Tags: investment property
Let's review the numbers using John and Joanne's example. They are first time property investors from Melbourne who have decided to invest in residential real estate to earn capital gains. However, because money is tight, they definitely want to minimize a negative cash flow outcome.
After window shopping at real estate agent display ads, John and Joanne sourced the usual property: a three-bedroom house with a pool at the rear.
The property is on the market at $345,000. The likely rent is $480 per week for the house.
Where to start
John and Joanne must first establish whether or not they can afford to buy this property, as well as if the likely profit outcome falls within their investing plan.
The place to start is to work out the true cost of the property, which means identifying and calculating the impact of settlement costs. Settlement costs are add-on expenses associated with buying a property and organizing finance.
In John's and Joanne's case, the settlement costs would be (figures denoted with a ^ indicate that it is a budgeted rather than a certain amount):
Step one: understand the purchase costs
Stamp duty: $10,500
Conveyancing costs and searches: $1500^
Transfer fee: $571.00
Total purchase closing costs: $12,571
Step two: understand the true cost of finance
Let's assume that John and Joanne borrow 90 percent ($310,500) on a 30-year principal and interest variable loan. The current interest rate is 6.68 percent.
Application fee: $919 (includes valuation and bank legal fees)
Mortgage Registration: $124
Lenders Mortgage Insurance: $4,470 (because we are borrowing over 80% lenders require loans be mortgage insured)
Total loan costs: $5,513
Step three: understand the total purchase price and how much you'll need
Total purchase costs: $12,571
Total loan costs: $5,513
Total cost: $18,084
Purchase price: $345,000.00
Deposit (10 percent+costs): $48,114
Loan Amount: $314,970 (90% of purchase price+ mortgage insurance)
Step four: look at the likely cash flow outcome (best case scenario)
Rent: $24,960 pa ($480 x 52 weeks)
Loan payments: $21,039 p.a ($404.61 * 52 weeks)
Rental manager: $1580 p.a ($19,760 * 8 percent^)
Rates: $3200 p.a^
Total expenses: $25,819
Annual negative cashflow: -$859 p.a ($16.50 wk)
Step five: identify the return
Would you get a better return putting your money in the bank at 4%p.a
Cash needed to buy: $48,114
Cash on cash return: $1,924 p.a in the first year
Step six: identify areas of risk
The return in step four is based on the best case scenario. There is no allowance for:
While the initial contract price is $345,000, John and Joanne will end up paying $363,084 after settlement costs.
Currently the selected property has a negative cash flow and compared to cash it doesn't stack up, but what we haven't taken into consideration is the tax credit that you would receive and the capital growth the property will receive in time.
Assuming they have the money for deposit and costs, this property seems to meet their stated planned outcome of being at least close to cashflow neutral and have a long term outlook that would see this property become cash flow positive in the near future.
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