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Build Wealth With Real Estate  






Selecting The Right Investment Property



This article is part two of the Building Wealth In Real Estate article.

The preceding article dealt with the factors that make real estate such an outstanding asset class for wealth creation purposes. This article deals with the selection criteria you need to consider when looking for investment property for the purpose of wealth building.

What is the best type of property to buy?

1. Limited Supply of Land

In Building Wealth In Real Estate, we expanded upon the second reason why real estate is such an attractive asset class: because of it's "limited supply".

This factor should not be lost sight of when deciding on the type of property to buy.

I personally will only invest in property where at least 30% of the value of the purchase price is made up of the land component.

Let's face it - if you buy a 2 bedroom apartment in a 14 storey building comprising 42 separate apartments built on a 1200 sq mtr block of land, how much of that land do you actually own? Only about 28.5 sq metres.

In the right location, the value of the land will continue to increase, but this comprises only a small percentage of the cost of your investment. The building itself will decrease in value as it gets older and approaches the end of it's lifespan.

Further, if you are buying in an area that has already been approved for high rise development by your local council, what is to stop a developer from buying up those ageing townhouses next door, knocking them down and putting up more 14 storey apartment buildings in it's place? This is a common occurrence, and the net result is that the developer will be diluting the supply, hence diminishing one of the key ingredients that you require for capital growth of your property: limited supply.

This is not to say that you should only focus on house and land packages. Our society is changing, more people are remaining single and less people are having children. There are more single households now in Australia than at any other time in recorded history. Hence, the demand for townhouses or smaller villa units in good locations for busy professionals, who don't have the time or inclination to weed the garden on the weekend, is on the increase.

To add to that, many baby boomers are, or will be, looking to downsize. Their children have left the nest and their 4 bedroom home in the burbs on the large block of land may not be what they wish to move into retirement with. Many instead prefer to downsize to a smaller unit which requires less upkeep, and is within walking distance to shops, restaurants and amenities. They can therefore cash out on their big suburban house, hence providing them with a larger nest-egg for their lifestyle in retirement.

So demographics should play a part in your selection criteria for the type of property that is likely to be most "in demand" in the future in your target investment area.

2. Select An Area of Stable or Increasing Population

You want to make sure that the town or area that you are looking at investing in does not have a decreasing population, or is not prone to a decrease in population. What do I mean by this?

Some smaller cities can be very dependent on a particular industry. There is a city of 180,000 people located about 70km from here. Property values there, like in most other cities in Australia, have appreciated very well over the past decade. Personally, I wouldn't invest there. Why? A significant employer in that town happens to be one large car manufacturing plant, with further employment provided by some smaller companies that build the components to feed it. I believe there is also an oil refinery managed by another multi-national. If ever that car plant were to close down, that city's economic prospects would be severely damaged, and I dare say that property values may drop. This is an example of an area that could be prone to a drop in population given the departure of a principal multi-national employer in that town.

3. Select An Area With Good Schools, Shops, Transportation, and Close to Public Amenities

Real estate agents are known for the mantra "Location, location, location".

Well, this is an important aspect of property selection criteria, but by no means is it the sole factor. A decent land component, as well as a stable or increasing population, are also necessary to ensure limited supply and maximise your potential for capital growth.

But location is important. So what makes for a good location?

Once you've chosen a town or city that is supported by a diverse economic and industrial base, you then need to pick a specific area within that town to purchase your property.

What do people need and what makes an area desirable?

The top four, in no particular order, are:

a) Shops and markets

b) Schools

c) Transportation: public transport close by, and a quick route to the city by car

d) Public facilities such as a post office, libraries and parkland

Followed by "lifestyle" attributes such as:

e) Restaurants

f) Café strips

g) Close to the beach

Investing in an area which includes all of the top 4, and some or all of the last three attributes, will stack the chips in your favour for the best capital growth prospects and demand for your property.

4. Affordability for the Renter

What is the median household income in the area? What are the average rents for the type of properties that you are considering?

A good rule of thumb to use is to ensure that the rent that you plan to charge to lease your property does not exceed 40% of the average monthly household income for that area. Thirty percent is a good benchmark.

It's interesting to note that with property cycles, a property price boom will often taper off and subside, and prices may even fall, when the average monthly mortgage repayments on property in a given area exceed 40% of the average household income for that area (assuming an 80% loan to value ratio mortgage). Conversely, once households are back down to only spending 30% of their monthly income to service a standard mortgage, the market will tend to cycle up again.

Obviously this rule of thumb will vary depending on the country and the market, as different countries have different tax laws which affect the affordability of a home mortgage (i.e. in some countries the interest on an owner occupier mortgage is a tax deduction, in Australia it is only a deduction on investment property).

Purchasing a prestige or high end property in a middle class or high end suburb may not be the best way to go. In boom times there may well be plenty of well-heeled prospective tenants for your property, but what about in a recession when many of these execs are laid off, and businesses are going to the wall under high interest rates?

You also don't really want to target the dregs or a run down property below the standard of the neighbourhood. Whilst this may be a good way to pick up something at little more than land value, your cashflow may suffer with long vacancy periods in between renters and with a more significant maintenance and repair bill on the home.

So your best bet is to target an average property in an average neighbourhood, that is affordable to the average resident in that area, and by that I mean that the rent you plan to charge does not exceed 40% of the average income for the area (with 30% being the better target).

5. Affordability for YOU, the investor

What I mean by this has nothing to do with the price of the property, but rather the amount of income it will bring in versus what it is going to cost you to hold it in the form of your mortgage repayments, insurance, maintenance, management fees, council rates and taxes.

There are many different schools of thought and methodologies for creating wealth with real estate.

