The residential property market has been weak over the past couple of years but it continues to be a core investment, alongside shares, cash and fixed income securities. The lesson from the fall in prices since 2010 is that investors have to make sure they pay attention to all the details when they invest in real estate: get the right finance; be clear about all the costs they will have to pay and stay on top of tax issues.
Getting the right finance
Property investors need to be able to control their costs to make sure they are getting an adequate return. One cost that will be subject to considerable variation during the life of an investment property is the interest rate on a variable rate mortgage.
Taking out a loan with a fixed or part-fixed rate make a lot of sense for property investors, says Sheyne Walsh, an adviser in the lending service division of Centric Wealth.
"For people who want to manage their expenses our view is that fixed rates are a cheap form of insurance," says Walsh.
"If it a choice between fixed or variable, borrowers usually prefer not to give up the flexibility of accelerated repayments, lump sum payments, offsets and redraws that comes with a variable rate loan. Where we recommend fixed rates we always suggest some variable as well."
The other question investors have to consider is their level of gearing. If their annual interest cost on their borrowing exceeds their rental income they are negatively geared. The advantage of negative gearing is that an investor can claim a tax deduction on their interest cost (net of rental income). The disadvantage is that they will not have any rental income available to live on.
If rental income exceeds interest cost the borrower is positively geared. The decision to be positively or negatively geared depends, to a large extent, on whether the investor wants to tax deductions or needs the income from the investment property to live on.
Understand the costs involved
Investment consultant Monique Wakelin, a director of Wakelin Property Advisory, says management and maintenance costs can consume as much as 25 per cent of annual rental income from an investment property. Costs include agents' or managers' fees, insurance, rates, body corporate fees and land tax. The managers' fee alone can be between two and five per cent of the rent.
On top of the purchase price investors have to allow for stamp duty, legal fees, conveyancing, pest and building reports. On a $400,000 investment property, stamp duty in New South Wales would be more than $13,000 and in Victoria more than $19,000.
Investors must include rental income from an investment property in their annual tax return (there is no GST on residential property rent).
Investors can claim tax deductions for many of the expenses involved in maintaining an investment property. This can get complicated because the Australian Taxation Office makes a distinction between repairs, which are deductible in the year the cost is incurred, and improvement, which affects the capital gains tax you pay when you sell the property.
Capital gains tax is payable when you sell an investment property.
The state of the market
Property market cycles are much longer than other market cycles. Share markets tend to rise and fall every three years but the last time there was a big residential property market slump in Australia, in 1990, the market took five years to recover.
Property prices have been falling for two years. From their peak in 2010 to their low in March this year, the Australian Bureau of Statistics puts the drop at 6.1 per cent, RP Data Rismark at 5.6 per cent and Residex at 3.2 per cent.
According to the latest RP Data report, published earlier this month, the capital city aggregate dwelling prices was down 2.4 per cent over the 12 months to the end of August.
ANZ Research published a report on the Australian property market in July, which says the market is showing "tentative" signs of stabilisation, following a period of considerable softness.
ANZ says: "The recent softness in prices has been mainly driven by weak household sentiment rather than economic fundamentals."
"In the absence of a sharp global economic downturn and escalating domestic unemployment, improving housing affordability, solid household financial positions and strong housing market fundamentals should support modest house price growth into 2013. We expect prices to increase at a moderate four to five per cent by the end of 2014."