Property 101: How much do you know about property?

Now , of course , most people listening to this podcast already own property , whether it's a home or investment or both , or maybe are thinking about getting into the property market . And , of course , property is an excellent asset class for accumulating and certainly preserving wealth , primarily for a couple of reasons .

Firstly , it's a necessity and we all need somewhere to live . It's got a historic tendency for prices to rise and in fact has less volatility half the volatility of the share market and so that gives people a sense of comfort . And , as I've spoken about in this podcast many times , you can borrow to invest in property .

So the ability to gear significantly against that asset is a great strategy . It's not the property per se , it's really the gearing that's driving those returns . So if we're all interested in property , then it holds true that it's really important to understand the fundamental concepts .

So in this episode I thought I would discuss and define certain terms and fundamental concepts that anyone that owns property should familiarize themselves with . Now , if you already feel like you know quite a bit about the property market and property in itself , it might serve as a really good test . You can ask yourself you know , how many of them do you know ?

So let's get into it . The first one is land value , or unimproved value is the term , and of course a property's value can be divided into two components the underlying land value and then the value of any improvements on that land . So that is the dwelling and anything else associated with it . Any land values are expressed on a per square meter basis .

So anyone operating in a particular geographical market whether you're a real estate agent , buyers , agent , value are you know will have a good feeling . For what is the underlying land value worth on a per square meter basis ? Typically it's expressed in a range because you need to adjust for factors like location .

You know within that particular soberber street , shape of block , size of block , you know whether the block is flat or it's sloping and any other sort of factors .

Understanding the underlying land value of a particular property can be very important if you've got intentions to develop , rebuild , renovate or even if you're just assessing whether it's a suitable for investment purposes .

You know you want to make sure that , as I've explained many times before in this podcast , that you're spending most of your money on the underlying land and less on the improvements , because you can't really change a land after you buy it , but you can certainly improve a property after you buy it , and so the land's intrinsic value is really important in

understanding you know the per square meter cost of particular land in particular locations can be very helpful . Okay , so the next term is loan to value ratio , or LVR is the acronym for that .

It's a metric that really compares the amount of debt on secure by a property compared to its market value , and certainly the banks use a valuation for a proxy for its market value , and so typically banks will end up to 80% of a property's value without requiring mortgage insurance , or up to 95 if you do pay mortgage insurance , which can be very expensive about

3% plus of a loan amount . And so LVR loan to value ratio is an important factor when considering you know how much you can borrow against a particular asset and also a component to your borrowable equity , which is another term which I'll explain later in the podcast .

The next term is value of improvements which really refers to the building value really any buildings or structures on a property . So it's really the market value less the land value . Typically the balance or the difference is what's referred to as value of improvements .

The alternative approach to valuing those improvements is to understand what the cost to replicate that property would be , sort of replacement cost it sometimes referred to . Now of course you've got to make adjustments for the age and condition of the dwelling and so forth .

But either of those two options again is a way to ascertain sort of building and land value and it might be appropriate . You know , if you've got a dwelling on a property that really has zero value , well then you can kind of imply that you have a notional sort of building value and the rest is land value . So that's value of improvements . Okay .

So the next term is comparable sales . It's the primary method for valuing residential property . Involves analyzing recent sales of similar properties in the same vicinity .

So a value will consider , you know , whether the property is actually comparable to the subject property and it will consider factors like the property's proximity to the subject property , architectural style , condition and size of dwelling , land dimensions and any other sort of distinctive features it's important to highlight , of course , that no two properties are really

identical , so there's a fair bit of subjectivity in the valuation process and generally , the more comparable sales you have and the more comparable they are directly comparable to your subject property , the more dependable that evaluation process becomes .

So when people talk about comparable properties , it's really important to understand whether , if you've got a property that is very run as the mill for the area you know , there's a lot of properties very similar to it it's likely that you're going to be able to achieve a reliable valuation result , whereas if you've got a property that's kind of unique and has a

few unique characteristics , that comparable sales analysis , in terms of coming up a valuation , is always going to be a bit challenging . The next term is gross rental yield . The gross rental yield is the amount of income that a property will generate , expressed as a percentage of its market value .

So , to sort of illustrate , a million dollar property that generates $500 a week , essentially 500 times 52 weeks is $26,000 a year . Divide that number by a million dollars , which is market value , and you get 2.6% . That's how you determine a property's gross rental yield .

Rental yields or gross rental yields are really used for assessing or predicting a property's cash flow , particularly from an investment perspective . However , you know I've spoken before about high yielding properties typically means they've got too much building value and not enough land value .

