Hard labour and grit a landlord's lot

By MARY HOLM

Q: I am a financial planner who specialises in property analysis for those of my clients who insist on entering the residential rental property market.

Many financial planners dismiss property investment out of hand.

I have learned from my wealthiest friends and clients that what distinguishes them from the crowd are commitment to the wealth-accumulating method of their choice, hard work, stable relationships and staying on course regardless of the poor market and bad press of the day - whether it is shares, deposits, property, antiques or, in some enlightened cases, a mixture of them all.

Many of them, however, prefer property. For them, I employ the internal rate of return (IRR) spreadsheet analysis method recommended by Professor Bob Hargreaves at Massey, on a daily basis.

I see many propositions that I wish I had seen first, because they offer such good long-term yields.

Your correspondent's rental proposition (in last week's column) is not one of them.

The analysis is typical of many examples that come to me from the clients of real estate agents. It might be simple. However, it is also critically deficient in several areas.

For the supplied example: a cashed-up return at year one shows a loss of 18.79 per cent by the time real estate fees, etc are paid. Not a 10 per cent gain.

One can't count the chickens, after all, until they have hatched. Let's say they have hatched in 10 years.

Many of the costs were neglected. These include at purchase: loan application fee $400, registered valuer $300, lawyer $1200.

At sale in year 10: lawyer $600, real estate agent $6610, including GST. Include these, and the IRR at year 10 is 5.92 per cent. The costs conspire to dilute the returns.

There is a degree of unreality in the assumptions that there are no vacancy or management costs.

The rental range discussed appeals to a market that is notoriously unreliable. Most such rentals are empty for two to four weeks of the year, say 95 per cent occupancy, for maintenance and downtime between tenants.

Property managers charge 7.5 per cent.

There is no free lunch. If you undertake management yourself, this can occupy one to two hours a week. At $25 an hour this equals $1300 to $2600 a year. In essence, any capital gains become wages.

Include these costs at 95 per cent occupancy and 7.5 per cent management, and the IRR at year 10 is 3.87 per cent.

Your correspondent's most blatant error is the assumption regarding the relationship between inflation and interest rates.

First, mortgage rates could be more accurately described as the average sum of inflation, risk-free rate and bank margin.

If one was to check back, I suspect that the actual interest rate average, in this exercise arguing 3 per cent property inflation, would be closer to 8 per cent.

It is upon this relationship that I have derived a final long-term IRR of 3.11 per cent. Financed 100 per cent, the IRR is 2.51 per cent.

This is somewhat lower than the simple but optimistic 10 per cent, but more realistically considers all of the cash flows.

The best figures come from retiring the debt on a 10-year table mortgage. This requires payments of $14,238 a year at 7 per cent. The IRR is 6.21 per cent.

I'm not sure what happened to the 200-word letter limit! But it's interesting stuff.

For the benefit of others, the internal rate of return is basically the return the project gives investors, taking into account cash flows in and out, and when they take place.

The point about landlords doing their own management is one that is often overlooked.

If, as a landlord, you really enjoy running the property, then I guess it makes sense not to regard your time as a cost.

Otherwise, though, you should put a value on your time.

Predictably - given how popular rental property is in New Zealand - I received lots of other letters on this topic. Here are excerpts from some:


Q: A flaw in the rent example is that for most of us living in the major centres, you cannot buy a house for $100,000.

A better example would be to use a median house price. That would increase the deposit required, unless you qualify to borrow a larger percentage of the house value, increasing the gearing and risk.

Also, there is an allowance for house inflation, but not general inflation.

I have read that over the long term, house prices do little better than inflation, so your house inflation return would be protecting your capital value, not increasing it.

Inland Revenue allows much more than $1000 in every $100,000, or 1 per cent, depreciation on houses.

That would indicate that replacement costs and/or maintenance costs would easily exceed 1 per cent over time, as you pointed out.

Good point about $100,000, although you can buy units for that price or not much more.

House prices do tend to rise a bit more than inflation - 2 per cent more since the early 1960s.

More recently, since inflation has been lower, the gap has been a bit bigger. Real (inflation-adjusted) New Zealand house prices rose about 2.5 per cent a year for the 10 years ending last September. In the Auckland market, it was about 4 per cent.

We should note, though, that these figures are median sale prices. They don't take into account improvements in the size and quality of houses.

The quality issue might be debatable, in light of recent water problems with newly built houses. But overall, the quality of housing stock, old and new, tends to rise over the decades.

And houses have almost certainly got bigger. People now want second living areas, second bathrooms and generally bigger rooms.

If we look at the average individual house, then, its value won't have risen as much as median sale prices, unless the owners have spent time or money upgrading it. In that case, the value of that time or money should be subtracted from the gain.

As for maintenance costs, read on for an example of what sometimes happens.

Q: We have owned a number of rental properties for many years now, and I thought some actual figures might be useful to you.

Our experience indicates that the costs and risk of rent gaps is higher than most people estimate.

Three years ago we had to loan one property $4500 to cover a shortfall in a year when a drainage problem shot the maintenance costs to $7724. The property has since paid this back.

By taking a conservative approach, we can make a little money, and it is a form of saving.

However, although on one property we doubled our money in three years, it is not a spectacular money maker, and there are episodes of hassles with tenants that require some sturdy resolve.

I haven't got room to run another set of accounts. But your letter highlights the element of luck in rental property.

If we had looked just at the property that doubled in value so quickly, we could conclude that rentals are brilliant investments.

If we had looked at another of your properties that had big rent gaps and maintenance costs, we could conclude the opposite.

You've owned several properties over many years, so you can take an over-all moderate view.

But the many people who own only one property are taking a bit of a gamble.

* Got a question about money?

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