37 – A Few Reasons for Investing in Property

rcrIt’s been a hard couple of weeks here. With a bank pre-approval valid for only three months before the reams of documentation would need to be supplied anew, it was go-time for getting agreement from Gemma and setting the wheels in motion with Open Corp for the second investment property purchase. I thought Gemma remembered and understood the reasons for buying the first property—and how that logic extends to a second. As my external voice of reason, however, she was reluctant.

A refresher was in order. I spent a few evenings nagging Gemma to think it over. I drew a few simplistic diagrams on the kid’s chalkboard to reinforce the key points. I asked her to re-read the very readable Property Investing Mini Guide from Open Corp (which I’d helpfully underlined and annotated—because that’s how I roll).

Gemma wasn’t sure about the risks but couldn’t explain to me the basis for her reservations—her default financial strategy is to ‘put it in the bank’ and ignore the negative impact of inflation. Her preference was to take a wait and see approach with the first property, which isn’t a good move if house prices continue to climb and become less affordable. How long do we wait? This first year also won’t tell us much: since the first property is in her name and she’s on maternity leave, we won’t see many tax benefits this financial year.

I argued the experience of the first build went well and the process of buying and tenanting was an exceptionally solid result with Open Corp. We wouldn’t have a long-term view of success or failure for the better part of ten years or more (one property cycle) but doing nothing with our available equity would leave us behind as inflation eats away at out savings at a rate of ~3% a year.

What should be an emotionless decision was quickly becoming a very heated emotional debate between us.

In addition to my points above, I banged on about historical growth rates, leverage, and risk.

Historical Capital Growth

Looking back in time we see Australian house prices growing continuously since the 1970’s (and well beyond). Whatever happened (or started happening) back then—be it government forces, population and other demographic shifts, war, tax incentives, rising incomes, or other market forces—has tended to continue. That’s over forty years of generally positive data.

chart2

The past is not a guaranteed predictor of the future but it does provide some guidance. Of course you’ll also find arguments against property investment using similar data—see this article which proposes we’re in a housing price bubble.

Leverage

Buying a property seems expensive but it’s not. We pay the up-front transaction costs (indirectly through a line of credit) and borrow 100% of the cost of the property through a combination of the line of credit and a primary loan. In other words, we put in about $70k to invest $380k. That’s a powerful thing: by my very simple math, if we put in a dollar, the banks put in $5 and the interest costs are largely covered by the rental income, tax deductions, and depreciation. Yes, both the LOC loan and the primary loan are subject to interest rate increases and other legislative changes (e.g. negative gearing) and it’s always wise to take these variables into consideration when doing your sums.

Risk

I’ve written about risk before but the options are simple.

1. Do nothing and inflation calls the shots. Even in a term deposit or a high interest savings account, your position will probably decrease or remain flat (i.e. unproductive). Real estate can be considered as a hedge against inflation given the relationship between GDP growth and demand.

2. Invest in the share market and Ben Graham’s insane Mr. Market calls the shots—in other words, the share markets are unpredictable and crazy; unless you’re investing in the company itself and understand the industry and the internals of the company, you’re betting against the house—so to speak. Plus, you don’t have any control over how your investment is put to work.

3. Invest in real-estate. Land has a long-term history of appreciating in value and putting a house on it will ensure the costs involved in holding the land are manageable. In time, the rental income may cover those costs and provide an income stream. If everything else turns to pot, at least you can live in a house and capital increases are potentially accessible via equity loan.

These aren’t the only arguments to consider but they’re a good starting point and encompass many of the finer details. Here a few more points to consider:

  • Real-estate investment is relatively easy to understand
  • You have more control over your investment than you would as a stock investor
  • You can create value (e.g. by renovating)
  • As a long-term investment the impact of any initial mistakes are likely to be lessened over time
  • There’s less volatility in the real estate market than there is with the stock market
  • Bricks and mortar have a high tangible value (compare to investment in a start-up that may have a product idea but no product and no revenue stream)
  • Rental income provides a stable income
  • Housing will always be in demand as our population increases
  • You have many options for managing your investment (subdividing, doing your own maintenance work, using a property manager or doing it yourself)
  • Portfolio diversification
  • And so on

In the end, Gemma came around and the IP#2 wheels are turning. We signed the hold agreement with Open Corp, put down the $1k hold deposit and $2k land deposit when returning the land contracts.

Gemma did caveat her approval of this build: this second property would be our last for a little while. I’m fine with that as this purchase will come close to exhausting the small line of credit we took out for the first build, secured against our PPOR, and the banks may not be too willing to extend us a third loan given the fact I’ll be back on stay-at-home dad duties in the next few months. The general tightening of the financial lending market over the last few years doesn’t help much either on this front (I’m not quite sure how the 26 year-olds in the magazines amass 10 properties in such a short timeframe!).

On request, Open Corp came back to us with a 400sqm property in Victoria, an hour’s drive south of Melbourne. I’ll discuss the specifics—and recount the process to acquire and build, as I did with the first IP, in future posts.

I suppose a disclaimer is also worth posting: I'm just a guy, I'm not an accountant, lawyer, solicitor, tax agent, mortgage broker, banker, financial adviser, insurance agent, land developer, builder, government agent, or anything else so I disclaim your application of anything I write here is to be applied at your own risk. What I write may be incorrect and you are best to seek your own professional advice (tax, legal, financial, and otherwise) before entering into contracts or spending your money. Your situation is unique to you and what I write here reflects my experience only. This content is not professional advice and is not tailored to your situation. I'm learning too and expect to make many, many mistakes along the way.

Enjoy,

Michael

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