If you've finally built up some equity and are not sure whether you can afford an investment property, read on to calculate your costs.
Okay – so you've bought your first home, been chipping away to pay it off for a little while now and your home has risen a bit in value since the hammer came down on your sale a few years ago. You're feeling a bit more comfortable financially than you have since you first signed up for your mortgage. So the next question is quite natural: Can I afford an investment property?
While 'can I afford it?' might seem like an obvious question to ask while you're going through the deliberations of whether an investment property might be the smartest next move in your investment strategy, coming to answer this question raises a suite of interesting points that will help you decide the suitability of this approach.
Now it's time to try on a few hats to see what the answer might be.
What causes property prices to move up and down?
Marc: Hi, guys, I'm Marc from finder.com.au. Today, we're talking about property prices with Adam. Thanks for being here with us.
Adam: Yeah. Thanks, Marc.
Marc: Property prices. Property prices are on everyone's mind at the moment, and it's easy to see why.
Adam: Yeah. Look, they keep going up, or at least they have in the past few years. There's a study that came out from CoreLogic that showed that, since December 2008 up to April of 2016, combined capital of city home values have increased by a little more than 50%, so that's pretty significant. So we know that they're rising quite a bit. What would it take for property prices to actually go down in the market?
Marc: Well, it's a good question, but I think, before we answer that, it's good to find out why they're rising in the first place. And there's a few factors, and supply and demand is a major one, obviously. So in Australia, demand is going up because population's going up. A bigger population means more people need a place to live.
Adam: Yeah, and then there's supply. There was a parliamentary inquiry in 2014, and it blamed a continuous lack of supply for rising house prices. And the reasons for this includes things like not enough land being available to developers. They blame tax policies, zoning policies, environmental regulations. Basically the policies include local, state, and federal governments that make it more difficult for developers to build new properties, which means that there are too many buyers and not enough properties for them to buy. And like you said, the law of supply and demand, that means prices go up.
Marc: Yeah, that's right. And interest rates are also playing a massive part at the moment in property prices going up. As we know, interest rates are at historic lows, and this makes it more affordable to buy property in the first place and this means that there's more buyers in the market.
Adam: Yeah. Now, one thing that we hear a lot in media is people like to lay the blame for rising house prices at the feet of foreign investors, and there's a couple of problems with this. First of all, there's a parliamentary inquiry that found that there's no evidence that foreign investors were driving prices up, and actually, overseas buyers can make property more affordable. That's because their investments increase the overall supply, and like you said, a lack of supply is what pushes prices up.
The inquiry also found that overseas investors, they don't really buy the types of property that first home buyers are buying. So first home buyers would be looking probably at more affordable properties on the city fringes, whereas overseas investors often are buying new developments right in the CBD that are in a price range that first home buyers, it really wouldn't be something that they would be looking at in the first place.
Okay, we've looked at why property prices are going up. What would it actually take for them to go down?
Marc: Well, it's a difficult question, and it depends on what you mean by "go down." So if you mean, what would it take for properties to fall by 30% to 50%, as many have forecasted, then it would probably take either a severe recession or extremely high interest rates. And high unemployment would be another reason why. And what this would do is it would create a situation where homeowners couldn't afford their mortgages anymore and they'd be forced to sell, and this would cause a massive over-supply of properties in the market. And then, as sales became more desperate, the prices would go down.
For property values to fall or slow down, most likely what would need to happen is interest rates would need to rise. And what this would do is it would make it hard for investors without a strong buffer of savings to afford their repayments and, as we mentioned before, cause a greater supply, which would tend to push prices down.
Adam: Yeah. Now, what we hear about a lot is the idea of a housing bubble. It's constantly in the media. And kind of like what happened in the U.S., where house prices crashed quite dramatically. And people are worried that what happened in the U.S. housing market could happen here. Now, we can't see the future, so we don't know what's going to happen. And not all experts agree, but most say it's pretty unlikely that we're going to see something similar to the U.S.
And there are a few reasons for this. First of all, Australian home loans are full recourse loans, and that means that the borrower is still responsible for the loan if they default on it. So that means if you borrow to buy a house and you can't pay your home loan back, not only does the bank take the house, but you still owe them the money for it.
Now, in the U.S., a lot of states had non-recourse home loans, so that means that borrowers basically, if they defaulted on the home loan, they could put the keys on the table, walk out, and that was the end of their commitment. So the banks ended up with a lot foreclosed properties that they had to try and sell, often at discounted prices, and they didn't recoup that money from the borrowers. So that puts a lot of stress on the banks and also puts stress on the housing market because all of a sudden it's flooded with the supply of foreclosed properties.