So , again , using a gross rental yield can give you a hint or an indication of the building versus land value split and therefore you know what capital growth you can expect over long run from a property with those sorts of characteristics . And while we're here , let's talk about net rental yield as opposed to gross rental yields .

So net rental yield is after subtracting a property's direct and regular expenses , excluding interest , because interest is really how you fund that property . It's not really related to the property per se . It doesn't have that direct relationship . So it's really gross rental income , I should say less expenses , divided by the property's market value .

It's not frequently used because properties comparable properties tend to have a similar income profile , so it's not really that important .

However , of course , it is important to look at that sort of granular level , particularly if you're looking at purchasing a particular property , to really look into and work out what its expenses are , including sort of council rates and insurance and , if it's an apartment , body corporate fees , because they can be quite expensive .

Based on our experience , the expenses typically range between 0.7 to 1.2 percent , sort of in that range .

So if you've got a gross rental yield as I used in the example just previously of 2.6 percent , your net rental yield might be about 1.5 percent and that's what's going to contribute towards servicing any lending costs if you're borrowed to invest in that property .

The next term to talk about is negative gearing . Negative gearing involves borrowing to make an investment where the borrowing costs exceed the net income that that investment produces , resulting in a financial loss in each year .

The Australian tax law obviously says that you can offset that loss against other incomes , such as salary and wage , thereby reducing your overall tax saving . Now you'd only employ a negative gearing strategy where you expect that the compounding capital growth from that asset over time will significantly more than offset any income losses that you might incur .

Now it's important to point out that any negative gearing benefits resulting from making a property investment just a positive consequence of that investment , not the reason for it . So that is , we're not investing to save tax , we're investing to build wealth .

The strategy we're using to build wealth is gearing , is borrowing to invest , and the consequence of that strategy , the positive consequence of that strategy is a tax saving , but primarily it's really about building wealth . Of course , the next term to talk about is cash flow shortfall .

Cash flow shortfall really is the difference between the property's rental income , less oil expenses , including any interest , in respect to any loans that you've used to buy that particular asset . Cash flow shortfall can either be expressed as a pre-tax or post-tax amount , and that's after you've included any negative gearing benefit .

And really I've included a bit of a formula which you'll see on the blog , on the website , just to sort of calculate at a very high level , or estimate , I should say , at a very high level , what a pre-tax and post-tax cash flow shortfall of a particular property investment might be . And you'll find that formula on the blog , on the website .

Of course the link is in the show notes , as always . The next term is borrowing capacity , and borrowing capacity obviously just refers to your theoretical maximum loan , the amount of lending that you can take on .

It really is the lower of the amount that you're comfortable borrowing , taking into account , you know , anticipated or future changes in cash flow and your willingness to take on financial risk , and the amount that the banks will lend you . So the difference between the lower of those two amounts is really your maximum borrowing capacity .

In a normal environment , most people would be willing to borrow less than what the banks will lend them , but in this environment , where borrowing capacity is very contracted at the moment because of higher interest rates , particularly higher benchmark interest rates , that's not necessarily true today , of course , everyone has a finite borrowing capacity and , as such ,

borrowing capacity is the scarce limit which I've really all the scarce asset which I've really spoken about quite a lot on this podcast , and so really you should allocate it as efficiently as possible , that is , contribute your borrowing capacity to assets that are going to generate the highest returns .

Given it's a scarce resource , you've only got a finite amount of borrowing capacity . You want to be really deliberate on how you allocate it . The next term is borrowable equity , and borrowable equity represents the potential amount that you can borrow against a particular property based on its current market value .

So to calculate the borrowable equity , what you need to do is multiply the properties market value by the maximum loan to value ratio , which is usually 80% , and then you subtract any credit limits already secured by that property .

So , for example , if your property is worth a million dollars and you have a loan of 600,000 secured against it , well then , your borrowable equity is 200,000 . The reason for that is a million dollars by 80% is 800 , but you've already got 600 secured by it . So therefore , 8 minus 6 , 200,000 dollars .

Now it's important to note this is a theoretical borrowing capacity because there's two things that you need to satisfy for the bank to lend you that 200,000 . The first one is do you have enough security ? So this is the borrowable equity term . The second one is do you have enough serviceability so income and expenses to be able to service that 200,000 .

You need to satisfy both security and serviceability in order to borrow it . So it really is . Borrowable equity is really a theoretical calculation . Now we use borrowable equity mainly just to ascertain someone's borrowing capacity from a security perspective . So do you have enough equity and property to be able to do what you need to do ?

Compounding capital growth rate is the next term and that really refers to the amount the price of a property is appreciated between two dates , expressed as an annual compounding percentage . And the easiest way to calculate a property's compounding annual growth rate is to use the XIRR function in Excel .

