How to reduce risk when buying an investment property

How to reduce risk when buying an investment property

Australia’s property investment market has shown signs of growth this year, with the highest value of investment loans written since before the GFC.

Record low interest rates combined with steadily rising rental prices in metropolitan areas means becoming an investor is an increasingly attractive option for many Australians.

Like any investment, though, buying an investment property can involve risk. If you’re thinking about taking out a home loan to finance the purchase of an investment property, here are some tips to help minimise the risk.

Do your homework

Buying property is an expensive enterprise, therefore doing research before you buy is crucial. Do your homework by looking into capital growth trends, rental yields and vacancy rates in the areas where you’re looking to buy to ensure you’re investing in the best possible – and least risky – suburbs.

Choose finance wisely

Apply the same diligence in researching and comparing home loans to get the most suitable option for your needs, factoring in other financial commitments.

“Finding a good deal on an investment loan can make a significant difference to the net return on your investment,” said Michelle Hutchison, spokeswoman for RateCity.

RateCity data shows that interest rates on investment home loans range by 2.17 percentage points, which could mean a difference of $553 each month in borrowers’ pockets or $199,000 over 30 years on a $400,000 loan.

“Lenders are eager to lend to investors so there is real opportunity to negotiate hard and secure a good home loan deal if you do your research,” she said.

Think long term

You always have to buy a property thinking you’ll hold on to it for eight to 10 years, said Toby Primrose, director of Australian Property Investor, a company that helps investors manage their portfolios.

“If you don’t want to do that, trading shares might be a better investment for you,” he said.

Once you factor in taxes, legal fees and other costs associated with selling, you will be slugged with a bill of approximately $30,000 on a $400,000 property, he said. If you plan to sell too soon after you buy, you may even lose money on the sale once you subtract these costs.

Property prices have historically risen in Australia, but it doesn’t happen overnight. As Primrose writes on his company website: “The only question you need to ask an investor is how long I will have to wait to double my money; the answer is usually seven to nine years.”

Don’t be seduced by the ‘flipping’ phenomenon
Spurred on by TV programs such as Flip This House, a growing number of people think they can buy a run-down or off-the-plan property and sell it quickly for a tidy profit. That’s one of the riskiest things a property investor can do, said Primrose, and he warns his clients against it – particularly when it comes to buying off the plan. “It takes five to seven years just to break even when you buy off the plan,” he says.

Primrose says the most effective way to minimise risk is to avoid trying to identify the next hot spot or “reading” the market. Even the experts can get it wrong.

Once you buy, be smart
One of the biggest concerns of any property investor is the risk of not being able to rent their property easily and enduring periods of no rental income. “There are two reasons why a property remains vacant,” says Primrose. “It’s either in a state of disrepair and therefore unattractive to tenants, or the rent is too expensive.”

His advice? Be diligent about the property’s upkeep and do your homework on the going rental rates in your area. Don’t rely on the seller’s estimates of what rent the property may fetch.

If you are buying an apartment, look at what other apartments in the block are commanding in rent, Primrose advises. For houses, check rental rates with local real estate agents.

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Learn more about home loans

What is an investment loan?

An investment loan is a home loan that is taken out to purchase a property purely for investment purposes. This means that the purchaser will not be living in the property but will instead rent it out or simply retain it for purposes of capital growth.

What is bridging finance?

A loan of shorter duration taken to buy a new property before a borrower sells an existing property, usually taken to cover the financial gap that occurs while buying a new property without first selling an older one.

Usually, these loans have higher interest rates and a shorter repayment duration.

What is a line of credit?

A line of credit, also known as a home equity loan, is a type of mortgage that allows you to borrow money using the equity in your property.

Equity is the value of your property, less any outstanding debt against it. For example, if you have a $500,000 property and a $300,000 mortgage against the property, then you have $200,000 equity. This is the portion of the property that you actually own.

This type of loan is a flexible mortgage that allows you to draw on funds when you need them, similar to a credit card.

What is equity? How can I use equity in my home loan?

Equity refers to the difference between what your property is worth and how much you owe on it. Essentially, it is the amount you have repaid on your home loan to date, although if your property has gone up in value it can sometimes be a lot more.

You can use the equity in your home loan to finance renovations on your existing property or as a deposit on an investment property. It can also be accessed for other investment opportunities or smaller purchases, such as a car or holiday, using a redraw facility.

Once you are over 65 you can even use the equity in your home loan as a source of income by taking out a reverse mortgage. This will let you access the equity in your loan in the form of regular payments which will be paid back to the bank following your death by selling your property. But like all financial products, it’s best to seek professional advice before you sign on the dotted line.

