Advice on my first IP?

[SuperDad]

Hi All,

I am looking at putting an offer in on my first IP, and am hoping from some guidance from my fellow PTers.

First, some good news (at least I think it is good news). I have located a property that has excellent potential for better-than-average capital growth. I have managed to get pre-approval for the purchase funds without having to cross-collateralise. I'll be releasing equity (up to 80% LVR) from my PPOR with bank A to use as a 10% deposit with bank B.

My first question is: Will I be able to claim as costs the interest costs on the total 100% of the purchase price (which = borrowing), or only on the 90% borrowed from Bank B? The 10% from Bank A would have been borrowed for the purposes of buying an IP, but how would I prove this to the IRD?

But wait, there's more (and this is where I am hoping for some guidance from you experienced investors). Even if we do purchase the IP for our price, it will produce a 5% gross yield. If I have done my figures correctly, then the IP will be cashflow neutral or slightly better after tax. I have been conservative with depreciation figures and chattels value, and have been pessimistic with respect to repairs and maintanence. We will have a good lump sum ($20000 or so) available to cover the cashflow deficit in the first year, until the tax rebate comes in the second year.

We are buying the property for its long-term capital growth (we have a minimum 10 year investment horizon), and we are happy with the low yield. However, I realise that, unbeknownst to myself, I might be wanting to do something foolish. If any of you have any cautionary advice (or encouraging advice for that matter) I would be very grateful to hear it.

Very best,

Paul.

[Dean@Massiveaction]

Impossible to answer your question intelligently without knowing your investing goals. You need a strategy and buying rules based on your goals. The only comment I can make is that for a yield that low I would hope you are buying AT LEAST 20% below valuation. If not, there are many better deals out there.

[revdev]

Hi Paul,

I realise you have stated your comfort with the low yeild, but personally speaking I look to gain momentum out of each purchase.
I am not sure if this property has any twists or special attributes, but with where we are in the prop cycle relying purely on CG is speculative. With your $20k in my bank, I wouldn't be using it to prop up a -neg geared property.

Just my 2c

G

[cube]

To answer the easy question - yes, the interest on 100% is deductable - the paper trail should be clear enough so that even the IRD can follow it!

This means having the (exact) same amount withdrawn from A and paid in to B, and having a LAQC minute for the transaction.

Calculating the cost of interest will be easy enough, until you start paying some of the capital back.

cube

[Re@der]

I don't know about your personal income situation but you may not have to use that 20k in the bank if you use IRD form IR23BS which allows you to pay less tax on salaried income through the year based on forecast loss from your LAQC. It sure helps with the cashflow on these low yield places when you first get into them.

[SuperDad]

Hi Pooomba and Revdev.

Pooomba,

Thanks for challenging me to give more information about my investing goals. They are as follows:

Primary Goal. My wife and I are aiming to be in a position where she does not need to work in 20 years time (age 56) if she does not want to. She has a very good superannuation package, which should be worth around 500K at that time (in future dollars).

In addition, we have identified that we would like a further $1 Million (in today's dollars) at that time. In order to achieve this, we will need $1.85M in future dollars (20 years time). (I have assumed an annual inflation rate of 3.5% to arrive at this figure.)

Assuming an annual rate of property inflation of 7% (more on this below), we would need 780K of property today, which would be worth $2.65M in 20 years. This would leave roughly $1.85M after debt is retired. (I'm not taking into consideration depreciation clawback here.) Of course, we won't be buying 780k of property this year, so those figures will need to be adjusted with time.

In order to achieve this goal, we have decided:

1. That we want to purchase 3 properties in the 250K-300K range. I will be able to manage these properties myself.
2. That we want to buy lower-quality properties in the best part(s) of our local town, which present the best possibility of cap. growth, and the best returns on renovation. Our research strongly suggests that 7% annual capital growth is not unrealistic in this area.
3. That the properties must be at least cashflow neutral after tax from outset. (Revdev - your comment has helped clarify this goal for me. I did say that the property migh be CF negative after tax, but this was only assuming a long rental vacancy.)

1-3 form our buying criteria, which are in turn determined by our Primary Goal. We don't, as such, have a buying rule such as "Buy at least 10% below market value". Of course, we are out to get the best deal possible. We also believe that by purchasing properties with a lot of unrealised potential, we will increase value.

With respect to the property we are currently looking at, I am taking a builder who specialises in renovations for a walk-through tomorrow morning. He should be able to confirm whether the property has the potential we think it does, and how much it might cost to realise that potential. And Revdev, this property does have special attributes. I think we will gain our momentum by realising the potential this property has (if that is financially viable), and then working of the gain in value. If we can't do this, we won't purchase.

Thanks you both for taking the time to help me.

Paul.

[SuperDad]

Cube and reader,

Thank you both. I was hoping that I would be able to claim on all the interest costs (thanks Cube), and I'll look at that IR23BS online tonight Re@der.

Thanks again,

Paul.

[revdev]

Great stuff Paul, thanks for sharing your goals...big step writing them down, huge step posting them into public forum....collectively we shall hold you accountable to them!!
Certainly sounds as if you have thought through where you want to go and how to get there...let us know how this deal shapes up!?!

All the best

G

[AustinWong]

I agree with Poomba.

