Diana Clement: What to do when property investment turns ugly

The cash flow has ended for many landlords. Photo / NZ Herald

A millstone around their necks is how some landlords view their rental properties.

At the heady heights of the last residential property boom it seemed a good idea to buy an investment property, or three.

Their accountant or even a real estate agent convinced them that it was a good tax dodge. Then the global financial crisis intervened and for some the investment property has turned into a financial disaster.

"We are seeing clients who have fundamentally bought themselves a pile of lemons," says Anton Nadilo, who runs My Money Mentor.

"They have bought properties that even at the time of purchase they paid too much for. They didn't understand the numbers, the cashflow position, and the rental yields. Fundamental things.

"They thought, 'I'm going to buy property', but they didn't understand the fundamental market cycles.

"Emotionally they are feeling a bit of anxiety with regards to their purchase. They are looking for an analysis of their property. They probably didn't do that when they bought and nor did their advisers, such as lawyers, accountants or property finders."

It is not unusual to see someone sitting on a potential loss of $30,000 to $50,000, says Nadilo. Most followed the herd into the "buying frenzy" between 2005 and 2008.

"The fundamental problem is finding the way to fund that negative cash flow position. Do they sell and lose 50 grand, or find some way to bide their time and fund the cashflow position until the market recovers and looks after their stupid decision."

It's a common scenario, which financial educator and registered financial adviser Lisa Dudson sees as well.

On the financial side, says Dudson, investors in this situation need to do their numbers and work out how much they are paying to prop up the property each week, month, or year, how much they might make by holding on for say three or five years, consider the opportunity cost of investing that money elsewhere and decide whether it is worth them holding on.

There are things investors can do if they choose to hold on, says David Whitburn, president of the Auckland Property Investors Association. That includes getting a rental assessment to determine if they are charging market rent. Typically most DIY investors under-rent their properties by about $40 a week, says Whitburn.

Another option with an underperforming property, which Whitburn did himself recently, is to spend money on the property to improve its rentability and the actual rent that can be charged.

One of the big problems that prevents recent landlords succeeding is that most have no systems and processes in place.

"They rely on intuition and gut feelings and that is not often the best approach with getting tenants," says Nadilo.

"They don't do reference checking and credit checking."

Nadilo and Dudson say they are seeing clients who have been pushed into a financial corner. They've owned negatively geared rental properties for a number of years and borrow the money to make up the shortfall each month.

Over the past few years, says Nadilo, the ability to claim depreciation of chattels and buildings against tax has been removed. What was costing them $30 or $40 a week per property to top up may now be $100 per property.

They may be paying $300 a week to top up three properties. That money isn't coming out of income, but rather being added to a revolving-credit loan.

"A lot of people are operating on these revolving credit rapid repay [loans]," says Nadilo. "As a result they may not even know what the property is costing them."

In the past, says Dudson, they may have been able to go to the bank and ask for a top-up on the revolving credit when it was used up.

Suddenly they are finding that the bank has tightened up and that avenue of easy credit isn't available. That leaves them between a rock and a hard place when it comes to funding those properties.

Another problem is that many investors fall into the trap of mental accounting. The property isn't growing in value, but you're not losing any money are you? Well, actually you are. Quite a lot. If the value is moving sideways, but inflation is running at over 5 per cent, the real value of that property is dropping.

In the meantime you're topping up the mortgage by $100 a week. That's not savings. It's losses. You may be getting some of it back in tax rebates, but not all of it.

It's not completely a financial equation, adds Dudson. Sometimes the stress is too much to hold on.

She saw one client who was staring a $200,000 loss in the face if she sold her leaky rental property. The stress had forced the self-employed woman from her work, which meant she was losing $100,000 a year as a result. In her case the best thing to do was cut her losses and sell.

Selling is definitely not the answer for everyone. Many of those who can hold on should, says property accountant Mark Withers of Withers Tsang.

"I'd tell people who can to hold the line and keep the faith."

The big advantage of rental property is the ability to leverage (to make money on borrowed money). Over the long term property will rise in value, magnifying the gains.

Withers says investors should question their own resolve rather than look to ditch a property.

"Property is a long-term investment - unless you are a speculator - so why abandon the plan and sell now while the market is flat?

"The glass is still very much half full not half empty. The net returns on residential rentals have never been better, rents are up and interest rates are low. The rental property will have better cashflow today than it did in the boom."

Withers argues that the tax changes have been minor in the scheme of things. "Sure depreciation is gone, but that was subject to recovery anyway and was only a timing advantage."

He says the loss in depreciation is made up for by the tax cuts people have received - especially if they are higher rate taxpayers. Most haven't calculated the tax cut versus the depreciation loss.

"Many are ahead on the deal, especially when you realise the depreciation was recoverable as income on sale anyway."

Also positive, Withers says, is that New Zealand has no:

* Ring-fencing of losses - stopping them being claimed against personal taxes.

* Capital gains tax.

* Stamp duty.

* Death duties.

* Land tax.

When it comes to any sort of investing there are always contrarians who buy when everyone else is running.

Auckland investor Lee Whiley is buying again for the first time in several years.

"I believe this is the best time to buy since 1993. Property prices have stabilised, interest rates are low and rents are rising.

"I am buying an Eden Terrace property with a 7.5 per cent yield. I can get money at 5.5 per cent and it will cost me 1.5 per cent for rates, repairs, maintenance and other costs. That makes it cashflow neutral."

Accountant and property investor Michael McCook of Accountability Net adds that the population is set to rise significantly in Auckland to more than two million in the next 30 years. With the current lack of building and shortage of land the numbers should stack up for rental property purchases.

The ultimate decision about what to do with a loss-making rental property, Dudson says, comes down to personal circumstances.

"It is trying to work through what are your options and what are the financial, lifestyle and emotional costs of those options," he says.

"What do those options mean for you?"