Don't let your investment property weigh you down

10 April, 2005

Discover the best tips on how to squeeze every cent from rental properties.

If you believe the economic pundits then an interest rate hike still looms like a storm at the end of a humid day. The Reserve Bank may not have increased interest rates last week, but that hasn't stopped speculation that we will see another rise in the coming months.

If you have an investment property, another interest rate rise could really hurt. So there's no better time to make sure you are maximising your returns.

We've made it easy for you - just follow these six steps to ensure you're squeezing every cent from your investment.

1. Evaluate your home improvements

A quick flick through the plethora of home improvement television programs and you would be forgiven for thinking that every investment property should be the subject of an elaborate renovation project.

But veteran property investor and managing director of Destiny Financial Solutions Margaret Lomas says all renovations should be subject to cost-benefit analysis.

As an example, Lomas bought four flats in Armadale in Melbourne - only two had renovated kitchens and bathrooms. The renovated apartments were let for $140 a week, while the unrenovated pair went for $115 a week.

Lomas calculated that the $350 a year in interest she would pay on the extra $5000 she would need to renovate was easily outweighed by the $2600 more she would earn on rent from the newly renovated apartments.

The timing of renovations is the key to whether they can be claimed as a suitable tax deduction.

Paul Moran, principal financial planner at Cameron Walshe, says a property must be on the rental market for renovations to be deductible.

This means you should not make any renovations before registering a property with a real-estate agent.

2. Manage your cash

Most financial advisers will tell you that when you are still paying off a debt on a family home, investment debts should be interest-only.

This allows you to focus on reducing the family home debt, so-called bad debt because it is not deductible. Once this loan is paid then you should turn your attention to paying down debt on investment properties.

But Lomas, who owns 21 investment properties, does things differently. She only buys positively geared properties (where the rent covers the expenses) or positive cash flow properties (where the rent plus the tax refund covers the expenses). See tip four on how to make your tax refund cover any shortfall in rental income and more.

She then ploughs any excess back into the loan and builds her equity so she can buy more positively geared or positive cash flow properties.

Lomas says that because all of her properties are, in effect, making money, they give her a buffer against interest rate rises.

Where are these magic properties, you ask? Lomas says you must be prepared to look all over the country and thoroughly research your market.

"People say to me 'how can you buy somewhere you have never been before'. But I do my research. I know about an area's long-term growth. I would know the area better than someone who lives there." (See the 'How To Buy Right' panel for Lomas's tips on researching an investment property).

Effective management of an investment property should also include regular evaluation of rents. In a market with falling vacancy rates, an increase in rent will fairly represent market values.

3. Review your outgoings

When times are tough for a small business, the first step is always to review the outgoings.

Moran says to apply the same methodology to your investment. He says don't be afraid to negotiate with the agent to try to get the best possible management fees, and be informed about agent-specified repair services.

"There could be a minimum call-out fee of say $75, so a simple light fitting change could end up costing you $150," he says

Investigate your home loan, too.

Moran suggests flexibility is the key in uncertain times. The best mortgage is one that can be switched between fixed and variable rates and debt reduction and an interest-only arrangement.

"If you are without a tenant for two months it might be beneficial to switch to interest only during this time to make sure the investment is sustainable," he explains.

Your other obvious outgoing is insurance (see tip six). Moran advises you shop around to make sure you are getting the best bang for your buck.

4. Make the most of your age

The key to maximising the returns from your investment property will be through your tax refund and the key to the best possible tax refund is depreciation.

National Tax and Accountants Association (NTAA) legal counsel Rob Warnock says for all buildings built after July 17, 1985 you can claim a depreciation rate of 2.5 per cent over a period of 40 years from the time of construction. However, for those lucky enough to have a property built in the first years of the introduction of depreciation rates (July 17, 1985 to September 15, 1987) you can claim 4 per cent depreciation.

But what happens if you have a property built before 1985?

You may not be able to claim depreciation of the building, but you can claim depreciation of all the fittings and fixtures.

The best way to do this is get a quantity surveyor to go through the property and make a list of the assets on which you can claim depreciation and their value. Examples include a dishwasher at an effective depreciation rate of 15 per cent over 10 years, ovens and cooktops at 12.5 per cent over 12 years and removable light fittings at 30 per cent over five years.

A quantity surveyor will only cost about $500 (also tax deductible) and this will quickly be made up in the tax deductions it will give in the following years. "It could just make the difference as to whether the property remains affordable," says Warnock.

Moran agrees, pointing to the following calculations.

Say you have a property that is worth $400,000, with a loan of $350,000 at 7 per cent interest (over 30 years). It earns $17,500 in rent and costs $27,800 in interest, maintenance, agent's fees and insurance each year. If you are in the highest tax bracket then, after a tax deduction of $4990 (48.5 per cent of the $10,300 loss), you are out of pocket $5300. If interest rates jump another half a percentage point then it's $6200 each year.

But Moran says that by adding $5000 worth of depreciation costs to the calculations your property will only end up costing you $2880 at 7 per cent interest and $3780 at 7.5 per cent (because your refund increases).

5. Get your refund

Don't let the tax office keep your interest. By making a Request for Taxation Variation you can receive your tax refund weekly, fortnightly or monthly, depending on when you are paid. What this means is that instead of receiving your refund in a lump sum at the end of the financial year, less tax is taken from your salary each pay.

That extra few hundred in your pay each fortnight could determine whether you can meet the expenses of your investment property. If you are attempting to pay down the debt of your property it could enable you to save thousands of dollars worth of interest and reduce the time of your loan.

Let's return to Moran's example above. If you are in the highest tax bracket, with a $400,000 investment property and you were to receive a tax refund of $7400 (for the $10,300 loss and depreciation costs of $5000) and were to plough that refund back into the loan annually you would pay a total of $256,868 of interest and reduce the 30-year loan to 18 years.

But if you were to pay your mortgage fortnightly with your tax refund of $285 you would pay only $248,915 interest over 16 years. So your loan reduces by two years and you save almost $8000.

6. Protect yourself

Landlord's insurance is a must - it is the most effective way to minimise your losses.

A good landlord's insurance policy will cover you for all unforseen damage and expenses. For example if a tree falls on your property and you are unable to rent it, or a tenant damages the property so you are unable to rent, the insurance will cover you for the rental amount for this period.

It will also cover you for any tenant damage and costs you might incur while trying to recover money from tenants.

Just be sure to read the fine print.

HOW TO BUY RIGHT

In a climate where speculation continues about interest rate hikes, the purchase of an investment property may seem risky. But Margaret Lomas, author of How To Create An Income For Life, follows a list of set questions to ensure she is purchasing a sustainable investment.

What is the cash flow of the property?

Lomas will only buy positively geared properties (where the rent covers your expenses) or positive cash flow properties (where the rent plus your tax refund covers your expenses), insulating her against interest rate rises and helping to build equity for further purchases.

What is the age of the property?

Lomas advises buying properties from 1985 onwards so that you can maximise your tax return through depreciation. If a property is older than this then it must have some outstanding feature so that the rent covers the costs.

What is the population growth?

A declining population or high commercial vacancy rates could indicate a region without good long-term rental prospects.

Why do people live in the area?

By knowing why people live in the area, you know what sort of rental property to buy. For example, if it is a retirement area you should buy property without stairs or a large backyard.

Is the property tenant-friendly?

You are not going to live there so don't be attracted by high-quality fixtures and fittings, which are costly to repair and replace.

Excerpt from Margaret Lomas's 20 Questions To Ask Before Buying An Investment Property.