Are you looking to buy a rental? Or convert your current, personal house to a rental?

Article by Ross Barnett, Coombe Smith Chartered Accountants

What do you want from rental properties?
My idea of the perfect scenario is a debt free personal house and passive income coming in from rental properties.

It appears we are around the peak of the market and for most investors, it is important to focus on cash flow or long term opportunity.

If you buy a standard house, at standard values through a real estate agent, it is likely to cost $5,000 or more each year, after receiving tax refunds. If Labour get in and take away the tax benefits, this cost would increase to $9,000 or $170 per week. Is it worth gambling on a capital gain of more than $9,000 a year over the next 1-5 years?

The only times I would buy a rental that is giving a large cash loss is:

If there was a ‘twist’ available that would change the cash flow substantially. The best example of this is a subdividable property. To start with, the cash flow might be negative $5,000 per year or more. But if you subdivide and sell a section (ensure you get tax advice!), this could substantially reduce the mortgage, even after paying tax. Or, subdivide and add another rental on the back to give more rental income.

If you are expecting a large inheritance or cash windfall which means you can pay off any personal house debt, and also reduce the rental debt so that it is then break even or better.

If you have large income and can quickly pay off any personal house debt and then quickly reduce the rental debt.

If it is a trading property and you are buying at a significant discount. NOTE: trading is risky and you would want to ensure there is still a good profit even if things go wrong.

Otherwise, my approach is slow and steady.

Can you improve rent on existing rentals?
A simple renovation can often improve the rent by $40 or more per week and give a large return on investment.

Can you subdivide or add minor dwellings to existing rentals?
Only buy rentals if either:

The rent covers all expenses and can pay down principal over 25 years, or

It is subdividable and ideally with the option of building a Duplex. You still need to buy well and do your numbers carefully!

Watch and wait, and hope the market crashes a little and that there is great buying in two to three years.

So overall, when buying a rental, I’m looking at how does this rental help me achieve my personal aims and goals. If I buy, I want a strategy of how this rental will give me passive income. That generally means buying extremely well, subdividing or reducing a large amount of debt. Otherwise you are left hoping or gambling on capital gain!

Convert Your Current Personal House to a Rental?
When trying to get ahead on the property ladder, a lot of people move to a new personal home and convert their existing house to a rental. Unfortunately, this is often done for emotional reasons!

If you are thinking about doing this:

1) Is your existing house a good rental?

Is there high tenant demand in the area? Look at population figures for the area and talk to a local property manager.

Will you be able to attract a good tenant?

Is the property easy care and low maintenance?

Is there an opportunity to add value in the future? For example, subdivide or add a minor dwelling.

2) What is the cash flow?

As a starting point, I would work out the Gross Yield. This is 50 weeks rent divided by the property value *100. For example, $400 per week * 50 = $20,000 divided by value of $400,000 would give 5% Gross Yield.

The Gross Yield gives an indication of the cash flow:

5% or under is going to be quite negative cash flow based on 100% mortgage.

7% or better should break even or be positive cash flow.

Between 5% and 7% is still likely to be negative cash flow, but a smaller, more manageable amount.

Review the income less the full expenses. The example below shows a $8,784 loss expected each year before tax. After tax refunds, this drops to $4,914 per year or $94.50 per week.

3) What happens if interest rates go up?

At 6.5% interest, the loss after tax refunds increases to $9,950 per year or $191 per week.

4) Can you afford the cash flow losses?

5) Do you want to gamble that the property will go up more than the cash loss?

6) Or do you have a plan to change the cash flow?

Minor dwelling to increase rent
Subdivide long term and sell section, or build second rental on section

Inheritance coming that can reduce the rental debt. NOTE: you are likely to pay off any personal debt first.
Often I find that personal homes are not great rentals and that it is better to sell the existing personal house and buy a specific rental, with better cash flow or better long term options.

I hope you have found these two topics interesting!

Ross Barnett, Principal
Coombe Smith Chartered Accountants
Hamilton Branch

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Distributed with authorisation from Ross Barnett, Coombe Smith Chartered Accountants.