Now that Australia’s property markets are moving to the next phase of the cycle, strategic investors are back in the market actively purchasing properties and setting themselves up for financial freedom.
After all, when it comes to investing your hard-earned cash, there are many investment options available, but choosing an investment vehicle that will generate wealth-producing rates of return is key… and in my mind, there is no better investment than property.
Here are 5 ways that investors make money from investment properties, and how to capitalise on each of them.
The cash flow of an investment property is the rental income you get from your tenant.
Once you take the various property investment expenses into account this cash flow can be either positive or negative.
Positive cash flow means there is money left over after expenses are paid and negative cash flow means the costs have exceeded the gross rental income.
Obviously, positive cash flow means there is excess income, which then goes straight into your pocket as profit.
Clearly the higher the rental yield, the better the cash flow and the more money you’ll make through this method.
Here’s how you calculate your rental yield:
1. What’s the rent you’ll charge a tenant in a year?
2. What’s the value of the property?
3. Divide the annual rent by the property’s value and multiply it by 100 to get a percentage figure.
So, if you’re collecting $25,000 a year from your tenant and the property itself is worth $500,000, then your gross rental yield is 5%.
Generally speaking, a gross rental yield of 3-4% in a metropolitan location is pretty good while in regional areas somewhere above 5% is more like what you’d get.
Clearly, you need cash flow to allow you to hold your portfolio for long enough so that the power of compounding of capital growth kicks into gear, meaning you must have a financial buffer to see you through the lean times.
This means you need to be careful about your cash flow and your ability to service your debts.
While not the highest profit center of all, cash flow and rental yield is a good place to start for successful rental property investing.
You’ve heard me say it before – cash flow keeps you in the game, but it’s capital growth that gets you out of the rat race.
Capital growth is the amount that your property increases in value over time.
You can calculate capital growth by finding the difference between the current market value of your investment and the price you initially purchased it for.
I’ve met so many investors who are fixated on rental yields – but for me, capital growth is always the number one thing to look out for when buying an investment property.
Building wealth through real estate is best achieved by buying quality investment-grade properties and holding them for the long term, allowing the market to do most of the hard work for you.
You see... residential real estate is a high-growth relatively low-yield investment.
And as this capital growth is not taxed unless you sell your property, this enables you to reinvest your capital to generate higher compounding returns.
On the other hand, rental income is taxed, leaving less to be reinvested.
This means for investors in the asset accumulation stage of their journey, the more capital growth you achieve (even at the cost of lower rental income) the more wealth you will accumulate in the long term.
But not all properties are created equal in terms of their capital growth potential.
In my mind an “investment grade” property, which ticks all of the following boxes, will most likely give you the benefit of supercharged capital growth:
- In a good location
- With a scarcity factor
- With renovation potential
- A high land or asset ratio
- Development potential
Accelerated or forced growth is the capital growth you “manufacture” by adding value through renovations or development.
It’s something made more popular by the hugely popular tv show: The Block.
I enjoy taking a dwelling that’s been a bit neglected and breathing new life into it, making it into a home my tenants will love and want to care for, and more importantly, it’s a great way of manufacturing equity for my property investment portfolio.
But, a word of warning… the way you make money out of property is not by buying, renovating, and flipping.
Because after stamp duty, interest, holding costs, selling commission, and tax there is rarely any profit in this strategy.
But buying, renovating, renting, refinancing, and repeating – that’s my BRRRR strategy.
Holding quality properties for the long term is a time-tested investment strategy that works.
Investors who renovate and retain property stand to gain so much more, with the potential to:
- Manufacture thousands of dollars in equity and fast-track your investment's capital growth
- Make your newly refurbished rental property attractive to a wider range of potential tenants
- Receive higher rental as your newly improved asset shines against its competitors
- Get the tax benefit of extra depreciation allowances.
Another profitable component of property investing is the tax benefits on offer.
Investors can breathe a sigh of relief that there will be no likely changes to negative gearing legislation in the near future.
By taking advantage of the tax breaks available, property investors can minimise their income tax while growing their wealth – talk about a win-win.
For example, say you earn $80,000 per year, and in total, you spend $25,000 paying for your investment property, but you receive $20,000 in rental income.
The $5,000 difference between the money you receive in rental income ($20,000) and the money you spend paying for the property ($25,000) is tax-deductible.
That’s $5,000 worth of expenses you can claim against your regular income tax.
