The big question

I often get asked if the first property should be bought as a home or an investment property. The short answer is – it depends. Nothing wrong with wanting to live in your own place if that is the objective. Yet, if the objective is to build an asset base that will contribute to your financial freedom – you may want to reconsider as getting the order wrong may set you back for years.

Personally, I am on the far side of this spectrum – I am happy to rent for as long as I can (I hope my wife is not reading this post). Putting the emotional aspect aside and using purely the financial reasoning, I will try to explain my take on this in details.

The difference

It all comes down to the fact that in Australia a principle place of residence and an investment property are classified very differently according to the ATO. Principle place of residence is an asset acquired for personal use, whereas an investment property is an income-producing asset. This means that an investment property shares many benefits available today for businesses, the most important one being able to claim tax deductible expenses known as negative gearing. This has been a heated debate and a buzz word recently as politician are trying to determine if this could be considered as an ‘unfair advantage’ for property investors.

Similarly to business – your investment property produces an income in a form of rent. It also incurs expenses such as depreciation, mortgage repayments, strata, water, council, maintenance and other fees. The difference between your income and expenses represents the amount you are left with in your pocket. If that amount is negative – you are losing money and hence can claim the tax deduction on the loss (i.e. negatively geared). If the amount is positive – you are making a profit (i.e. positively geared), hence the income tax is your new friend.

Most of the above is straightforward and widely known, so you may ask – how may it slow us down in building an asset base or property portfolio? The answer is simple – it costs you more to hold a principle place of residence compared to an investment property. You have less money left in your pocket on a monthly basis living in a property compared to renting it out.

I have to make multiple assumption that would be too many to list here, but to illustrate the concept, I suggest to consider the following example:

Income (monthly)		Expenses (monthly)
Total:	+ $2100	Total:	- $2900
Rent	$2100	Loan repayments	$1800
		Council rates/land tax	$130
		Water rates	$90
		Insurance	$100
		Body corporate fees	$230
		Repairs and maintenance	$50
		Depreciation	$500

Based on the above table holding the investment property would cost you $800 ($2900-$2100) a month (before tax). This means you are making a loss and hence considered negatively geared. If we assume that you are on a 37% tax threshold – the ATO would return you $296 (37% from $800) back. The cost of holding an investment property is hence reduced to $504($800-$296) a month. Small particularities and personal circumstances aside – you can see that it is 37% easier to hold an investment property compared to living in it.

This must be personal 

I do need to mention that although the above data represents a real example, it should be considered for illustrative purposes only. You will find that rent, interest rate and any other fees or rates above change over time and personal circumstance of each one of us are different. This means that there is no one size that fits all and we always need to get a professional financial and taxation advice. Nevertheless, I hope the table conveys the concept clearly.

As with everything – it is never black and white since residing in the property has also it’s advantages such as being exempt from the capital gains tax. This could be important for some people, yet since I am not planning to sell any of my investment properties (ever) – I cannot see myself benefiting from it. In addition – you can only have one principal place of residence, but since I am building a property portfolio this yet again does not apply for me. The other important thing to keep in mind is that the properties that perform the best are not necessarily the properties you want to live in. I have explained my property investment strategy in the earlier post, hence the type of properties I like to invest in are not the type of properties I would like to live in.

The end result?

So what happens with the money that I get to save by renting the property out? I save it for the deposit for the next investment property. It helps me to get the second one sooner as whilst I am saving the investment property also grows in value. Later, when the time is right I can use both (my savings and the equity from the investment property) to fund the deposit for the next property. Now that I have two of them appreciating, they both help me to get the third and forth one and so on. And let me tell you – the benefit of getting in sooner is often underestimated. Delaying the purchase for couple of months can easily cost you thousands of dollars as the market does not wait for us. In addition, when banks work out your loan servicing capacity the owner occupier and investment properties are again calculated differently.

In a nutshell – when building a property portfolio my intention is to get the parent properties to spawn their amazing children as soon as possible. To achieve that I need to ensure that the way my properties are run is very lean and optimal. This is achieved by taking the full advantage of negative gearing, correct loan structures and what Albert Einstein calls the ‘eighth wonder of the world’!

Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it. ― Albert Einstein

Over time my view on buying property for living and renting has changed multiple times and now the cut is very clear. I chose to rent where I want to live and I chose to invest where it makes more financial sense.

 

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