"Disclaimer: we use a lot of assumptions, such as inflation, house prices growth, equity returns in this example. This is only for illustration purpose. Any information in this example does not constitute or formulate any investment advice. We do not take into your personal financial circumstances. Historical prices do not indicate future performance. We reserve all copy right from this material."
It is a good topic at the moment, given house prices have fallen in Australia over the past 12 months. In any debate, you should always consider both sides of the story. Certainly, in finance, you need to be able to see whether the cup is half full or half empty. Hindsight is a wonderful thing, but decisions are often made not just considering on historical evidence, but also based on feelings, preferences, etc.
We hear so many stories about people buying investment properties based on advice from a variety of professionals. Their advice is often, but not limited to, you pay less tax on the investment due to negative gearing and so forth. So, let’s do some basic calculations.
Example 1: Buying an investment property in 2014, valued at $1 million.
Questions:
If you bought a $1 million property in 2014, what is the current value of your property in 2019 (inflation adjusted)?
What is the total cost, based on the time value of money, after 5 years?
In this example, we assume the following:
Inflation rate: RBA target is 2-3%, so 2.5% has been assumed in this
Investment loan interest: often fluctuates but 4% has been assumed (=RBA cash rate 1.5% + 2.5%).
LVR: 80% as the minimum, even though some lenders accept 90% LVR
Investment loan terms: 25 years
For the simplicity reason, we assume both, property and shares, grow at the same rate at 5% pa
Stamp duty: 5% as this is your transaction cost.
Rental yield: 4% with a loading of 96.15% occupied (factoring in 2 week vacancy per year)
Other costs have not been taken into account such as council rates, legal, broker & agent fees, personal tax, rental growth, outgoings, selling fees, again for the purpose of simplicity.
Answers:
When you buy something in 2014, how do you know how much it is worth in today's (2019) money? We simply use inflation (2.5%) to adjust to today prices.
Today value (2019)
= 1,000,000*(1+0.025)^5 = $1,131,408.21 (1)
Why is this important? Because it gives you the same purchasing power in todays money. That’s why $1,000,000 today is a lot higher than $1,000,000 in 5-years time (if you use the same formula $883,855 today will become $1 million in the future). You will see later, why this is important.
Now let’s look at the deposit (20%) and stamp duty (5%) that you paid for your property, also indexed to inflation rate (for simplicity reason, we will not index to share market growth, which is your opportunity cost) of 2.5%:
=1,000,000*25%(1+0.025)^5 = $282,852.05 (2)
At the same time, you will need an (80% LVR) investment loan: = 1,000,000*0.8 = 800,000 loan, at 4% interest with a monthly payment of $4,222.69 for 25 years.
=PMT(0.33%,300,800000,0) = 4,222.69 (3)
The monthly rent you would yield from your property is 4% of the property value, or 4% of $1,000,000, with 50 weeks being rented per annum, is:
=4%*1,000,000/12*96.15% = $3,205.13 (4)
or $801.28 weekly
So your monthly cashflow:
(3) – (4) = -$1,017.57 (5)
Let pause for a second:
You will need to meet your monthly loan payments, instead of using that money for other purposes. This is your opportunity cost, so what would that cost be, if we assumed we invested the equivalent amount in shares instead?
Using an annuity formula, and by investing every month for the equivalent amount, for 5 years in shares that return say 5% annually, based on time-value of money (TVM), your account will grow to:
FV = 1,017.57*({(1+5%/12)^60-1}/(5%/12)) = $69,200.71 (6)
So, what is your total TVM cost and inflation-adjusted cost?
= 282,852.05 + 69,200.71 = 352,052.77 (7)
And, what is your property Future Value after 5 years If it grows at 5% pa (2014-2019)?
FV = 1,000,000*(1+0.05)^5 = $1,276,281.56 (8)
Now let’s connect the dots here:
(8) – (1) - (7) = (207,179.42) (9)
So let’s think intuitively and try and make our decision.
Why do we index our prices to inflation and bring it forward to a future value? Because we want to have the same purchasing power with our money.
If we bought something 5 years ago for $1,000,000 and sold it for $1,276,281.56. Does it mean we make $276,281.56? Not necessarily, because you give up the purchasing power of $1m 5 years ago, that will might equate to $1,131,408.21 in today’s money.
Still not convinced?
Here is another example:
“If you bought an apartment in 1994 for $100k, and you sold it for 1 million 25 years after in 2019. Does it mean you would make 900k and could buy 9 houses in 2019? No because the purchasing power has decreased.”
