auction of 12 homes being sold by mortgagee sale, held by real estate agency Barfoot & Thompson at their auction room overlooking Albert Park in Auckland's CBD.

Although it was a glorious day, no one was bothered with the view. They were too busy working and reworking their calculations about what they were prepared to pay.

The other auction was the same afternoon at CBD apartment specialist City Sales. Good views were also to be had from their offices high on the Karangahape Rd ridge, but once again no one was looking out the window. These were hard-nosed, professional investors. Gone were the mums and dads looking to leverage off the equity in their family home and take a punt. At these auctions, those sorts of people were more likely to be the vendors, or in the case of the mortgagee sales, the people having their properties sold out from under them by the banks.

At both auctions there were often several bidders chasing the same properties and many sold under the hammer, with deals concluded on others before the end of the day.

So clearly there were still plenty of people out there who believe RIPs are a good investment and who have the spare cash to do something about it.

Typical of what sold at the Barfoot auction was a three-bedroom house at Weymouth in South Auckland. It was on a large 892m2 rear section in a quiet cul-de-sac and had a detached double garage, which would make it suitable to rent to a family.

It had a council rating valuation of $245,000 and had been purchased by previous owners in April last year for $295,000.

Although this was a modern home built of low-maintenance materials, the auctioneer commented, "it needs a bit of work."

So there was an opportunity for an investor who was handy with a paint brush and hammer to add some quick value to the property and it sold under the hammer for $218,000.

Typical of the apartments auctioned by City Sales was a one-bedroom unit in the Zest building in Auckland's CBD.

At just 22m2, it would definitely qualify as a shoebox, but its location on the 10th floor would at least give it a good view. Most importantly, such apartments remain popular with students and younger office workers and their owners generally have little trouble finding tenants.

Valuation records show it had a council rating valuation of $75,000 and had been purchased for $105,000 in 2003. It sold under the hammer for $98,000.

So there are still bargains to be had in the market but are they good enough to allow investors to make reasonable money from them?

The Star-Times looked at several scenarios for each property, based on how much of their own money investors might put into each (their equity), how much they borrowed and the effects of rising interest rates.

Although there is little doubt shoebox apartments were disastrous investments for many who bought them off the plans at inflated prices, their prices now make them standout investments.

If the apartment in our example had been bought with mortgage finance of 60% (a bank may require additional security for this type of property), it would give its owner a pretax return of 12.5% on the cash they put into it.

If the mortgage interest rate was increased to 7.25%, the pre-tax return would drop to 10.2%.

And if the buyer could pay cash, and these things are cheap enough to enable plenty to do that, the pre-tax return would be 8.4%.

Balancing those returns is that CBD shoebox apartments appeal to a narrow range of tenants, and could be adversely affected if there was a sharp decline of foreign students here.

However even through the recent recession, their occupancy levels held up well and there are no more of this type of development underway.

Whereas the Weymouth house would be likely to appeal to a broader range of tenants, and therefore might be considered a safer bet by some investors, its returns were less spectacular.

Because it was rundown, we allowed for refurbishment costs of $10,000 in our calculations.

If 60% of the purchase price was provided by mortgage finance at the current floating rate of 5.25%, it would be self-funding and provide its owner with taxable income of $6500, equivalent to a pre-tax return of 6.7% on the $97,200 in equity invested.

But if the interest rate went up to 7.25%, the cash return was reduced to $1638, all of which could go in income tax. The equivalent pre-tax return would be 4.64%.

If the investor paid cash, the return would be 6.14%.

A useful comparison would be with the dividend yields from shares in well-known NZX-listed companies. Listed investments have the advantage of better liquidity, being easier to sell. But their prices can also be more volatile, increasing the likelihood of capital gains or losses.

But stocks providing similar yields to properties in the examples we used include (as of Monday) AMP NZ Office Trust 8.53%, Briscoe Group 6.73%, Freightways 7.6%, Goodman Property Trust 9.12%, Telecom 9.84%, and Vector 9.87%.

Of course those returns take no account of any potential capital gains (or losses).

However property assets usually enjoy an advantage over shares when capital gains are factored in, because of leverage. If property values rise, the investor gains on the value of the whole property, not just their equity. Investors do not usually borrow money to buy shares so the leverage benefit does not normally apply.

