Don’t Do These 4 Things When Investing in Rental Property
Most of the students that I’ve coached in Steve McKnight’s Property Apprenticeship program own one or two rental properties. They’re inspired to learn from Steve because they dream of building a real estate portfolio that will provide passive income for an early retirement.
After the first few sessions in Steve’s course, many of them say something like, “%#&$, I wish I would have done this course before buying my last property!”
Most of us tend to learn what not to do the hard way. While I’ve personally fared well in my property deals, I can’t say the same about my share investing.
The primary difference between my property investing and share investing is simple – I sought mentors to guide me through property transactions, while I attempted to invest in shares on my own without a coach, and with very little training.
There’s an ancient Hebrew proverb that says, “Poverty and disgrace come to him who ignores instruction, but whoever heeds reproof is honoured.” While productive failure has its merits, the highest wisdom is to learn as much as possible from others who have done what you hope to do.
In hopes of helping you avoid the common pitfalls, here are the top four things not to do when investing in rental property:
1. Don’t Assume That All Real Estate Only Goes Up In Value.
On a recent trip to Melbourne, my wife and I visited a day spa. She wanted a pedicure and I was quite happy to lie flat and let someone rub my back. When we were checking in, the lady asked me what I did for a living. She responded, “Oh, I tell all the young people who come in here, ‘Buy property! It doesn’t matter where or what it is, just buy property. You can’t lose!’”
What she was essentially saying is, “All real estate only goes up in value.” I was thinking of some people who I wanted to introduce her to that could give her a dose of reality.
One couple I was thinking of retired a few years ago after selling their family farm. They used a million dollars to buy a personal residence. Then, upon the recommendation of a popular real estate investing “educator,” they sunk the other million dollars into rental properties in a Queensland mining town.
They loved life for a few years, raking in a six figure passive income. But, when the mining industry slowed down, the mines realized it would be cheaper to fly in and fly out their employees. The property market took a massive hit. Now their rental properties aren’t worth half what they paid for them and if they can get tenants, the rental income is abysmal.
Many Australians have seen significant capital growth in their rental properties over the last few decades. So much so, that some would say we’re due for a pullback. If you’re bullish on real estate in a particular area, be sure you can justify your opinion with plenty of cold hard facts.
2. Don’t Ignore The Importance Of Rental Yield.
Because we’ve seen significant capital growth over the last few decades in Australia, and because rents have not increased at the same pace, rental yields have taken a big hit.
Gross rental yield is a function of the purchase price of your property and your rental income. In other words, rent/price = yield. If you purchase a property for $300,000 and your tenant pays you $300 per week, assuming a two-week annual vacancy, your yield is five percent.
But it’s helpful to compare the yield from your rental property with the average historical yield in Australia. That will give you an indication of what you might expect in the future.
Although this post from rpdata is over a year old, it contains a chart that shows a helpful picture of the change in dwelling values and rents versus gross rental yield. Notice how yields were historically over seven percent before the boom. Now the average yield in capital cities is barely over four percent. This is not sustainable. Once Aussies wake up to the reality that properties don’t appreciate indefinitely, they will demand higher yields.
If you’re planning on buying a low-yield property today, be mindful that future investors will likely be putting pressure on yields to rise. Why wouldn’t they, when the risk-free returns from the banks are higher than the net after tax yields of rental properties today?
What causes yields to rise? There are only two factors: either rents will rise or property values will decline. You can safely expect at least a little of both.
3. Avoid Investing In Rental Property To Lose Money.
One of the primary tax laws propping up the Aussie real estate market today is the negative-gearing benefit.
When property costs are greater than property income, the ATO allows the investor to offset that loss against their personal income. If this places the investor in a lower tax bracket, and if the property appreciates in value, it’s a win for the investor.
Since I can’t improve upon what Steve McKnight has already written about this topic, check out his Seven Negative Gearing Truths here. In a nutshell, here’s what he says: “Be very careful about blindly purchasing any kind of property. Be extra cautious when buying something when the outcome is likely to be negative cash-flow.”
4. Don’t Mix Business With Pleasure Or With Charity.
When I first begin working with a client, they often share with me what investment properties they currently own, and why they acquired them. It’s not unusual to hear things like:
“This one is also a holiday home.”- “The vacancy rate is a little high, but the view is incredible.”
- “My son is living in this one. He still owes me a few months’ rent.”
- “We built this house for my sister to live in after her divorce. We were looking for a rental property anyway, and wanted her to have some place stable to live.”
“This one is also a holiday home.”Now don’t get me wrong. I’m a big believer in having fun, going on holidays and even buying a holiday home if you can afford it. I also believe it’s important to look after our family when we can afford to.
But it’s also important to be clear on when we can and cannot call a piece of real estate an investment asset. The goal of an investment asset is to make money. But, the goal of a holiday home is to have fun, and the goal of moving a family member into your property is to show love.
There’s nothing wrong with owning property for reasons other than making money. Just don’t call it an investment. Here’s why:
What happens when your son doesn’t pay rent? Will you evict him? Unless you’re the most evil mother on Earth, you’ll give him chance after chance. You’ll also probably justify why you need to cover his rent for the next six months. Your love has rendered you powerless to make a good investment decision. This is how it should be.
And what about the holiday home as an investment? Any time we allow any factor other than growth or income to play into an investment buying decision, our judgement has been clouded. Disciplined investors always focus on the numbers.
Conclusion
These four fundamental truths are some of the basics that we teach in Steve’s course. Whether you learn from Steve or from someone else, be sure to invest in your property education.
Although it’s never too late, the best time to educate yourself in property is before doing your first deal. You’ll find there are some fundamental truths that can save you from a world of pain down the track.
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