Buying a rental property as an investment: what you need to know

This post is by Giles Ellis, Director at GECA Chartered Accountants based in Newmarket.

Any investment, whether buying a rental property or a share portfolio, should start with clarity around your objectives, risk profile and time frame. Investing is about yield and risk.

Generally speaking, residential rental property investment is a long term and low risk investment. Gross yields vary according to the type of property and the affordability of housing in general. As a rule of thumb a good residential rental property investment should have a gross yield in excess of the average floating interest rates. In a low interest rate environment such as we have at present it is prudent to allow for interest rates of 7% (rates below 7% are low by historical standards).

Thinking About Buying A Rental Property?

Borrowing to invest (called gearing) increases risk. Gearing in excess of 80% of the purchase price or market value is higher risk. A property will be cash flow positive before tax if the rent received exceeds cash expenses including interest, rates, insurance, maintenance and property management fees.

Buying a rental property is a long term strategy to create financial independence. Being relatively low risk, with regular and reliable income, and with values and income yields generally inflation proof property investment is suitable for most retirement plans.

Ways to play the game

There are different ways to play the property game – rental properties are high risk if aggressively geared (you’ve borrowed lots of money to buy the property) and/or you plan to resell or “flick”. Buying to resell is not actually investment, it is a business and highly speculative. The capital gains are taxable and the transaction may be subject to GST.

If you are just starting out as a property investor then we suggest that you start with a simple investment. Some clients have ignored this advice and gone straight into complicated property deals involving subdivision, building, renovations and so on and have lost money (and in some cases a lot!). So start simple, and build up your knowledge and experience before tackling more sophisticated and complicated investment opportunities.

Determine your objectives before buying a rental property

The first step is to determine your objectives. Are you investing for positive cash flow or capital gain? All properties are likely to get capital gain over the medium to long term of at least the rate of inflation. For long term investors the capital gain is “icing on the cake” rather than the cake itself. While it is always preferable to buy a bargain (a property at a discount so you have immediate capital gain), the ongoing cashflow (yield) is generally more important than capital gain.

It is important not to pay too much for the property when you buy, so avoid buying a rental property at the peak of a property boom. Conversely, the best time to buy is often at the bottom of a market cycle when there is less demand and more people are selling than buying.

If the property is cash flow positive it will pay its own expenses and also put money in your pocket, or pay off the mortgage. Negative cash flow properties require you to make regular cash contributions and it is easy to over commit yourself, especially if your personal situation changes. It is likely that you can only afford one or two negative cash flow properties, but theoretically you could own an unlimited number of cash flow positive properties.

Set yourself some rules

Once clear on your objectives, set some investment rules to simplify your search. There are literally thousands of properties on the market at any time and it is impossible to look at them all.

Leverage your valuable time by limiting your search to:

  • a particular type of property (for example, an apartment or a 3 bedroom family home in a particular suburb close to shops, schools and public transport)
  • A particular style of building (for example, you may decide to avoid plaster construction completely, or target buildings over 20 years old, or brick and tile construction)
  • A particular price range (based on your ability to borrow, which a mortgage broker will be able to advise you)
  • A minimum desired gross yield (so you need to know the approximate weekly rent that the type of property you are looking for is able to command. The NZ Property Investor magazine is a good source of information)

Gross yield is calculated as the gross annual rental divided by the purchase price of the property. For example, if the rental income was say $450 a week the annual rental would be $23,400. If the purchase price was $390,000 then the gross yield (before expenses) is 6% ($23,400 dividend by $390,000). At this point don’t get bogged down in too much detailed analysis. A gross yield calculation enables you to compare different properties quickly and easily.

Do your due diligence before buying a rental property

Once you have found a property that meets your criteria the next step is due diligence. Find out the government valuation and maybe get a quotable value off the internet. Compare these values to the asking price. Find out the reason the vendor is selling – desperate vendors are much more negotiable on price. Look around the neighbourhood and talk to the neighbours. Think about the desirability of the property for prospective renters. Is the garden or building high maintenance? Is the property handy to schools, shops and buses etc? Is initial maintenance work required? If so, add the initial maintenance costs to the purchase price and recalculate the gross yield. Consider reducing your offer price by the cost of the outstanding maintenance work.

At this point you will also prepare a detailed financial analysis of the property. It is a good idea to get a second opinion from your accountant to make sure your numbers are robust.
At some point you will need a building inspection and probably a registered valuation. Do not rely on reports or valuations commissioned by the vendor. You will also need a lawyer to look over the sale and purchase agreement and check out legal title and LIM (Land Information Memorandum) report and so on.