Your yield is very low. The other thing I would ask is how many properties can you buy using your current investment rules? My first and only IP was purchased at 22% below registered valuation. It has a 9.3% yield at the moment but if I flick off the spare section the purchase came with I would be on 11% yield. The the current 9.3% yield my wife and I still need to top up $65 a week (nothing if we sold the section). Our LVR is around 50%. But I am not intereted in proping up any more properties at this stage with money out of our own pocket. Just something to be considered if not already.

So how many properties can you prop up? Your LVR seems quite high, most seem to talk about the 65% LVR

Cheery

Lawrence

[Stevegoodey]

It might also be worth considering paying a higher deposit out of the equity (or cash) from you ppor or you may incure low equity fees on your 90% lending for the investment property.

Steve

[SuperDad]

Hi Steve.

The mortgage broker I saw today (Ben Kessell at Mike Pero in Hamilton) is very confident that he can get the lender (National) to waive the low equity fees/lender's mortgage insurance. If not, then I will have to think about putting in more from our PPOR. However, I'd rather not have to do this.

Lawrence - your question got me thinking. Firstly, even with the 5% gross yield, we wouldn't be propping up the property after tax, but would be about $30 per week in the black. I know that's not a lot of wiggle room. (I think I will need to sit down with an accountant before putting in any offer on any property to make sure that I have my figures right.) Secondly, on the LVR. We will be borrowing 80% against the Dec 2004 purchase of our PPOR (230K), which we got below market value. We are currently renovating and, post renovation, expect our property to be worth around 330K (conservatively). So we've got quite a bit of leeway there. Given this leeway, we don't mind borrowing to 90% of the IP. Indeed, I thought that there were advantages in borrowing to such a level, such as a better rate of return on initial investment.

Now, as to the question of how many IPs we can purchase given our investment rules. The honest answer is that I do not know. We have identified that we only need three properties to achieve our goals (assuming 7% annual growth). It may well turn out that if we purchased the property we are looking at, we might not be able to get finance for another two years.

I need to think hard about this implication. On the one hand, this might not be a bad thing - it would give me a couple of years to get the feel of property management, and to upskill. On the other hand, what if a great deal were to come along in the meantime...? But if I can get a great deal now, I shouldn't miss that opportunity in the hopes that I will make a better deal at some point in the future, should I? (BTW, that is not a rhetorical question.)

Thanks for your help Steve and Lawrence.

Paul.

[revdev]

Hi Paul,

Just as a side, many here look for properties that are cashflow positive or at worst, cashflow neutral PRETAX.
After that you are dealing with assumptions.

All the best
G

[JohnL]

Just one point in terms of investment strategies.

Some people would consider an investment which relies solely on future capital gains as speculating, not investing. They argue that a good investment should be making you money now, before appreciation or tax benefits are taken into account.

Your current investment strategy loses real money every year and is relying on an interest free loan from the government via tax rules (which are also subject to change) to be almost cash neutral.

However, it is fair to say that historically properties have appreciated above the rate of inflation so your strategy will probably work, as long as some major global events don't come along and effect us all.

One thing I would look into is to find out the long term historical appreciation adjusted for inflation for your area and use that for you capital gains calculation (plus 2% or whatever you think the average inflation will be over the next 15 years). As we have such high inflation in the eighties, it may be unrealistic to look at long term gains before inflation. I think I read somewhere in a newspaper last year that the average gain for NZ over the last forty years was 1.5% above inflation, but this does seem low and it was quoted in a newspaper!!!!

If this is your strategy and you are happy with it, why not wait four years and get some real bargains. There are several advantages which you can model on your spreadsheet.

One is that property prices are possibly going to be less than they are currently - based solely on what happens after booms in previous property cycles (you can look on QV to get a graph of that in Hamilton to see what actually happened in your area).

Secondly, the movitate vendors really do accept offers at 80% or lower as there are few buyers out there. Even mortgagee auctions become worth going to again!!!

Thirdly, in 15 to 17 years, you may capture two property booms. If you wait until the next boom in underway in Auckland (Hamilton prices probably will take off a year or two later - once again you can look at the graph of a central Auckland suburb to compare what happened in this boom), then you are only proping up a negatively geared property for say 11 years instead of fifteen, but still getting the same, or better capital gain than if you buy now.

The disadvantage I can see is 'action' is delayed, along with the learning curve. And this is a very serious minus so I would definitely go ahead and buy at least one property now. Perhaps one with a highly yield?

Just some more points to consider.

I think its great for you to have developed a plan and thanks for sharing it. Its much easier for us to put further ideas out for consideration against a specific plan than some general statement about wanting to be financially free in 15 years time!!!

John

[Monid]

Hi Paul

7% Price growth on average seems a very unrealistic assumption to me, especially because to make this in real terms the growth rate will be needing to run at 9%-10%.

This seems unlikely over the long term, and indeed in the short term very unlikely.

I believe that I read that the long term average house price increase was around 4%-5%, so once you inflation adjust that you are talking about 1%-3% at best.

While I've gradually come around to the notion that relying on some small percentage of capital gains is reasonable I usually wouldn't count on more than about 1%-2%

David

[SuperDad]

Hi David,

You wrote:

7% Price growth on average seems a very unrealistic assumption to me...I believe that I read that the long term average house price increase was around 4%-5%, so once you inflation adjust that you are talking about 1%-3% at best.

David

This agrees with what JohnL had to say also. Thanks for that input (both of you). I will (a) do some more research on this for myself and (b) run my calculations using a more conservative growth figure.

Does anyone else have a growth figure they use, and what do you base that figure?

Paul.