Insights into residential property investments

Introduction

Last week a client showed up looking for advice on how to work through a residential property purchase. He challenged us to come up with 2 approaches - aggressive and conservative that highlighted the basic for his partner! This particular client has seen the ups and downs of life, love and humanity and we knew that he likes information to be presented simply in an tabular form!
So we got to work…and in that process we uncovered some insights that we thought we'd share with our clients!
Please note that we are NOT recommending one approach over the other and acknowledge that the right answer for you will lie somewhere in the continuum. In working through the scenarios, given the purpose of this article, we consciously removed all impact of tax structures, available tax losses, different types of mortgage products available in the market today and your ability to negotiate any variance to those.
We've woven our insights into a story about John and Jane - see if you can pick them before you read the key insights part of the article!

John and Jane

The scenario is based over 7 years. Everything remains the same except in year 7

• both John and Jane are laid off, and
• They are unable to tenant their apartments for an extended period of time due to some reason for example methamphetamine contamination or anything that will take a little time fix!

The property

• Residential, as its value is dependent upon emotions & opinion as opposed to commercial properties where value is dependent upon cashflows.
• 2 x exact design properties, located side by side with exactly the same location & environmental advantages,
• Purchase price, say, $250,000 - suitable for investment purposes!
• For the purposes of this analysis, there are no other costs and the legal fee is fully paid by the bank.

John

• Has a salary of $75,000 with $50,000 in deposit!
• Is highly motivated individual and wants to pay off the property as soon as possible.
• Only knows one way to use financing, and that’s the way that his parents taught him how to do: Put down as much money as possible and finance as little as possible!
• Is going to put down 20% because that’s what his parents did when they bought their home, and
• Wants to build as much equity as possible and as fast as possible, while at the same time paying down the mortgage as fast as possible.
• He’s going to get a 15-year fixed, which will allow him to pay off the property in just 15 years.
• All the money he makes from renting the place plus some from his salary, he intends to pay towards the mortgage so he able to pay off the mortgage with in the 15 Yr term.
• The apartment is kept up, and it appreciates at 3% per year.

Jane, on the other hand

• Has a salary of $75,000 with $50,000 in deposit!
• Is also a highly motivated individual, but she grew up on the other side of the country. Her parents didn’t teach her much about finance, so she had to study it on her own.
• Has come to the conclusion that she is going to do exactly the opposite of what John is going to do.
• Is going to take as long as possible to pay off the mortgage, and that means getting a 30 year period on her mortgage loan.
• Is going to put as little down on the property as possible, and in this case, it’s say 3.5% with an First Home Allowance. (Yes we know the current minimum is 10% deposit but in order for insights become more obvious, we've sort of adopted the poet's license and reduced the deposit requirement!
• Is going to save the difference in monthly mortgage payments ($302) and put that in her savings.
• The apartment is kept up, and it appreciates at 3% per year.

The Numbers

 Please take your time reading these slowly trying to spot the insights

Key Insights

1. Cash vs. Equity: Cash IS king and Equity is completely useless unless you want to calculate net worth! On a day to day basis ones net worth is as useless as the 'g' in Bolognese sauce! Cash is liquid money and is absolutely essential when you finance real estate. When the proverbial hits the fan, cash is what you will need as then, even your net worth will take a hit - even though it may be short term!
2. Value vs. Financing: The value of a residential property will go up or down regardless if you have a mortgage on the property. Value is completely out of your control in residential real estate because it’s usually based on someone’s opinion instead of cash flow (like commercial real estate). This is an important point when investing. Home mortgage money is ALWAYS the cheapest money that you’ll ever borrow, so why not finance as much as possible. If the numbers don’t work for the smallest deposit possible, move on to the next property. Remember, a good investment property is one that produces net cash flows to your liking, not one that adds to your "equity” only. 
3. Smaller down payments vs. bigger down payments: This goes along with reason number one. Nobody cares about equity unless you’re trying to determine your “net worth.” So, when given the choice of putting down a lot of money or a little money, put down a little money and either save or invest the rest. Leverage is key. Nobody ever got rich using their own money! Use the bank’s money most effectively. Don’t put more money into a property to try and generate a cash flow. Just move on to the next one.
4. Long Term Mortgages vs. Short Term Mortgages: Remember, when you’re financing an investment property, you can always pay more, but you can NEVER pay less. Leverage, again is key here. A shorter term mortgage means that your payment is going to be higher — period. Regardless of the interest rate you’ve obtained on your short term mortgage, it will be more than a longer term product, even if the longer term product has a higher interest rate. Every single dime, nickel, or penny you give to the bank is money that you’ll never get back unless you refinance (borrow against the house as collateral) or sell. Those are usually major transactions.

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Challenge yourself to find a cash flowing residential properties that enables you to make a smallest possible down payment, get a longest possible term mortgage, and to top up as little as possible from your other sources, the costs of maintaining the property. As there is a whole continuum. this puts you in position to best manage the cashflows and equity gain in a way that minimises the impact of significant events over the term of the investment!

Key message
Overall the simple message is this. In order for key insights to become obvious, we've made some radical assumptions about the house price, deposit requirements, annual property appreciation rate, levels of maintenance, fixed period of the loan contract, no negative gearing or tax advantages, bright line test, your tax structures etc All of these impact your choices and have consequences on your tax position. If you have questions about yours check with your advisor at Core Business Services advisor about. S/he can outline what works best for you. 

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Disclaimer
The above publication discusses income tax & other issues generally and is not intended to be specific tax or other advice. Whilst every effort has been made to provide valuable, useful information, Core Business Services Ltd, any related suppliers, associated companies & practices accept no responsibility or any form of liability from reliance upon or the use of its contents. Any suggestions should be considered carefully within your own particular circumstances, as they are intended as general information only. Please do consult with your tax advisor or call this firm for information / advise specific to your circumstances before finalising any particular course of action.