Readers of this blog own property or intend to purchase it in the future, whether for owner occupied or investment purposes. Property is an excellent asset class for accumulating and preserving wealth. This is primarily due to its fundamental nature as a necessity, its historical tendency to appreciate in value, and the relatively lower level of price fluctuations compared to shares, instilling a sense of security.
Therefore, it is prudent to grasp the fundamental concepts related to property. In this blog, I will define and explain some common terms that both owner-occupiers and investors should familiarise themselves with. And if you feel like you already know a lot about property, perhaps test your knowledge – are you familiar with all these terms?
Land value / unimproved value
A property’s total value can be divided into two components: the land value and the value of any improvements, such as the dwelling. Normally land values are expressed on a per-square-metre basis. It is important to adjust for various factors such a location, shape of the block, size, whether the land is flat or sloping, amongst others.
Understanding a property’s land value becomes crucial when you have intentions to develop, rebuild, renovate, or when you’re assessing whether a property is suitable for investment purposes. In these scenarios, the land’s intrinsic worth takes on significant importance.
Loan-to-value ratio / LVR
The Loan-to-value Ratio (LVR) is a metric that compares the amount of debt secured by a property with its market value (total debt divided by the property’s value). In practice, banks rely on their own property valuations as a stand-in for market value. Typically, banks are willing to lend up to 80% of a property’s value without requiring mortgage insurance, and they can extend loans of up to 95% of the property’s value with mortgage insurance in place.
LVR is an important factor that determines ones borrowing capacity.
Value of any improvements
The term “value of improvements” essentially refers to the value of the buildings or structures on a property. This value can be determined by subtracting the land value from the total property value. Alternatively, you can estimate it by considering the cost of replacing any improvements. Naturally, adjustments must be made to account for the age and condition of the dwelling and improvements.
The primary method for valuing residential properties involves analysing recent sales of similar properties in the same vicinity. Valuers consider various factors, including the property’s proximity to the subject property, architectural style, the condition and size of the dwelling, land dimensions and any distinctive features. It’s important to note that no two properties are entirely identical, which introduces a degree of subjectivity into the valuation process. Generally, the greater volume of highly comparable sales that can be identified, the more dependable the valuation assessment becomes.
Gross rental yield
The gross rental yield is the amount of rental income a property can generate from tenants, presented as a percentage of its market value. To illustrate, if a property is valued at $1 million and rents out for $500 per week, its rental yield is 2.6% (calculated by multiplying $500 by 52 weeks and then dividing by $1 million).
Gross rental yields are valuable for assessing a property’s cash flow and for making investment comparisons. However, I have warned against investing in high yielding properties as they generate less capital growth – see here.
Net rental yield
A property’s net rental yield is calculated by subtracting all regular, direct expenses excluding interest from the property’s rental income and dividing this result by its market value.
Net rental yields are not frequently used, as comparable properties tend to have similar expense profiles. However, it is still valuable to analyse of a property’s expenses, particularly for apartments that often attract Body Corporate fees, as these expenses can significantly influence the property’s cash flows.
Based on our experience, total expenses typically range from 0.7% to 1.2% of a property’s value.
Negative gearing involves borrowing money to make an investment where the borrowing costs exceed the net income generated by that investment – resulting in a financial loss. Australian tax law permits you to offset that loss against other income, often salary and wages, to reduce the overall amount of tax you pay.
The only reason an investor should employ a negative gearing strategy is when they expect that, in the long run, the compounding capital gains from the investment will ultimately exceed the income losses incurred. You must never invest with the predominant aim of saving tax. Your aim must be to primarily build wealth.
Cash flow shortfall
A cash flow shortfall is the difference between the rental income a property will generate and all expenses including interest. A cash flow shortfall can be expressed either before tax or after tax. The formula for calculating a property’s cash shortfall is provided below including typical assumptions that I use. This calculation is used to assess the affordability of a property investment.
Your borrowing capacity is the lower of:
- The amount you are comfortable borrowing, taking into account your anticipated future cash flow and your willingness to take on financial risk; and
- The amount that banks are willing to lend to you.
