Measuring returns on an investment property.

Hi, I’m Bron Lawson from Westpac’s Davidson Institute here to talk to you about ‘Measuring returns on an investment property’. This is the third in our series of videos on investing in property and today we are talking about measuring the return on our investment property. Why? Because just like any other investment the reason we invest in property is to help create additional income, build wealth, and work towards a better financial future.

In this video we are going to explore the concept of how we know when an investment property is profitable. And achieving the goals that we wanted it to. In the other videos in this series, we covered things such as ‘why we invest in property’, investment strategy, the risks of investing in property, and financing the property. This video looks at some of the financial aspects of property investment to get a clearer understanding of whether the property is performing as an investment.

We are going to look at how the property might impact our personal cash flow and how to put together a cash flow forecast for the property to ensure it is either self-sustaining or we know when we are going to need to dig into our own pockets to support it. We’ll also look at how we measure the return we are getting on the money we have invested, and finally what are some of the things we can do to maximise those returns?

Investing in property is not a set and forget investment. There are lots of moving parts, an important one of which is your personal cash flow. So, let’s delve into how an investment property can impact your cash. Cash flow is as simple as ‘cash in’ less ‘cash out’. ‘Cash in’ will generally be rent collected, most commonly on a monthly basis. Cash going out is quite a number of different things that we will look at shortly.

Understanding your subsequent cash position – either surplus, deficit, or neutral – and managing that, is an important part of getting the most out of your investment. So, we have cash coming in from the investment in the form of rent. Looking at the investment holistically we’ll also have cash in when we sell the property and exit the investment.

Then in terms of the cash out … Firstly, there are a number of up-front costs, including the property purchase. This was covered in the ‘Financing an investment property’ video so I won’t go into those details again here.

Once we have established the investment, there will be some ongoing costs … these include things like your loan repayments and interest, property management costs if you have the property managed by an agent, your council rates and utilities such as water, repairs and maintenance, and it’s important to insure the property too, not just for loss or damage to the property but for loss of income as well. Depending on the ownership structure and value of the property you may incur Land tax too.

When it comes time to sell the property, or exit the investment, there will be other costs such as agents’ fees to sell the property, solicitor costs for the conveyancing, there may be costs to exit your finance, and you should consider, and get advice from your accountant, as to whether you might incur capital gains tax on the sale too. We’re going to focus here for the moment on the ongoing day to day management of cash flow.

An effective way of getting an understanding of whether you have a positive or negative cash flow is to put together a monthly cash flow forecast. This matches up the cash in, your rent, against your cash out such as management costs, loan repayments etc. Thus, you can see where there may be peaks or troughs in the cash flow from the investment, so you are aware of when your own cash flow might be impacted. That is, when you may need to put you hand in your own pocket to support the investment.

Let’s have a look at an example of a month by month cash flow. So, let’s say this property is receiving $300 per week in rent which is ‘cash in’ of approximately $1300 a month. ‘Cash out’ is most likely to be things like management costs, let’s say roughly $90 a month, loan repayments of $1200 a month, and insurance of $60 a month … meaning that each month the cash flow from the property is in deficit by $50 and will need to be supported from other resources.

Then in this example, in August there is some maintenance due on the property which will need to be provided for from other resources as well. Isn’t it great though to have that visibility and to then be able to make considered decisions on how to supplement the cash flow beforehand rather than be surprised at the time and have to scramble around to find the cash?

By doing this for a whole year you will have a much clearer view and can plan more effectively for how you are going to cover shortfalls, as well as what might be the best use of any surplus cash.

So, that’s looking at how an investment property might impact our cash flow however it is equally important to measure the overall return from our investment as well. There is considerable time and effort involved in selecting and managing an investment property, not to mention a number of associated risks, so we need to assess whether the property is providing sufficient return in line with our overall investment strategy.

One way of measuring returns on the investment is to calculate the Gross Rental Yield. This ratio simply compares the amount of rent received with the amount of money invested. It gives an indication of how effectively the investment property is generating an income. To calculate the Gross Rental Return, take the annual rent received on the property and divide that by the purchase price of the property and multiply by 100 to get a % return.

By way of example, a property rented for $300 per week calculates out to annual rent income of $15,600 (assuming it is tenanted 52 weeks of the year); divide that by the purchase price of $300,000 and this property is achieving a 5.2% return. This can then be compared to other rental returns in the area to determine whether the property is performing in line with others, and with the investors’ own anticipated return from the investment.

