You’re set. You’ve worked hard to establish a profitable property portfolio.
Sit back and watch the property values rise and enjoy the rewards.
What could possibly go wrong? Lots!
Interest rates could skyrocket, tenants could trash your property, termites could infest your houses, governments could build a freeway next to your investment… and that’s just to name a few.
Nobody knows what the future holds but there are strategies you can implement today to protect everything you’ve worked hard for in years to come, so that you’re in a good position regardless of what happens.
The future is risky and all your hard work and the value of your portfolio could vanish.
Every property investor needs to confront future uncertainty and implement strategies to manage the raft of risk faced.
They need to ‘future proof’ their portfolio.
Future proofing is mostly about good defence scanning your portfolio for potential risks and rolling out strategies to manage and mitigate them.
But the future has opportunities as well; opportunities to expand your portfolio and build wealth.
So, smart investors make sure that when they future proof, they don’t become too defensive and hibernate; they play good defence and manage risk, but prepare for offence and opportunities to buy.
So in this article we explore 10 ways to future proof your portfolio, without losing your ability to take offensive action and expand your portfolio.
One of the most basic and best ways to manage future risk is to regularly inspect your properties.
David Hellett, Victorian manager of Archicentre, the building advisory service of the Australian Institute of Architects, says regular inspections are important to detect faults before they reduce the value of your investment.
He says building faults such as termites and roof leaks will get worse if undetected. Termites, particularly in Queensland and New South Wales, are a major risk.
“There can be pretty horrendous damage up there with termites,” he says. “If you’re sitting on a property year after year and termites enter the property, and you’ve got no idea and the tenants aren’t aware, you could have tens of thousands of dollars of repair bills to deal with.”
Hallett says a pre-purchase building and pest inspections is an absolute minimum when buying a property, but after that there are no hard and fast rules.
He recommends, though, a pest inspection at least annually, and a building inspection every two years at least.
“Pest is more important to do frequently,” he says.
Inspections cut the health and safety risks to tenants of dodgy buildings.
A balcony with timber rot, for example, could collapse and injure tenants.
“if you’ve got rising damp in a property because of a damp environment inside the building, it can also cause respiratory problems for small children in particular,” Hallett adds.
Jason Cunningham, head of accountancy firm The Practice, advises viewing the property yourself every six months, or at least annually.
“A lot of people have property managed by property managers or agents,” he says. “That’s all well and good. But nothing beats attending with the real estate agent and looking at is yourself.”
Hallett also recommends a maintenance program, including garden maintenance and guttering cleaning.
“It’s about making sure you’re looking after your asset, and making sure the property remains in good order and you’re not exposing yourself in the worst case (scenario) to someone getting injured, or to some substantial damage happening,” he says.
Insurance is another obvious way to manage future risk.
Every property should have home and contents insurance.
But Cunningham recommends investors take out landlord insurance as well.
“You can essentially have landlord insurance, not only to protect you against potential damage by tenants, but for periods where you don’t have any income or rent,” he says.
Carolyn Majda, manager of Terri Scheer Insurance, a specialist in landlord insurance, says standard building and contents insurance generally doesn’t cover landlords for the specific risk they face, which includes malicious damage by tenants, accidental damage, legal liability for death or injury, and loss of rental income because of property damage or because of tenant absconds.
“These types of losses can amount to thousands of dollars,” she says.
Majda says you can research your tenant’s rental history but you can’t predict their future.
“Even the best tenant can accidentally damage a property or lose their job and be unable to pay the rent” she says.
“Most landlords rely on the steady flow of income from their rental property to repay their loans, generate income and build wealth.”
When you look at landlord insurance, it’s important to read the fine print.
Different insurers have different conditions for loss of rent cover.
Majda says not all policies cover loss of rent if a tenant dies or absconds, or for vacant periods when you repair damage caused by tenants.
“The policy might cover ‘damage’, but it would be wise to check whether this includes both accidental and malicious damage by the tenant.”
Landlords should also check if the policy covers a level of professional fees if they’re audited by the Australian Tax Office.