Some investors advocate a quick cash model where they use their negotiating skills to buy a property at a discount and resell quickly at a mark-up. Yet others will buy a run down property, renovate it to create capital appreciation, and then resell it at a profit. Then there are the positive cashflow gurus whose focus is on the passive income that a portfolio of properties can generate, and these investors use creative techniques such as vendor financing wraps, or rent to own lease-options.

In case you haven't guessed it yet, the methodology and focus of this article is about creating wealth from the capital gain and price appreciation of a property portfolio. Whilst the price appreciation is the focus, cashflow is also very important.

If you buy a property that is costing you $100 p/mth to hold, after your rental income has offset your holding expenses, you have a negative cashflow situation and this will limit the number of properties that you can buy on this basis. Sure you're getting a tax deduction against your income on the negative gearing, but you're still losing money.

Sooner or later, whilst you will still build up enough equity to fund the purchase of further properties for your portfolio, you may not have the spare cashflow to sustain the holding cost. The other disadvantage to a negative cashflow property is that if you lose your employment or main source of income, your investments will then financially bleed you to death as opposed to feeding you.

Ideally, you want to select a property that meets the aforementioned criteria of:

a) Good land content;

b) An area of increasing population;

c) Close to schools, shops, transportation and public amenities;

d) Affordable for the average resident in the area; and

e) Where your cashflow is either break-even or a little positive.

Whilst it is not too difficult to find properties that match criteria 1 thru 4, getting that to mesh in with a break even or positive cashflow property as specified in criteria 5 can prove to be a challenge in some markets.

If you can only find negative cashflow properties in your chosen market, and if you are not prepared or unable to contemplate investing in other towns or areas, then don't let the negative cashflow be the show stopper. You can still become very wealthy over time purchasing negative cashflow properties providing they increase in value over the years. It's just that your ability to hold any significant number of such properties in your investment portfolio will be limited by your disposable cashflow from your other sources of income.

You will also expose yourself to greater risk in the event that you lose your business, employment, or primary source of income, but many people have generated substantial wealth over time with negative geared properties, and providing you are diligent in your selection criteria, and our national economy doesn't suffer any major disaster, then building wealth with real estate is every bit as possible for you too!

6. Get Educated First

Your best bet is to educate yourself about property investing, what to look for and evaluate, BEFORE taking the plunge. The difference between some knowledge and little or no knowledge could be in the $10's of thousands of dollars to you on your first purchase.

You also need to research your target area thoroughly so that you have a good idea of what a particular property should sell for just by looking at it from the outside. This will put you in a position to identify value once you see it, and will also insure you against paying above market price for a given property.



Summary - Building Wealth With Real Estate

To cap off, let's summarise what we have learnt about creating wealth with real estate.

Real Estate is a choice asset class for building wealth for 4 principle reasons:


  1. It provides better leverage than any other asset class, with the ability to typically borrow at least 80% of the purchase price on house and land packages. 100% lends are possible in some circumstances.

  2. Real Estate is a real asset - it physically exists, and everybody needs a roof over their head. Wherever there are people, there will be demand for real estate.

  3. There is a limited supply of land. There is no more land being created! If you select property with a land component in an area of increasing population and demand, the laws of supply and demand will work in your favour to increase the value of your investment.

  4. Price Inflation. Given a healthy national economy, no deflation, an increasing population, or at least increasing demand for property in your chosen investment area, then your real estate investment is liable to increase in value over time. You may have no control over the state of the economy, but you can stack the chips in your favour by selecting the right type of property in the right area.

Investment Property Selection

1. Solid Land Component

Aim for an investment where at least 30% of the purchase price is comprised of the land component. House and land, villa units, townhouses, and low rise apartment buildings can all fit the bill. Land is the only limited resource, and that means value for you. If you purchase a unit in a high rise, not only will the value of the building depreciate over time, but what is to stop developers erecting more high-rises and diluting the supply in your market?

2. Stable or Increasing Population
Invest in an area with an increasing, or at least stable, population base. Avoid towns which are dependent on a single industry for the bulk of their employment. If the industry folds, so will the tenants.

3. Transport, Shops and Public Amenities
Invest in an area close to schools, shops, public transport and good public amenities such as a post office, library and parklands. These are the basic factors that make an area desirable to live in, and will help to ensure continued demand for property in that area over the long term.

4. Average Property Affordable For The Average Worker
Select a median property in a median area, one which is affordable for the average Joe & Jane. High end real estate is prone to vacancy and busts in recessionary times. Low end real estate is less desirable, can attract a lower quality of tenant, and cost you more in maintenance. Aim for a property that will rent for no more than 40% of the average household income for that area, preferably 30% of the household income.

5. Affordability for you, the investor.
Try to invest in property that at least pays for itself, that is to say that the rental income will at least cover your mortgage repayments, insurance, maintenance, management fees, local rates and taxes. If this is not possible in your area, consider alternative areas. Otherwise you can still build wealth with negative geared property. It is just a little more risky and the size of the portfolio that you hold will be limited by your ability to service the negative cashflow with your other sources of income.

6. Education First
Educate yourself about property investing first, before making that first investment. Buy a few books. The difference between some knowledge and little or no knowledge could be in the $10's of thousands of dollars to you on your first purchase.

Also research and make yourself very familiar with the properties in your target area before making a purchase. This will help you to spot bargains and will insure you against paying above market value for a property.

Lastly, but most importantly, take action on what you have just read. Time is of the essence when investing in real estate. I wish I had purchased my first property when I was 18. Instead it took me until I was 30 to buy my first one. I missed out on 10yrs+ of capital growth. Prices doubled in that period of time. Instead I chose to go backpacking through Europe for 10mths at 19/20yrs of age. No regrets, as I can't change the past and it was a great life experience. But I would have been miles ahead financially if I had started on the property bandwagon at age 20 instead of at 30!


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