Everyone has a finite borrowing capacity. It is a scarce resource which should be allocated efficiently. By identifying your maximum borrowing capacity, you can ensure that you make the most prudent use of this scarce resource.
Borrowable equity represents the potential amount you can borrow against a property, based on its current market value. To calculate a property’s borrowable equity, you multiply its value by the maximum LVR, which is typically 80%, and then subtract any existing loans secured by that property. For example, if your property is valued at $1 million, and you have a $600,000 loan against it, your borrowable equity is $200,000.
It’s important to note that this is a theoretical calculation because your ability to access the additional $200,000 depends on factors like your income and expenses, a concept known as “serviceability.”
Borrowable equity serves as a key factor in assessing an individual’s borrowing capacity, determining whether they have sufficient collateral to secure the desired loan amount.
Compounding capital growth
Compounding capital growth is the amount the price of a property has appreciated between two dates expressed as an annual percentage. The easiest way to calculate a properties compounding capital growth rate is to use the XIRR function in Microsoft Excel.
The compounding capital growth rate is a tool used to assess how a specific property has performed in the past. This analysis aids in forming expectations regarding future expected capital growth.
Net sale proceeds
Net sales proceeds is a calculation of what cash you may receive if you sell a property. This is calculated by subtracting selling costs, repayment of any loans and payment of any CGT liability from the expected sales price.
Capital Gains Tax
Capital gains tax is the tax that you may have to pay if you sell a property for more than what it costs you to purchase. I have discussed CGT in detail here.
Land tax is a tax levied by states on the value of your land holdings at the end of each calendar year, excluding your home. I have discussed land tax in detail here.
A managing agent is a real estate professional that manages your investment property. They will manage most aspects of investment property ownership including screening prospective tenants, collecting the rent, property maintenance, paying all expenses, legal compliance, recording keeping, and dealing with any problem tenants. Property managers tend to charge between 5% and 10% of gross rental in most states of Australia, depending on the type and location of the property.
It is possible to divide a property both vertically (air space) and horizontally such that each share has a separate title. Subdividing a property means that you will split one title into two or more separate titles so that you can deal with them separately.
Semi, attached, and detached dwelling
A semi-detached property is a dwelling that shares one common wall with the next property. This is also referred to as a dual-occ or dual-occupancy.
An attached dwelling is one that shares two common walls with each adjoining property.
A detached dwelling is not attached to any other dwellings.
When you subdivide a property, there may be common areas like driveways, gardens and shared amenities such as elevators and pools. Any property with these shared spaces must establish a Body Corporate, which is a distinct legal entity responsible for managing and overseeing these common areas. The Body Corporate looks after matters like maintenance, obtaining building insurance, enforcing rules, making decisions and resolving disputes.
In most cases, the Body Corporate appoints a Body Corporate manager to handle administrative tasks and ensures legal compliance. Additionally, a group of property owners is selected as directors to oversee the Body Corporate’s operations.
If you’re buying a property within a Body Corporate, it’s vital to verify that it functions smoothly without internal conflicts, has sufficient capital to cover maintenance costs and understand the associated annual fees.
A property title is a document that records specific information about a property including the owner. All states now maintain electronic property titles except for Tasmania.
The most common type of title in Australia is called a Torrens title and provides absolute ownership rights.
Strata titles allows people to own a particular unit or lot within a larger development in addition to a share in the ownership of common areas. This is common in blocks of apartments.
A Company title is more common in older apartment blocks where owners own shares in a company that owns the whole apartment block.
A Leasehold title is provided over land that is owned by the government and lease for a specific period, often 99 years. This is common for some of the apartments on the wharfs in Sydney.
When buying a property, it is important to understand its title and any borrowing and legal implications.
A first mortgage is a legal agreement that establishes a primary claim or priority position on a property’s title in the event of default on the mortgage loan. First mortgages are registered on the property’s title.
Knowing the basics
Being familiar with fundamental property concepts and terminology is essential for gaining a deeper comprehension of the property market. This knowledge empowers you, as the adage suggests: “Knowledge is power.”