So although RIPs can provide reasonable returns and a good income stream compared with other asset classes, unless there is a significant increase in property values which flows into capital gains, it is unlikely to be a road to riches.

CASE STUDY 1

One-bedroom shoebox apartment in the Zest building, Auckland CBD. Purchased for $98,000

Rental income on this unit was assessed by its property managers at $240 – $260 a week, so we used the lower figure of $240 for our calculations. Because shoebox apartments are often left vacant over Christmas, we used an average occupancy of 48 weeks a year, to give estimated annual rental income of $11,520.

Body corporate fees and rates were $2262 a year and we allowed another $1000 for repairs, maintenance and sundry expenses. At the floating mortgage rate of 5.25%, total outgoings would be $8198, leaving a cash surplus of $3322.

Taxable income, assuming interest payments of $3371, would be $4887, which on the $39,200 actually invested, would be a whopping pre-tax return of 12.46%.

If the mortgage interest rate was increased to 7.25%, the cash surplus would reduce to $2701 and taxable income would decline to $4007. But that would still provide a healthy 10.22% pre-tax return on the $39,200 invested.

Because lenders would be unlikely to provide an 80% mortgage on this type of property, we did not consider that option. (Many would also require additional collateral security to be provided if they were to lend up to 60%).

However, an investor who paid cash and purchased without a mortgage would have a cash surplus and taxable income of $8258 a year, equivalent to a pre-tax return of 8.43%.

CASE STUDY 2

Three bedroom house at Weymouth. Purchased for $218,000.

We looked at three equity scenarios: where the buyer funded the purchase with 40% of their own cash and 60% mortgage finance: 20% equity/80% mortgage and 100% equity/no mortgage.

Because the property was in poor condition, we also allowed for $10,000 of renovations, funded by the investor and added to their equity.

With interest rates expected to rise next year, we looked at the effects of a rise in mortgage interest rates, from the current floating rate of 5.75% to the two year fixed rate of 7.25%.

According to the Department of Buildings and Housing's tenant bond centre, the median rent for a three bedroom house in Weymouth was $320 a week, but because we've allowed for $10,000 of renovations and it had a large section we used the upper quartile rent figure for the area of $350 a week.

Assuming it was rented for an average of 50 weeks a year, this would provide gross rental income of $17,500.

Against that we made an allowance of $3500 a year to cover expenses such as rates, insurance, repairs and maintenance.

If it was purchased with a $130,800 (60%) mortgage, with a 20-year term and fortnightly repayments, the annual repayments would be about $10,982 at the current floating rate of 5.75%.

That would give total outgoings of $14,482 a year, which when deducted from the rental income would leave a cash surplus of $3018.

So on those numbers, it would pay for itself.

But how much money would the investor really make?

The outgoings such as rates and, insurance and maintenance and the interest portion of the mortgage repayments would be tax deductible and able to be offset against the rental income.

We've allowed an average of $7500 a year in interest payments, which would give total deductions of $11,000, leaving taxable income for the investor of $6500 a year, received partly in cash and partly as increased equity through capital repayments on the mortgage.

In the above scenario, the investor would have contributed $87,200 to purchase the property and a further $10,000 towards renovations, taking the total amount of cash invested to $97,200.

Taxable income of $6500 on the $97,200 invested would be equivalent to a pre-tax return of 6.7%.

If the mortgage was increased to 80% of the purchase price, the higher mortgage payments would severely impact on cash flow, leaving a cash surplus of $642 a year, putting the investor at risk of having to dig into their own pocket to prop up the investment if anything went wrong.

Higher interest costs would reduce taxable income to $4000 a year, which on the lower equity of $53,600 would be equivalent to a pre-tax return of 7.46%. But the cash surplus would be marginal and would be insufficient to cover likely income tax.

If an investor purchased the property and paid for its refurbishment without mortgage funding ($228,000 equity) the cash surplus and taxable income would be the same – $14,000, providing an equivalent pre-tax return of 6.14%.

So what happens when a mortgage interest rate of 7.25% is factored in?

Where the mortgage was 60% of the purchase price, the annual cash surplus would reduce to $1638, while taxable income would decline to $4544.

If the mortgage was 80% of the purchase price, the property would produce negative cash flow of $2483 a year, while taxable income would be $1390.