Factors affecting your return
September 24, 2015 in Investing
When assessing the potential return on your investment, consider all the elements at play, including yield, capital gain, risk, expenses and taxation.
Your return comprises both income and capital gain, less expenses. There are also significant tax implications when purchasing an investment property. Risk plays a part when you consider the worst-case scenario and whether or not you can afford it.
Broadly speaking, commercial property investment relies on making most of its return from rental income, whereas residential investments tend to rely more heavily on making a capital gain. Doing your figures before you invest is critical to make sure your investment return is worth the risk.
Yield vs total return
One indicator of return is rental yield. To work out your yield, use the following formula:
Gross rental yield = [annual rental income/total property expense] x 100
This figure tells you the rate of income return as a percentage of the property. It is often used as a comparison metric in property.
Typically, a residential rental property would return a yield of around 4–5 per cent. By comparison, commercial properties average around 7–7.5 per cent yield. A higher yield tends to mean higher income, which will help with servicing the property’s expenses (such as loan costs).
The other key indicator of return is your capital gain; that is, how much money you stand to make when you sell due to the increase in value of your property. Usually a property with a higher yield will have lower capital gain potential. A commercial investor wanting to make a significant capital gain would usually need to buy a property with scope for improvement or expansion. Otherwise, you should ensure your net rental yield is high enough to provide satisfactory return on your investment.
Total return on investment = [(gain from investment – expense of investment)/expense of investment] x 100
Two investment scenarios
Let’s consider typical investment scenarios for residential and commercial property.
An investor buys a two-bedroom unit in a good location, valued at $650,000.
Loan: They borrow 90 per cent of the value ($585,000) at an interest rate of 4.3 per cent. On interest-only repayments, the loan would cost $2,096 per month.
Rental: The rent on the property is $2,200 per month.
Expenses: $200 per month (maintenance, rates and management fees) plus loan repayments of $2,096 per month = $2,296 per month.
This has a gross yield of [2200×12/650,000] x 100 = 4 per cent.
However, net rental yield (including expenses) is [($2200×12) – ($2,296×12))/650,000] x 100 = –0.17 per cent.
Capital gain: Over the next three years, the property achieved a capital growth of 15 per cent, selling for $747,500 and making a capital gain of $97,000.
Total return: [(747,000 + (3x12x$2200)) – (650,000 + (3x12x$2296))/650,000] x 100 = 14.3 per cent
An investor buys a suburban office space, valued at $2 million.
Loan: They borrow 50 per cent of the value ($1 million) at an interest rate of 4.5 per cent. On interest-only repayments, the loan would cost $3,750 per month.
Rental: The rent on the property is $13,500 per month.
Expenses: Loan repayments are $3,750 per month.
This has a gross yield of [13,500×12/2,000,000] x 100 = 8.1 per cent.
However, net rental yield is [($13,500×12 – $3,750×12)/2,000,000] x 100 = 5.8 per cent.
Capital gain: Over the next three years, the property achieved only 2 per cent capital growth, selling for $2,040,000.
Total return: [(2040,000 + (3x12x$13,500)) – (2,000,000 + (3x12x$3,750))/2,000,000] x 100 = 19.5 per cent.
While the commercial property had a better yield, the residential property had better capital gain. In this case, the commercial property gave a better return overall.
Of course, there are many other factors to take into account when determining your potential return, including risk, expenses and taxation.
Usually, a higher yielding property will have increased risk; the main risk being vacancy. For example, an older building in a bad location with a shorter lease and unknown tenants will typically command a higher yield (between 8 per cent and 10 per cent) than a good quality commercial property with a long-term secure lease to a stable larger business (between 5 per cent and 6 per cent).
Since commercial property investment relies heavily on rental income to generate a good return, investors need to minimise the risk of long-term vacancy. From our commercial investment scenario above, it is clear that prolonged loss of rental income would create serious cash flow problems and quickly have a significant impact on the total return.
A number of factors can reduce demand for commercial property, increasing the risk of longer-term vacancy. The strength of the economy, how appealing the property is to tenants and overall market supply of the property type in question are the key elements. To improve your chances of securing a long-term lease, consider offering incentives, such as a rent reduction or rent-free period.
Residential properties, on the other hand, tend not to be vacant for long periods, so vacancy risk is low.
Examine the current yields, demand, vacancy rates and supply in our market analysis and minimise your investment risk.
When calculating your potential yield and total return, you will need to take into account your expenses – both upfront and ongoing.
- Upfront: Deposit, stamp duty, legal and conveyancing fees, mortgage and lender fees including lenders mortgage insurance (if borrowing more than 80 per cent of the property’s value), building inspection fees
- Ongoing: Interest and loan repayments, maintenance, insurance, council rates and/or strata fees, water, property management fees (optional) and possible loss of rent during vacancy.
- Upfront: Deposit, stamp duty, legal and conveyancing fees, goods and services tax (GST), valuation fees, loan application fee and line fees
- Ongoing: Interest and loan repayments and any loss of income due to vacancy (assume tenant pays maintenance and repairs, property management fees, refurbishment, insurance, and rates).
If you rent out your investment property, whether commercial or residential, there are a number of tax implications to be aware of. You must include any rental income in your tax return but you can claim tax deductions for certain property expenses.
You can claim a deduction for expenses related to renting out the property, including (but not limited to) interest on loan repayments, insurance, body corporate fees, maintenance expenses, management service fees, rates and depreciation (of furniture, fixtures and so on). You can also claim capital works and depreciation on the building itself over a number of years. You can’t claim expenses not paid by you (that is, expenses covered by the tenant) or the acquisition and disposal expenses of the property (including stamp duty).
If you make a capital gain when you sell your property, this will be added to your income tax for that year, to be paid at the marginal rate. If you owned the property for more than one year, you can claim a 50 per cent discount, reducing your tax by half.
If you make a capital loss, this can only be offset against a capital gain, and you can carry the loss forward and deduct it from future capital gains. You can include all expenses relating to the purchase or sale as part of your expense base, so be sure to keep all records.
Negative gearing happens when the income generated by the investment is less than the expense of owning and managing the investment (including interest paid on the loan and the cost of repairs and maintenance). Our residential investment scenario above is an example of negative gearing. The loss incurred can be offset against other assessable income, enabling a tax deduction.
Negative gearing is particularly popular with residential property investors as it is expected the capital gain will compensate for the shortfall – typically, a negatively geared property will have better capital growth than a positively geared one. If your income is greater than your expenses, then your property is positively geared, and you will need to pay tax on the net income.
Special tax implications for commercial property
Commercial property has an added tax complication – GST. Find out more about the GST implications of commercial property investment.
Tax implications, particularly for commercial property investment, are complex. Since commercial property involves high-value transactions, the tax implications are substantial, so ensure you get reliable tax advice before you purchase your property.