Some people can be hesitant to invest in property as they often perceive the risk to be high. Whilst every investment carries an element of risk, investors can calculate the property’s break-even point of capital growth to assess the risk of a potential property investment before making the purchase. This is the point at which the capital gains equal the cash shortfall of holding the property (assuming that the property is negatively geared).
Let’s look at a simple example. Assume you purchase a $400,000 property (worth $400,000). When you subtract all the expenses (including interest on the loan, management fees etc) from the rent and take into account depreciation and tax benefits, this property has a negative cash flow of $10,000 pa, which is fairly typical. So, in other words it costs you $10,000 out of your pocket to hold this property. In this example, what is the break-even point? It’s easy to calculate. By simply dividing 10,000 (the cash shortfall) by 400,000 (the value of the property) and multiplying the figure by 100 (to make it a percentage) we obtain an answer of 2.5%. Therefore, if the property grows 2.5% in that year, your investment has broken even.
Obviously you would want more than 2.5% growth to justify the risk, especially when long term growth rates are generally much higher than that. But it shows nonetheless how little capital growth you actually need on an investment to break even.
For the sake of this example let’s assume that the property does grow by only 2.5% in the first year you own the property. What happens to the break-even point in the second year when you take into account that rent on this property has now increased. Let’s say that your out of pocket expenses are now $8000 pa rather than $10,000. With a quick calculation you can work out that your break even point is now only 1.95%. Anything above that figure and you’re ahead.
Here’s an interesting question, what happens to the break even point when you buy a property below market value? It involves the same calculation but brings up a strange result. Let’s go back to the earlier example where you bought the $400,000 property but let’s say the property is actually worth $450,000 when you buy it. All of your costs are the same and so is the rent, which means your out-of-pocket costs are still $10,000 pa. So what’s the break-even point? You might be thinking to yourself that you’re already $50,000 ahead so isn’t the break even point negative? You would be right. It is now -8.9%. This means that even if through some shock and highly unlikely occurrence, the property value falls by 8.9% you would have still broken even. Clearly, if you manage to buy a property below market value you give yourself a great head-start.
While I would always recommend hunting for the best capital growth opportunities, it’s still important to consider your out of pocket expenses so that you can work out your break even rate of capital growth. If you’re unsure how to work out your out-of-pocket expenses, your Momentum Wealth consultant will be able to assist you. It’s important to remember that property is a medium to long term investment. Focus on choosing the property that will generate the best returns over time and try not to focus on the short term fluctuations.