Of course I've got a link on the blog on the website for you to look at that . And essentially , a compounding capital growth rate is used as a tool to assess how a specific property has performed in the past , and this analysis helps with respect to forming expectations around future compounding capital growth , assuming that the fundamentals hold in place .

You know that's one of the things about property is that the factors that generate capital growth tend to be static and factual , static in they don't change very much Until we erode . The proximity to schools , shopping strips , proximity to public transport , all those things don't really change and they're a question of fact rather than a question of subjectivity .

And so , looking at a property and the properties around it , compounding capital growth rate starts to build a bit of a picture on what returns can you expect in the future . Net sale proceeds is our next term and it really refers to how much cash you will receive if you sell the property .

This is worked out by subtracting the sales price that you expect , less the repayment of any loans , any selling costs like agent fees and , if it's been an investment property , any capital gains tax liability need to pay . Subtract those three elements from the sale price , we'll give you the net sale proceeds . A couple of quick tax ones .

So CGT or capital gains tax , really refers to any tax on any capital gain that you might make if you sell an investment property or a second home . Land tax Land tax is levied by the states based on the value of your land holdings at the end of each calendar year and excluding any land that's associated with your home , your primary place of residence .

I've published podcast episodes on both CGT and land tax individually in the past so you can certainly hunt them down . The next term is managing agent . The 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 , undertaking any property maintenance , paying for all expenses , legal compliance , record keeping and really dealing with any problems . A property manager will charge a percentage , a commission , of the gross rent , usually between 5 to 10 percent .

It just depends on the type of property and which state in Australia you are in which will determine where , inside that range , you end up paying . The next term is subdivision . It's possible to divide a property both vertically and horizontally . So horizontally , you're just dividing the actual land .

Vertically , you can divide the airspace above that land like they do with large apartment blocks , and essentially subdividing is really means that you're splitting one title over two or more separate titles . Sometimes you will see buildings described as semi-attached , attached or detached dwellings .

So semi-detached properties , dwellings that share one common wall with the next property . They're also referred to as dual lock or dual lock occupancy properties . Attached dwellings will share two common walls with the adjoining properties , so they'll be sandwiched in between two properties , if you like . And a detached dwelling doesn't share any walls .

It's a standalone dwelling on its own parcel of land and it's not connected to any adjoining properties . The next term is body corporate . When you subdivide a property , there might be common areas like a driveway , gardens or shared amenities like elevator or pools .

Any property that has these shared spaces must establish a body corporate which really is a distinct legal entity responsible for managing or overseeing these common areas . So they look after things like maintenance , obtaining building insurance , enforcing rules , making decisions , resolving disputes and those sorts of things .

In most cases , the body corporate will appoint a body corporate manager to handle the administrative tasks and ensure legal compliance . Additional group of owners typically selected as directors of that body corporate to oversee those operations and really oversees the body corporate manager .

If you're buying a property with a body corporate , it's really vital to ensure that the body corporate functions smoothly , without internal conflict , and has sufficient capital to cover any maintenance costs and and really that you understand the annual levies that you might need to pay for that body corporate .

As I said , they're responsible for really managing your asset and can have a big impact over its value . The second last term is property title . A property title is a document that records specific information about that property , including the owner of that property . In all states now , property titles are electronic , except for Tasmania .

The most common property title in Australia is called a Torrens title and really provides absolute ownership rights to the owner . A strata title allows people to own a particular unit or lot within a larger development in addition to , you know , a share of the common property , and so this is common in blocks of apartment . That's a strata title .

A company title or company share title is more common with older style blocks of apartments where owners own a share in the company that owns the whole block of apartments . A leasehold title is provided over land that's owned by the government and lease for a specific period , often 99 years .

This is common for some apartments in on wharfs in Sydney , for example , and so when buying a property it's really important to understand the top title type and whether there's any borrowing or legal implications associated with that particular property title type . And the final term I want to talk about was first mortgage .

First mortgage is a legal agreement that establishes the primary claim or priority position on a property's title in the event of a default on a mortgage . First mortgages are registered on the actual property's title , on its electronic title .

There's also second mortgages , which is really the secondary claim after the first mortgage has been paid , but they tend to be that common these days Second mortgage loans . Most lenders want to hold the first mortgage . So there you go .

That serves as a bit of an introduction to property or reminder , if you like , on some of the property attributes and terms and so forth . It's really important to understand the basics , the fundamentals of a particular asset , particularly if you're going to hold a lot of your personal wealth in that asset . So I hope that's been useful .

And a little bit longer episode today . I apologize for that as well . Okay , until next week . Bye for now .