There are some other reasons that people think that probably won't happen here, and one of them is that arrears in Australia are still near historic lows. So basically people who are behind on their mortgage repayments, it's a very, very small proportion here. And in fact, most people are ahead on their home loan payments, so they've got a bit of a buffer built in there for economic shocks. Another thing is that Australia's population is concentrated in some really dense urban areas, so basically, like, Sydney, Melbourne, Brisbane. You've got a large population, a large proportion of the population in very few areas, and that keeps demand really high.
So if property prices aren't going to most likely fall off a cliff, are they going to keep rising at the same pace that we've seen in recent years? Because it seems like a pretty significant pace at which they're rising.
Marc: That's a great question, and I think most experts agree that, at least in Sydney and Melbourne, prices aren't going to increase at the pace that we've seen them increasing over the last few years. And more than likely what'll happen is that growth will increase at single-digit levels or at least go sideways for the near future.
Thanks for listening, guys. For more information, go to finder.com.au.
From a financial strategy perspective
The answer to whether or not you can afford something – whether it's a holiday, a car, a piece of designer furniture or a share portfolio – will very often come down to your priorities. Sure – you could afford that overseas European vacation if you live on nothing but muesli and rice for the next six months – but is that a sacrifice you're willing to make?
Deciding whether you can afford an investment property will, for many people, be a matter of first sorting out your priorities. Sure you might have made a gain on the home you live in and you're pretty confident you can meet the mortgage repayments once you have a tenant renting your place – but if having a longer term financial strategy is not on your radar – then I'm sure you can find a whole lot of other ways you might prefer to spend your time and money.
Questions you must ask
- So before you do anything sit down and work out:
- Why do I want to buy an investment property?
- How will this fit into my longer-term financial strategy?
- What type of investment property do I want:
- one that brings high rental yields
- or one that I'm hoping will increase in value so I can sell it at a profit in five or ten years?
- Do I want to renovate to add value or do I want a property that I can bring tenants to immediately?
- Do I want to buy a house or an apartment?
- What will be the interest rate on my investment home loan?
All of these questions will help you formulate your strategy and lead you closer to the answer of whether or not you can afford the type of investment property that fits into your longer term plan.
From a practical perspective
It's always good to be practical. The more detailed information you have for any purchase, the better. So here's a list of the expenses you need to be aware of if you decide to become a property investor:
- You are going to have to meet all the ordinary expenses of buying a property such as stamp duty and bank fees and maybe mortgage lenders' insurance depending on the size of your deposit.
- You should do research into the area you're thinking of buying in and find out what type of rental yield is realistic for the properties you are looking at and what type of tenants the area or quality of house will attract.
- Remember there are other expenses to owning an investment property including maintenance (the expected and the unexpected), insurance, council rates and water utility payments (landlords don't always have to pay for water, it's only compulsory in apartments where there's no unique meter system) and body corporate if it applies.
- Work out what you will need to pay each week or month once you subtract the rental yield from your mortgage repayments and an apportionment of the related expenses (that is, TOTAL EXPENSES per month minus RENTAL INCOME for a month =).
- Ask yourself, does this weekly or monthly figure feel manageable – this is likely to vary depending on your personal risk profile.
- Finally, ask yourself, will you feel comfortable if you can't find a tenant for one month, three months or six months? (You can sometimes get landlord's insurance to cover unexpected vacancies so this could be an option for you for peace of mind).
From the bank's perspective
Once you've crossed the first two hurdles and decided that, yes, an investment strategy is a killer idea in my long-term financial plan and I feel comfortable that I can afford my mortgage and expenses without it intruding too uncomfortably on my lifestyle – you then have to jump the final hurdle: does the bank think I can afford an investment property?
The best way to answer this question is to ask the bank – and if you get "no" from one bank, don't forget to try another and don't forget to look at credit unions and smaller banks to get your loan through.
Calculating your serviceability
Often the banks will use the word serviceability when talking about loan amounts. Use the calculator below to see how much you could potentially borrow.
Before you start
It is important to have a clear idea of your investment strategy before you start. Make sure you
- work out your investment goals
- have a clear budget
- calculate your expected investment costs
- calculate your expected rental gains
Once you have a clear vision of where you want your investment strategy to go, knowing if you can afford it or not will become clear.