That means that the Australian Taxation Office (ATO) would assess your tax as if you’d earned $75,000 instead of $80,000.
So, every week or fortnight, or month, you’ll pay tax as if you earn $80,000, but then when it’s time to file your tax return, you’ll get a refund of any tax paid on the $5,000 difference.
According to current tax rates, that’s around $1,625 back in your pocket.
Not only that, but you can also usually make a claim each year for depreciation, which is an allowance for the wear and tear of the property over time.
15 tax deductions property investors can make in Australia:
1. The cost of advertising and marketing for new tenants
2. Loan interest and bank fees
3. Body corporate fees and charges (not including special levies)
4. Building, contents, landlords, and public liability insurance
5. Council rates (claimable for the number of days the property is rented)
6. Property management fees
7. Depreciation, relating to the wear and tear of the building and its contents
8. Negative gearing (this is when your property costs you more than you are earning from it. I.e: you have a negative cash flow)
9. Gardening expenses
10. Land tax
11. Utility fees (where it’s not paid by the tenant)
12. Pest control
13. Repairs and maintenance
14. Some legal costs and lease document preparation expenses
15. Capital gains discount
According to the ATO, here are some property investment costs you CAN’T claim:
- Stamp duty is charged by your state or territory government when you purchase the property – this is a capital expense.
- Legal expenses, including solicitors' and conveyancers' fees for the purchase of the property – again, this is a capital expense.
- Renovation expenses. Repairs are allowable deductions, while renovations are capital expenses. Think of it this way: repairing one broken kitchen cabinet is tax-deductible. Replacing all of the kitchen cabinets with new ones is not.
- Borrowing expenses on any part of the loan you use for private purposes. For instance, if you refinance your investment property loan and use $20k of your equity to renovate your own personal kitchen, the interest on that loan is not tax-deductible. This can be really tricky to manage and track, so it’s a good idea to keep your private and investment-related loans separate wherever possible!
Equity payoff is a different type of money earner.
Rather than earning money, think of it this way… you own an investment property but it’s your tenant who is paying down the mortgage.
Hopefully, it even leaves you with some surplus cash flow too.
Here’s an example: You buy a $500,000 rental property with 20% down. That means you paid $100,000 upfront and the remaining $400,000 is the balance on the loan, in addition to interest payments.
Over 30 years, the mortgage balance is paid down every month through the income you receive from your tenants.
At the end of those 30 years, your mortgage has been paid off and you now own the property outright.
- Also read:This week’s Australian Property Market Update – Latest Data, State by State November 28th, 2023
- Also read:The Boom and Bust of our Property Cycles: A Journey Through the Investor’s Mind
- Also read:Latest property price forecasts for 2023 revealed. What’s ahead in our housing markets in the next year or two?
- Also read:The 10 Safest Cities to Live in Australia
- Also read:Everything you need to know about the state of Australia’s property markets in 20 charts – November 2023
The money isn’t immediately liquid because it’s in the form of equity, but you can either keep it as equity or pull it out of the property.
The bottom line is that you turned $100,000 into $500,000, plus any capital growth and additional cash flow.
What's your investment strategy?
Now you know how you can make money through investment property, the trick is to set up an investment strategy to make your financial freedom a reality.
Note: Just to make things clear...buying an investment property is NOT a strategy!
It's important to start with the end game in mind and understand what you need and what you want to achieve and then you have to build a plan, a strategy to get there.
The property you eventually buy will be the physical manifestation of a whole lot of decisions that you will make, and they must be made in the right order.
You’ve heard it before – failing to plan is really planning to fail.
On the other hand, strategic investors devise a strategy – they bring their future into the present and devise a plan to achieve the results they want.
So your "end game" might look something like this:
1. You will have your own home with no debt against it
2. A substantial asset base of investment-grade residential real estate with a level of gearing against it, plus
3. Some commercial properties which bring in cash flow, as well as
4. Some income-producing assets such as shares or managed funds may be in your Superfund.
By having a mixture of growth and income assets and a conservative level of debt, you'll be able to live off the "cash machine" of your investments.
How big an asset base you're going to need, how long it will take to accumulate, and how much cash it will spin out will depend on a myriad of factors and that's why we always recommend the starting point - even before you start looking at a property as building a customised Strategic Property Plan.
And that's what we always recommend for our clients at Metropole - whether they have beginning investors or are in the middle of their wealth creation journey.
That's because attaining wealth doesn’t just happen, it really is the result of a well-executed plan.