Don’t sign the agreement without having a professional check it first, even if you think it is conditional and you have a way out. Many new investors have signed conditional agreements that they subsequently have been unable to get out of. The real estate agent is acting for the vendor (not you the purchaser) as their commission is paid by the vendor from the sale proceeds.

The property is not for you to live in – it’s a business transaction and should be viewed objectively. If the numbers don’t stack up, or the due diligence fails, move on. Next please! There are lots of great deals out there.

Get advice on structure

Unless you have taken prior advice or are an experienced investor, then we suggest you sign the sale and purchase agreement under your own name as “purchaser” and the words “or nominee”. This enables a deed of nomination to be executed prior to settlement to ensure the property is purchased in the correct legal entity. At this point talk to a good property accountant, if you haven’t already, and get some expert tax planning advice.
Getting the initial ownership structure and financing correct will in large part determine the tax effectiveness of the investment in the medium to long term. In some cases a company or LTC (Look Through Company) may be the best entity to purchase the property in. Your accountant should be able to advise about the structure (if a company you will need to consider the share capital, directors, shareholders and so on).

There maybe one off opportunities to do some clever tax planning, for example possibly switching existing non deductible (private) debt into tax deductible (investment or business) debt. But care needs to be taken as there is always an over riding requirement for there to be valid commercial justification for the transaction and structure. Minimising tax is not valid commercial justification in the eyes of the IRD, and could even be treated as tax evasion which is a criminal offense.

Ask your accountant about whether a chattel valuation is desirable. A chattel valuation is different from a property valuation and can increase the amount of depreciation able to be claimed for tax purposes.

Arrange finance

Once the structure is agreed on and set up you need to arrange finance. Sometimes getting finance can be tricky, a good mortgage broker can be worth their weight in gold. A mortgage broker is paid by the bank so does not usually cost you anything. A mortgage broker will be able to advise you how much you are likely to be able to borrow, options as to structuring the finance and which bank is likely to give you the best deal available at the time.

The mortgage broker may be able to negotiate a reduction in mortgage application fees and even perhaps a rebate on legal costs.

Once the deal is unconditional you will need to arrange insurance for the property, effective from the day you settle. A small detail perhaps, but not to be overlooked!

Managing the rental property

Will you manage the property yourself or you will use a property management company? Many new time investors try to manage the property themselves but unless you know what you are doing that can be a mistake. Getting the property let quickly by a suitable tenant is vital. You can outsource the letting process even if you wish to manage the property yourself.

A signed rental agreement is needed as well as a bond from the tenant of up to four weeks rent. The bond should be promptly sent to the Department of Building and Housing. Doing a thorough check of the proposed tenant and checking their references and credit history is important. Property inspections should be carried out regularly (perhaps every three or six months) and the rent regularly reviewed (at least annually) to ensure it is market rate.

Repairs should be attended to quickly to retain tenant goodwill and ensure the property does not deteriorate. If the tenant gets behind with the rent this must be followed up straight away. If there are rent arrears or the tenant does a runner you may end up at a tenancy tribunal hearing. When a tenant moves out you will need to clean the property, advertise and select a replacement tenant as quickly as possible to minimise loss of rental income.

Unless prepared to invest sufficient time and effort, it is better to pay a reputable property manager to manage your property on your behalf. Many seasoned investors maintain that tenant management is the most difficult aspect of being a property investor.

Record Keeping

Once you have bought the property and have a tenant in place then you need to organise some record keeping for accounting and tax purposes. Once again ask your accountant about the best way to handle this and clarify the deductions you are able to claim. You should set up a separate bank account for your rental activities and consider using cloud based software that enables you to view information from any location or device with internet access.

Since most residential property investment is not subject to GST you will usually only be required to file annual income tax returns at the end of each financial year. If cashflow is tight and you expect to make a tax loss you are able to file a special tax code application to reduce the PAYE deducted from your pay if appropriate. Any tax implications as a result of owning the property will be calculated at the end of the tax year when your income tax returns are prepared.

Although accounting for a rental property appears straight forward there are many tax issues that need to be considered. We recommend having an experienced property accountant prepare the financial statements and income tax returns each year.

GECA offer an obligation free first meeting to property investors. Contact us to set up a time talk about your strategy to become financially independent as well as your accounting and tax requirements.