One of the best ways to future proof your portfolio is to create a ‘buffer’; that is spare cash or equity to ride you over during tough times.
Raiss says many investors ignore, for example, tax effective strategies than can build equity.
One rarely used strategy is a scrapping schedule.
If you renovate and rip out, say a kitchen and bathroom, you hire a quantity surveyor.
They create a scrapping schedule, which values the things you’ll throw away.
“The values aren’t zero,” Raiss says. “It’s hard to pick a number, but say for an older style home – 1960s style – you’d probably get $5000 to $6000 on a scrapping schedule. That’s a $5000 to $6000 write-off in the first year.”
You also rehire the quantity surveyor to create a depreciation schedule on additions and depreciate that normally.
Raiss says this strategy creates more equity by giving you back a tax refund. “You can use the tax on that amount for future interest rate increases, help you pay for renovations, or to go towards the next deposit. We see a lot of clients using scrapping schedules to beef up their buffer.”
Editor’s note: The laws around depreciation allowances have changed since this article was first written – please seek up to date advice before taking any action.
Property millionaire and author Jan Somers says banks often lend when you don’t need the money, but won’t lend to you when you want it.
Lines of credit help solve this problem.
Say you have a property worth $500,000 with a $200,000 mortgage. A bank agrees to lend you 80 per cent of the value – or $400,000.
You can invest your available debt from $200,000 to $400,000 through a line of credit. You only pay interest on the $200,000 when you draw it down (start using it).
“We’ve set up lots and lots of credit lines for when an opportunity presents itself, or you need that money when doing a renovation,” Somers says. “The key is to set it up before you need it. You’ve got to have that set up well in advance.
“It gives you the capacity to move forward with confidence,” Somers adds.
“The fact you can move forward with confidence means you’re there ready to pick up the next property very quickly and you don’t um and ahh about whether you can afford it. It allows you to ‘ready, set, go’ into your next phase.”
Many investors try to reduce risk and pay off their loans, or they sock away money in a regular cash account for a rainy day.
But offset accounts are a better, more tax-effective path.
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Because they meet the criteria of being able to play both offence and defence: they allow you to have cash ready for unforeseen costs and tough times, but also for deposits when you see an opportunity to buy.
An offset account is like a normal interest bearing account.
But instead of accruing interest, it offsets interest paid on a loan it’s linked to.
Say you have a $400,000 home loan, you make minimum payments on the loan, and any surplus money is put into the offset account, which is built up to $100,000.
With an offset account, you only pay interest on $300,000 – the balance between the $400,000 loan and the $100,000 offset account.
The beauty is that at any stage you get access to that $100,000 for unforeseen costs, renovations, or deposits for new purchases.
Cunningham says all his properties have offset accounts because they allow him to reduce interest payments.
But unlike paying down the principal of a loan, he also has access to account funds when he needs them without bank approval.
Cunningham also recommends you allocate a percentage of the offset account for maintenance and general property upkeep.
Raiss says there’s another reason for offset accounts: they’re tax effective.
He says many investors, including those who suddenly get large sums such as through inheritance, pay off loans.
But if you then want to borrow money back for personal reasons, it won’t be tax deductable.
“Having paid the loan, the tax man says the reason or the next loan is personal so it’s not tax deductible,” he explains.
“If you need personal money and have an offset account, it allows you to maintain tax deductible debt.”
Cunningham says that while we like to bash and berate banks they do generally operate on sound principles on debt.
Banks are generally happy to lend you 80 per cent of the value of a property.
But if you want to borrow more than that you have to pay mortgage insurance.
Based on their long experience lending to people, the banks are basically saying: it’s risky to borrow more than 80 per cent of the property’s value.
“You’re better off sticking to their line of thinking,” Cunningham says, and not borrowing too much.
You shouldn’t spend more on property construction or renovations than you’ll get back in rent or capital gains.
If you do you’ll suffer losses and significantly increase your future risk.
If you have a $500,000 home, for example, and you spend $200,000 on renovations, but buyers are only willing to pay $600,000 at most in your area, you’ve effectively blown $100,000.