Remember though that this ratio doesn’t take into account capital growth of the property, nor the expenses associated with the property. I’d suggest it’s also worth looking at another common measure, Net Rental Return, which does take into account the holding and managing costs including the effects of depreciation and tax.

This is a more complex measure that we won’t go into today, but I highly recommend discussing with your accountant or financial adviser which measures are the most appropriate for your investment strategy.

So, how can we then measure the return including the capital growth in the property? To realise capital growth of course you need to sell the property so this next set of measures we’re going to look at includes the income and outgo of buying and selling the property as well, providing a comprehensive measure of overall performance.

One way to do this is to develop a profit and loss statement, or P&L. An investment property is a vehicle intended to make money for us and as such can be treated like a business. A P&L looks at what income has been received over the life of the investment, less the costs that have been paid, to determine how much money has been made from the investment.

For example, let’s say this investment property has sold for $395,000 and the rent received over the life of the investment is $47,000. This is total ‘cash in’ of $442,000.

Then record all the costs associated with the property over the life of the investment … the purchase price of $300,000, upfront costs of $35,000, interest and fees of $50,000, annual maintenance, rates and so on of $15, 000, and final exit costs of $5,000. A total of $405,000. Take the costs away from the total income and we’re left with a profit of $37,000.

So the investors have made a profit from the investment of $37,000 (not taking into account any taxation benefits or costs). But let’s take this a step further and see how this stacks up in terms of % returns.

Return on Investment ratio or ROI is really useful when you are considering the entire investment, including the sale of the property. To calculate it, simply determine the profit from the investment using the P&L format that we just looked at and then divide that by the total costs spent on the investment, and multiply by 100, to get a percentage return.

In the example we just looked at, the profit was $37,000, and if we divide that by the total costs (let’s call it funds invested) of $405,000, this calculates a Return on Investment of 9%. This return can then be compared with other investment options, such a term deposit or shares, to establish whether this investment has performed well or not. Was the money invested well here in property or could a better return have been achieved in another type of investment?

Let’s now look at some of the things we can do to maximise the returns on an investment property. This means maximising the income and minimising the costs so here’s a few hints on how. In terms of maximising income: • Your property selection is vitally important. You’ll want to select a property that is in a sought-after location, that has the features that are going to be attractive to tenants, and keeping it well maintained will help maximise your occupancy rate.

Setting the rent can be a tricky part of the equation. After all, in most instances you’ll be looking to cover the majority of your costs but you’ll also need to take into account the local market conditions. Ideally, you should aim to set the rent at a level that is going to attract good paying, long-term tenants • Ensure you have landlord’s insurance to cover both damage to the property and loss of income should something go wrong with a tenant.

Now, how can help keep costs down? • The biggest cost with most investment properties is interest so shop around to ensure you get a competitive rate of interest on your finance. • Reduce your finance as quickly as possible to keep interest costs down. Let me show you an example how the simple actions of making fortnightly repayments instead of monthly can make a significant difference to the costs over the life of the loan.

In the example on the screen I’ve used the MoneySmart “How can I repay my home loan sooner?” calculator to demonstrate the difference. I’ve looked at a home loan of $400,000 at the variable rate of 4.52% and we can see that by making repayments of ½ the monthly repayment on a fortnightly basis we can significantly reduce the overall term of the loan and the interest costs. In this example, the overall term is reduced by 4 years, and the interest saving over $40,000.

The time and interest savings are generated because the more frequent repayments reduce the principal amount more quickly, which reduces the interest that is charged. So, if it suits your cash flow to make the fortnightly repayments as opposed to monthly you can achieve significant savings on the interest costs for your investment property.

Continuing with our ways to minimise costs … • Regular maintenance helps to keep the property in good condition to hopefully avoid any significant unexpected repairs. • Keep your agent honest. Shop around for competitive property management fees. But also remember that you get what you pay for. You may choose to pay a little more to ensure you get a property manager that is going to take care of your property and your tenants as they’re likely to achieve better results in the long run.

In this video we have looked at how the property might impact our personal cash flow and how to put together a cash flow forecast for the property, how we measure the return we are getting on the money we have invested, and finally what are some of the things we can do to maximise those returns?

We hope you’ll take the time to watch the other 2 videos in this series on ‘Investing in property’ and ‘Financing an investment property’ as getting your finance correctly structured is one of the keys to achieving the returns you’re looking for from investing in property.

Thank you for watching our video on ‘Measuring returns on an investment property’. I trust you found it helpful and I encourage you to check out the other resources on the Davidson Institute website to help build your financial confidence. Bye for now.