And why do we include the negative monthly cashflow in our calculations? Because that is your opportunity cost. For example, if you invest in something that returns 8% pa rather than 12% pa, your opportunity cost is 4% on your initial capital.
Now, let’s go back to equation (9), the real capital gain {(8)-(1)} is $144,873.35 by using indexation method. We will waive CGT (tax) payment for now, because we all have different individual tax obligations.
So, the time value of your money being paid monthly ($1,017.57) along with your initial deposit and stamp duty, will equate to ($352,052.77) (7). As a result, your net opportunity cost would equal: -$207,179.42 (9).
Equation (9) is telling us that we are giving up -$207,179.42 to own something that might grow from $1,131,408.21 to $1,276,281.56 in absolute terms.
From a cash flow (accounting) perspective: if we sell the house 5 years later for $1,276,281.56, what is our net Profit and loss (P/L)?
We can calculate this P/L by subtracting our loan balance of $696,836.93, our deposit and stamp duty of $282,852.05 (inflation adjusted) from our selling price:
1,276,281.56 – 696,836.93 – 282,852.05 = $296,592.58. (10)
What is our true cost or benefit? We simply find out by subtracting our opportunity cost from our P/L (10) – (9):
296,592.58 (10) – 207,179.43 (9) = $89,413.16 (11)
In other words, this is our net purchasing power in the future from this transaction (11). And if we repeat all the above steps assuming property prices grow at 4% and shares at 4%, we get to equation of (11) = -$28,107.06. Why? Because we are 80% geared, or leveraged. So what’s the benefit? It can magnify our gains, but also our losses.
Again, we will not consider NPV and IRR calculation in this example, for the purpose of simplicity. The problem with using NPV and IRR rules: the size of the project, and timing of cashflows, as well as projects are independent, that is, when the decision to invest in one project does not affect the decision to undertake another.
So, do we make our decisions on feeling or historical evidence?
What is your key consideration? Have you heard of Warren Buffet? He is reportedly still living in the same house he bought in 1958 for $31,500 ($142,058.21 in today money if we use inflation rate of 2.5% pa.). What is Warren current house value, if it grows at 5% pa? A mere $617,814.07 in 2019 (or 5.5% pa = $825,487.67).
Remember Albert Einstein? He famously said, “Compound interest is the 8th wonder of the world”.
Please note: we use various assumptions in this example, therefore it does not constitute or guarantee any investment recommendation whatsoever. It is provided only for illustration purposes. We have also not considered other factors such as your personal circumstances, etc. in any of the calculations above i.e. we are not recommending or formulate any investment advice or personal advice to you. The numbers may change significantly, if alternative assumptions are utilised. Therefore, we are not recommending any advice in this example.
Now let’s go back to negative gearing side of the equation.
Only investment loan interest can be offset for tax purposes, not on the principal payment. However, investors may have monthly loan payment sometimes includes both, depending on your loan terms (interest only for a short period, then the full payment will kick in, etc.…) with your lender. Think about that from a cashflow perspective?
On top of that, will the rent payment received cover other associated costs such as council rates, insurance, management fees, utilities or depreciation? You will need to consider these factors, there is no free lunch in investment world. And finally, will your tax returns (if received at all) cover the differences?
One of the most important principles in investment world is the relationship between risk and reward. So what are the risk factors associated with an investment property? Some risks to consider are availability and suitability of tenants, location, the area’s outlooks such as future growth, development & infrastructure, demographic and average income.
How do these risk factors fit into your risk profiling? And does it give you the diversification benefit? And last but not least, liquidity risk can also be very important. How long it might take to get a new suitable tenant, or how long would it take to sell in the future if you experience cashflow stress?
A good investment manager will consider a risk and reward relationship. He or she would typically look at the risk/s the investment is exposed to, and how they would manage the downside.
If they are happy with their risk trade-of ratio, then he or she will look at the diversification techniques and how to achieve the optimal allocation to each investment.
Even though we can’t guarantee or predict the future, but by doing some analysis, we can factor in appropriate probabilities and fallbacks in order to provide some comfort or buffer in our assessments.
We’d love to hear your opinion/comments via info@infinitezephyr.com
Book a meeting with us today, to find out how we can help.
Written by Dean Nguyen, January 2019.
Disclaimer: we use a lot of assumptions, such as inflation, house prices growth, equity returns in this example. This is only for illustration purpose. Any information in this example does not constitute or formulate any investment advice. We do not take into your personal financial circumstances. Historical prices do not indicate future performance. We reserve all copy right from this material. Infinite Zephyr & Wealth Pty Ltd.
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