To avoid overcapitalising you need to know three things in detail: the value of your property (for current rents if you plan to rent it), your exact renovation costs, and exactly how much you can sell the property post renovations (or exactly how much more rent you can charge).
This requires research.
David Hallett says study what local renters or buyers want and are willing to pay and make renovations that meet their needs.
For small homes, for example, the market wants storage space and outdoor living areas; for mid-size homes, the market wants two bathrooms, four bedrooms, study space and guest rooms.
“It’s a matter of knowing what demographic you’re trying to appeal to and pitching the house into that appropriately,” Hallett says.
You should also be careful where you spend money on renovations.
You might be tempted to spend $30,000 to put brand new kitchen into a weatherboard home, but that’s unlikely to generate big enough increase in rent to cover the cost.
“Stone benchtops, imported tap ware, etcetera, aren’t necessarily going to appeal to everybody or command a higher price,” Hallett says.
One area of renovation that will pay off increasingly in the future is to make properties sustainable.
Renters are more conscious of the environment, and more conscious of big rises in energy bills.
“It’s about making sure the building is insulated so it’s cheaper to run,” Hallett says.
“If the tenant is paying the energy and water bills – they’re expected to surge over coming years – a building that requires less energy to heat and cool is going to be more attractive.”
To make your properties more sustainable, consider some of the following:
- insulate walls, ceilings and exposed floors;
- install compact fluorescent lights or energy-efficient LED downlights;
- install a rainwater tank;
- install water-saving showerheads, taps and fittings;
- shade windows with eaves, verandahs, external blinds and trees; and
- install a solar hot water system, and/or a high efficient gas water heating system.
Somers says fixing interest rates gives her total peace of mind. “You can just forget (about) it,” she says.
Raiss agrees that if you’re uncertain and nervous about the future, fixing interest rates is like an insurance policy, and allows you to at least know your exact interest costs.
But there are a few downsides to fixing rates.
For a start, they’re more expensive than variable rates, though it depends on when you fixed them.
Raiss says effective fixing usually means you need to pick the interest-rate cycle, which is difficult.
“I have only ever fixed twice,” he says. He timed it well and both were huge wins. But he says they were “pure luck”.
Raiss says another downside to fixing interest rates is the exit fees when you break the loan, which are payable even when you sell your house.
Cunningham says, as general rule, when he’s giving advice to clients he recommends that 80 per cent of the time you’re better off with variable rather than fixed-rate loans. “But I change my advice when it’s got to do with investment properties,” he says.
“People like to lock away rates. They then know their rents and expenses associated with interest payments. They know their yield and can lock in an interest rate and they know what the difference is going to be for the next period of time.”
But for locking away a certain rate, you’re trading off the fact that for 80 per cent of the time it’s better to have variable rates.
Cunningham suggests a compromise: split loans 50 per cent between fixed and variable. “It’s about trying to get the best of both worlds,” he says.
One of the biggest risks investors face is a change in planning laws.
Governments at all levels are trying to improve home affordability.
That has already led to a push for higher-density living, speedier development approvals and the release of land for property development.
These changes increase the risk that changes in laws, and particularly planning laws, could hurt your property investments.
Angie Zigomanis, a residential property analyst at BIS Shrapnel, says investors need to know what’s going on in their local area from a planning perspective.
“Make sure there are no long-term factors that may impact on your property, such as a freeway reserve,” he says. “Make sure you know whether there’s a reserve or proposal.”
Zigomanis says to check at local, state and federal government levels “any proposals that might impact on longer-term capital growth”.
“You may find that you’re in a budding commercial area where a high-rise building might appear adjacent to you,” he says.
“Be aware of any local factors that might affect your property directly, or anything indirectly that might affect the amenity of your area. Make sure you’re as well informed to what potentially could come through.”
Editor’s Note: This article was written by Ben Power and initially published in Australian Property Investor Magazine in 2011. If was also published then on Property Update with their permission but we’ve republished it today for the benefit of our many new readers as the information is just as relevant today as it was when first published.