Property is HOT - how hot?
There’s a lot of interest in property at present. Many investors have turned to this asset class because of disappointing returns in other investment areas. The logic seems compelling. Last year, the average house price across New Zealand moved up by over 14%. Add to this the fact that you can use your home equity to purchase rental real estate and, in certain circumstances, reduce your tax bill on other income and it looks pretty attractive. How attractive?
We have evaluated a hypothetical property investment to see how well the figures stack up. The critical part of this analysis is determining the rate of capital appreciation on the property and the inflation figure to apply to expenses. We have not used last year’s real estate appreciation figure of 14% but a rate based on a much longer time frame. Our sources of information were Valuation New Zealand’s Capital Valuation Index, the Real Estate Institute of New Zealand and Statistics New Zealand’s Consumer Price Index.
We think it is fair to adjust for the much lower inflationary conditions we now have. Our inflation figure is 2.5% per annum rather than the heady 8.20% that applied from the mid 1970s to around 1990. Residential property earned a margin of only 1.6% a year over and above the rate of inflation for the 32 year period so we have also looked at more recent figures from the Real Estate Institute covering the period from July 1998 to July 2003. The rate of capital gain for those years is 5.5% per annum, but this includes the very strong returns of the last 24 months.
Allowing for ‘Unders and Overs’ we think it reasonable to apply 4.1% per annum to property and 2.5% to inflation.
We have also assumed:
• The property cost $500,000 and there were legal fees of $1,000 to pay at purchase.
• We held the property for 5 years and sold it via a real estate agent.
• There were no borrowings.
• We paid the rates, insurance and maintenance and repairs and these costs were adjusted for inflation by 2.5% per annum.
• We rented the property for an average of 48 weeks per year and the rental income was $500 per week, also going up by the rate of inflation.
The Cash Flow
Here’s how the money in – money out picture looks.
Money out Money in
Start Buy the house and pay $1,000 in legal costs $501,000
Year 1 Rental income less expenses $19,500
Year 2 Rental income less expenses $19,988
Year 3 Rental income less expenses $20,487
Year 4 Rental income less expenses $20,999
Year 5 Rental income plus proceeds of house sale less expenses $612,169
To find out the total return of our property investment we have used a calculation called the Internal Rate of Return. This takes into account all the funds going in and out of the investment over five years, including the final sale, and it allows for the time value of money. The time value of money is an important concept that says if an investment has a positive return it must be worth less today than it is tomorrow. Investments therefore have a present value and a future value. The internal rate of return finds what the rate of return must be if the present value of future cash flows including the final market price of the investment is to equal to the current market price of the investment.
In our example the Internal Rate of Return is 7.18%.
Looking at the total return a little more simply, our property has had capital appreciation of around 4% per annum and income of about another 4% a year. (e.g. Year 1 income was $19,500 being 3.9% of the cost of the property). There were some expenses involved in quitting the property and we therefore had a return per annum of about 7-8%.
At present, property returns are running ‘hot.’ Capital gain is a long way ahead of long term averages. Long term averages are made up of highs and lows – at present it’s the former. With rents static or moving up only slowly, the higher the valuation figure for a property goes, the lower the income yield. At present, we understand that income being paid on some ‘investment property’ is as low as 2-3% per annum.
It is worthwhile remembering that every investment has its day. Market cycles affect most forms of investing and property is not immune. We think there is a place for property investing. It doesn’t suit everybody but it does suit some. Before committing to any transaction, do the numbers and look at the bigger picture. Weigh up all the options. Your return may be much better than the long term average. It may also be lower. For an average return of 7-8% you may be better off doing something else. Alternatively, you may enjoy the experience immensely.
If you have over NZ$350,000 to invest and want truly impartial advice, contact us to find out how we can put your money to work to fund your important goals.
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