What is a Reasonable Price to Pay for an Investment Property?

Financial Autonomy is a framework that identifies three paths to gain choice. I have identified these pathways through working with clients for many years and observing how people who have achieved financial freedom and security have done so. These three paths are investing in stocks, investing in real estate, and self-employment or entrepreneurship. Financial Autonomy explains that most people choose to combine two or three paths.

In my experience, someone strives to achieve freedom through a single path. While I am most comfortable with investing in shares, real estate investment is still on my radar.

This week’s blog is inspired by an actual problem my wife and myself are currently experiencing. We’ve been thinking about the possibility of buying an investment property when prices are low. This week’s title is exactly the question we’ve been bouncing around: what is a fair price to pay for a property as an investment?

It’s good to know that there is no need to act. It’s not often that you can take advantage of an economic downturn in your career. I don’t want to miss this opportunity. With many clients, I have noticed that the success of investment properties is often a matter of luck. Property values rise in bursts. Property values can increase for a few years, then plateau for five or more. You can enjoy a great deal of growth if you are lucky and buy at the right moment, but you could also be stuck paying for maintenance, council rates, and loan costs while the price stagnates.

By the way, I am not saying that I know all the answers in this blog post; far from it. It might be useful to share my thoughts on whether or not a property investment is a good idea. If this is something that you are also considering, it may help with your thinking process.

It’s worth it!

I’m starting with the fact that investing in properties is a pain. As an investor, owning shares is easy. Dividends are paid every six months, and I don’t have to do any work. All of this does not apply to property. For me to consider a property as an investment, I need to be convinced it’s attractive.

Leverage is the number one attraction of property investments. If it weren’t for how easy it is to borrow money for property investments, the property would not be an asset class that I was interested in. We are able, due to the equity we have in our house, to borrow the full purchase price. If the value of our property increases, we could achieve a great return on investment. As we have discussed in previous episodes, borrowing money to invest is not without risk. We will discuss the risk of rising interest rates, but another risk is the fact that you have to repay the loan if your property’s value drops.

Rental Yield

Rental income and growth in value are the two components that make up the return on investment property. The growth component is the most controversial. In the past, Australian property values have risen because of a growing population. COVID has disrupted that trend, but it seems likely that immigration will continue to drive population growth. This is something that should be considered and not taken for granted. Japan and Europe are experiencing declining populations, and property prices tend not to increase.

While I am confident that the property market will grow over the next ten years, any growth in a shorter time frame is a big question mark for me. Unless I invest a lot of money and time in renovations, I will get my money back.

Growth is what I want and why I invest, but if I buy an investment property, it has to be a good one from the point of view of rental income. Rent income is something I’m confident about. I can check online to see what stocks are available and what weekly rent is being asked. If I am buying in an area with a high population, I have reasonable confidence that another tenant will be found within a short time if the first one leaves.

When I purchase a home, I am aware that I will have to pay for the following: interest on my loan, council and water rates, insurance and maintenance fees, and Owners Corporation fees. It is hard to estimate the amount of maintenance, but you can get a good idea of it when you buy a property.

You’ll want to pay off the principal at some point, which will increase your monthly outgoings. However, this also increases the equity in the property. So, while I must consider the cash flow, I do not think about it when deciding on a fair price for an investment property.

Negative gearing is a concept that you are probably familiar with. Negative gearing occurs when the investment costs exceed the income received. Negative gearing can be viewed as a way to build wealth through tax subsidies. While there may be some truth in this, you shouldn’t ignore the fact that your investment will make a loss. More money is going out than it’s coming in. Tax savings are good, but only if your property value increases. As we discussed, this is not guaranteed.

A small amount of negative equipment is okay for me, but I do not want to see a large gap between the rental income and expenses. I currently think about rent as a percentage of the price. I’m looking for the rental yield to be roughly equal to the loan cost. This way, I can be sure that my interest costs on the loan for the property are covered, and I only need to cover the expenses of ownership. I run the risk that interest rates will rise, that the property may be unoccupied for a while, and that the wear and tear of a home mean that carpets and kitchens might need to be updated at some point.

Renting out an investment property at a price that covers the interest is still a risk. But for me, that is the risk level that I can accept.

Interestingly, I have found in my research so far that the rent rarely covers the interest expenses. The property prices don’t seem to have adjusted enough for the fact that interest rates are 5% and higher. Rents may need to be raised more, but I think they have been rising fairly quickly. The property prices have not adjusted enough, at least so far.

We prefer to purchase a property that has an owners’ corporation, as it makes the process easier. It’s mainly apartments, and you are looking at properties with one or two bedrooms.

According to my research, I found that it is easier to buy a one-bedroom property where the rental yield is equal to or greater than the interest rate on the loan, but a two-bedroom home is more difficult to purchase. This is an interesting dynamic. A unit with one bedroom might sell for $300,000 and bring in $300 per week. However, a unit with two bedrooms might cost double the price but only generate $450 per week. We prefer to purchase a property with two bedrooms because we believe that tenants will be more interested in renting it. They might use the second bedroom for a home office if they work from home. Single parents may want to use the second bedroom as a home office for their children. Two people could share a house, and each has a bedroom. While that is our preferred option, it isn’t easy to get the numbers to work.

Future Interest Rates

As my focus is on the income equation, assumptions about interest rates are an important input. The Reserve Bank is expected to raise interest rates by another half percent from this point. What if I’m wrong? Even if they are correct, how long will this rate last? If I base my calculations on a 5% rate of interest, but in 18 months, the rate has risen to 7%, I will be very unhappy, and my investment value is likely to have decreased. What if rates, as predicted by some, peak in the next few months and then decline over a year or so? If this is the case and I am able to buy a property with a rental yield that is roughly in line with the current interest rates, I will be in a good position.

No one has a magic crystal ball. You have to consider the probability of each scenario. Then, you can proceed from there. As it should, investing is not risk-free. We receive our returns because of risk. As investors, it’s our responsibility to consider the risks and identify opportunities that make sense in relation to the risk.

How would you rate the liveability of a city?

While we are shopping, a new challenge arises in deciding what value to assign to liveability. What is the value of being close to a beach, for example, or walking distance from a train station? What is the value of a nearby car park or trendy shopping area?

My problem is I haven’t found a solution, but I feel that the rent should reflect these qualities. I, therefore, don’t think I need to change my decision-making process in any significant way. Rents should be higher if living near the beach is more desirable. My criteria is that the rental yield should roughly match the interest rate on the loan still holds. My research to date doesn’t support that. It may be the case that owner-occupiers are more likely to buy a property if it has a higher liveability. This will push up the price without necessarily increasing rents.

This is not something that I have figured out, but it is definitely a factor when investing in real estate. I’ve spoken with several agents who have been involved in the property market over the years. They often stress the importance of purchasing a “quality” home, whatever that may mean.