Most investors tend to underestimate and often ignore the risk that the actual cash flow from an investment property will be significantly lower than projections. Consequently, investors often end up ‘bleeding cash’ to cover the shortfall between the rental income, interest rates and other associated property costs.
Investors often experience this problem because:
- They often rely on unrealistic rental income projections made by the same real estate agent selling them the property, and therefore have a vested interest to overestimate the potential return
- They tend to overestimate the demand for their property and its appeal to a broad audience.
- They typically underestimate (and often ignore) the ongoing property maintenance costs.
The aggregation of these factors is likely to have a significant impact on cash flow. This may impact the personal financial situation of the investor or even their ability to hold the property.
To determine this risk prior to making an property purchase, investors should perform a ‘cash flow stress test’ — which is a free property data online tool that we have made available — to forecast their likely cash flow and assess the potential impact if circumstances change (such as interest rate increases).
Now, let’s break down each of these factors into components and identify effective ways to address them.
Unrealistic Rental Income
This is particularly relevant when buying off-the-plan properties. To perform an independent assessment of projected rental income, the following steps should be taken:
- Conduct research and compare the asking weekly rent to properties with similar attributes.
- Know the average vacancy rate of comparable rental properties. This helps investors ascertain rental demand.
- Obtain information detailing the number of new properties in the pipeline. This is particularly important when buying off-the-plan, as they are often built in areas where there are many building approvals.
- Factor in the seasons. For example, the weekly rental income in beachside suburb may be significantly lower than expected if the property is for lease during the winter.
Assess Property Demand
- Ensure there is tenancy demand for your property type and configuration. For example, the demand for small units in well-established and family-oriented suburb, is usually limited.
- Consider that even the greatest property is not occupied 52 weeks a year. There are vacancy periods between tenants and there could be unexpected events that leaves the property vacant.
- Factor in the seasons, as the demand for your property could be low in some periods of the year
Ongoing Property Costs
- Management Fees – unless you manage the property yourself the overall management costs could be significant. On top of these fees, you may be required to pay ‘letting fees’ every time your agent looks for a new tenant.
- Interest Rate change – the majority of mortgages for investors are on a variable rate basis, meaning that changes to interest rates would have a major impact on the ongoing costs. When interest rates are very low, investors often ignore the that in a few years interest rates could be 1.5-2% higher than the current level.
- Rates & Taxes – while the majority of the investors assess strata and rates, they often ignore land tax. This could add significant costs to houses, particularly in Sydney and Melbourne.
- Other costs – this is the most ignored category. ‘Other costs’ include the ongoing repair and maintenance of the property for the long term (to ensure that the property is in good condition).