Mortgage Calculator, Property Value

An estimate of how much your desired property is worth. 

What does pre-approval' mean?

Pre-approval for a home loan is an agreement between you and your lender that, subject to certain conditions, you will be able to borrow a set amount when you find the property you want to buy. This approach is useful if you are in the early stages of surveying the property market and need to know how much money you can spend to help guide your search.

It is also useful when you are heading into an auction and want to be able to bid with confidence. Once you have found the property you want to buy you will need to receive formal approval from your bank.

What is a loan-to-value ratio (LVR)?

A loan-to-value ratio (otherwise known as a Loan to Valuation Ratio or LVR), is a calculation lenders make to work out the value of your loan versus the value of your property, expressed as a percentage.   Lenders use this calculation to help assess your suitability for a home loan, and whether you need to pay lender’s mortgage insurance (LMI). As a general rule, most banks will require you to pay LMI if your loan-to-value ratio is 80 per cent or more.   LVR is worked out by dividing the loan amount by the value of the property. If you are looking for a quick ball-park estimate of LVR, the size of your deposit is a good indicator as it is directly proportionate to your LVR. For instance, a loan with an LVR of 80 per cent requires a deposit of 20 per cent, while a 90 per cent LVR requires 10 per cent down payment. 

LOAN AMOUNT / PROPERTY VALUE = LVR%

While this all sounds simple enough, it is worth doing a more accurate calculation of LVR before you commit to buying a place as there are some traps to be aware of. Firstly, the ‘loan amount’ is the price you paid for the property plus additional costs such as stamp duty and legal fees, minus your deposit amount. Secondly, the ‘property value’ is determined by your lender’s valuation of the property, not the price you paid for it, and sometimes these can differ so where possible, try and get your bank to evaluate the property before you put in an offer.

How much money can I borrow for a home loan?

Tip: You can use RateCity how much can I borrow calculator to get a quick answer.

How much money you can borrow for a home loan will depend on a number of factors including your employment status, your income (and your partner’s income if you are taking out a joint loan), the size of your deposit, your living expenses and any other debt you might hold, including credit cards. 

A good place to start is to work out how much you can afford to make in monthly repayments, factoring in a buffer of at least 2 – 3 per cent to allow for interest rate rises along the way. You’ll also need to factor in additional costs that come with purchasing a property such as stamp duty, legal fees, building inspections, strata or council fees.

If you are planning on renting the property, you can factor in the expected rental income to help offset the mortgage, but again it’s prudent to add a significant buffer to allow for rental management fees, maintenance costs and short periods of no rental income when tenants move out. It’s also wise to factor in changes in personal circumstances – the typical home loan lasts for around 30 years and a lot can happen between now and then.

What is equity and home equity?

The percentage of a property effectively ‘owned’ by the borrower, equity is calculated by subtracting the amount currently owing on a mortgage from the property’s current value. As you pay back your mortgage’s principal, your home equity increases. Equity can be affected by changes in market value or improvements to your property.

What is stamp duty?

Stamp duty is the tax that must be paid when purchasing a property in Australia.

It is calculated by the state government based on the selling price of the property. These charges may differ for first homebuyers. You can calculate the stamp duty for your property using our stamp duty calculator.

Mortgage Calculator, Loan Purpose

This is what you will use the loan for – i.e. investment. 

What are the pros and cons of no-deposit home loans?

It’s no longer possible to get a no-deposit home loan in Australia. In some circumstances, you might be able to take out a mortgage with a 5 per cent deposit – but before you do so, it’s important to weigh up the pros and cons.

The big advantage of borrowing 95 per cent (also known as a 95 per cent home loan) is that you get to buy your property sooner. That may be particularly important if you plan to purchase in a rising market, where prices are increasing faster than you can accumulate savings.

But 95 per cent home loans also have disadvantages. First, the 95 per cent home loan market is relatively small, so you’ll have fewer options to choose from. Second, you’ll probably have to pay LMI (lender’s mortgage insurance). Third, you’ll probably be charged a higher interest rate. Fourth, the more you borrow, the more you’ll ultimately have to pay in interest. Fifth, if your property declines in value, your mortgage might end up being worth more than your home.

What is appreciation or depreciation of property?

The increase or decrease in the value of a property due to factors including inflation, demand and political stability.

What is appraised value?

An estimation of a property’s value before beginning the mortgage approval process. An appraiser (or valuer) is an expert who estimates the value of a property. The lender generally selects the appraiser or valuer before sanctioning the loan.