Property Investment 101: The Beginners Guide
Buying a property is likely to be the biggest investment you’ll ever make.
Whether you want to live in it or rent it out, this guide gives you everything you need to know to get started. You’ll learn:
- Basic property investment strategy
- First home owners grant and stamp duty
- How to work out what you can afford and how much deposit you need
- Positive and negative gearing
- How to calculate your return on investment
- Bonus: Free property investment calculator you can download and use right away
You’ll get practical examples and actionable step by step guidance the entire way.
Sound good? Let’s get started.
Why invest in property
Before you begin you need be aware of the main pros and cons of investing in property (some of these only apply to properties which are rented out).
- You can benefit from capital growth
- You can generate rental income
- Interest and expenses can be offset against your income (see negative gearing further down)
- You are investing in something you can see and touch (and live in)
- If interest rates rise so will your repayments
- Your money is “tied up” e.g. you can’t sell off a bedroom for quick access to cash
- Initially, your rent may not be enough to cover your expenses
- You may not have tenants 100% of the time
- Hidden initial and ongoing costs you may not be prepared for
Capital growth is the rise in value of property over time
Australian real estate has a history of strong capital growth. Check out the “Post GFC” graph below from RP Data.
The long term national average in Australia is around 7% growth per year, but you probably know that prices are often cyclical. For this reason property should always be thought of as a long term investment. We’re talking 10 years plus.
The graph above also shows how important it is to invest in the right location. Strong national growth is one thing, but you can clearly see the difference between properties in Hobart or Brisbane, vs. Sydney or Melbourne. The same is true for suburbs within those cities.
We won’t go into the strategy of choosing where to invest right at the start, but just remember: they key to success in real estate is choosing the right property, in the right place, for the right price.
Property investment strategies
There’s a variety of investment strategies out there, some more risky than others. We’ll go through the most common ones below.
Buy and hold
This is the most popular strategy for new investors. You “buy” a property and then “hold” it.
You can make money from capital growth, and you also have the option to rent it out.
Achieving capital growth will typically depend on 3 factors:
- Property: The type, construction and condition are all important considerations.
- Location: Is it close to the city, transport, shops, schools, beaches, jobs etc.
- Price: Did you buy it at or below market value
We will look at an example of buy and hold property strategy in a moment.
Property development is taking an existing property or piece of land and making improvements for profit. The most common methods include:
- Renovating – Upgrading an existing property e.g. adding a second level, or a new kitchen
- Buying land and building a new house
- Demolishing an existing house and rebuilding a new one
- Building an additional house next to the original e.g. behind it on spare land
You don’t need to worry about these at this stage, so don’t get confused. It just wouldn’t be a complete guide if they weren’t at least mentioned.
Flips – When you find a great deal and buy a property below market value, then sell it on to another buyer for profit before you settle.
Wraps – Here the owner sells to another party on “vendor terms”, and effectively becomes a financier as the purchaser pays off the property in a series of instalments to the owner. It’s all negotiable.
Lease options – The tenant has the option to purchase the property, and part of the rental payments can be used to pay off the property. Useful when the tenant can’t obtain finance to buy at present.
While these strategies can all be effective, they are best left to more seasoned investors until you have at least 1 property under your belt.
Everything we talk about from this point forward will be predominately about Buy and Hold properties.
First home owner grants and stamp duty
The First Home Owners Grant (FHOG) is a one off payment for first home buyers who purchase or build a residential property to live in.
It is usually only available for properties up to a certain capped value, and unfortunately was recently changed so that is typically only available to those buying or building new homes.
The only exception now is Western Australia ($3,000 grant), however it too is soon to be abolished pending Royal Assent of the amended legislation – see WA link below for the latest info.
Stamp duty (now known as transfer duty) is a tax on the transfer of real estate and is a significant upfront expense when purchasing property. First home buyers are usually entitled to a concession, although these concessions are also now only available to those buying or building new homes.
Be very careful when using online stamp duty calculators. Many websites still incorrectly include first home buyer concessions. Always deselect the first home buyer option to make sure you get the right estimate (unless you’re buying in WA or NT).
The FHOG and stamp duty concessions are administered slightly differently by each individual state and territory. If you are buying or building a new home then you should check out the relevant state revenue website. See the links below.
- New South Wales First Home Owner Grant (New Homes) Scheme and duty exemptions
- Queensland First Home Owners’ Grant and duty exemptions
- Victoria First Home Owner Grant and duty exemptions
- Western Australia First Home Owner Grant and Home buyers assistance account
- South Australia First Home Owner Grant
- Tasmania First Home Owner Grant
- ACT First Home Owner Grant, Home buyer concession scheme and Deferred duty
- Northern Territory First Home Owner Grant
Most people choose to lodge their application through their mortgage broker or lender, although you can also apply yourself through the links above. The money should become available on settlement day, and is usually used as a credit against the transfer duty.
It’s worth noting that if you purchase your property with a partner, only one of you may receive the grant, however neither of you will be able to claim it again in the future.
What can you afford?
What you can afford will be based on 2 things:
- How large your deposit is
- How much you can afford in repayments
These days’ banks are typically only approving loans with a maximum 80% LVR.
LVR (Loan to Value Ratio) is the (Total Loan Value / Property Value) x 100%
Say you wanted to purchase a property for $500,000. You would need a $100,000 (20%) deposit to take out a loan of $400,000 (80%).
If $100,000 sounds like a lot of money, that’s because it is! Coming up with 20% is difficult and not something many first home buyers can do even with a partner.
So what can you do? There are two main options:
1. Purchase lenders mortgage insurance (LMI). This insures the bank, not you, for if you default on your repayments and they are unable to recover their costs after selling the property (i.e. if it drops in value).
In the example above, if we required a $450,000 loan (90% LVR) then mortgage insurance would cost around $8,800, depending on which calculator you use. LMI can be added to the loan amount.
The maximum LVR you can have and still obtain a loan is usually 95%. In today’s climate however lending rules are getting stricter, and the larger your deposit the more you will save on your LMI. You should aim for lower than 90%.
2. Get a guarantor. The bank obtains a guarantee over a second property (usually belonging to a close relative) to cover the difference between your deposit and the 20% deposit.
Again, this is only if the bank is unable to recover their costs after selling your property (if it were to drop in value). This is the option I went with for my property.
Once you’ve paid off part of your mortgage and your property has hopefully appreciated, you can get your home revalued to reassess your LVR. Once it’s less than 80% your guarantor can then be removed from the loan.
Using the guarantor method saves you money, but for some it may not be possible. Either way, you do not need to wait until you have a 20% deposit to buy.
Following on from the earlier example, if you take out a loan for $400,000 at an interest rate of 6.00% (it’s lower than this at the moment), then you can calculate our monthly repayments.
First though, you will need to work out stamp duty and have an idea of what sort of deposit will have.
Note: We will assume we have a principal + interest loan on a 30 year term. I am currently putting together a home loan guide which will go further into detail on these options and much more, including a complete expenses and repayments calculator. Stay tuned.
The screenshot above is taken from a calculator I created to work out affordability. Once we have inputted our property value and deposit amount in blue, our repayments are automatically calculated.
In this example, let’s say you have a 10% deposit (90% LVR), and are using the guarantor method to avoid paying mortgage insurance. How do those repayments look?
A rule of thumb that some experts advise is that your repayments should be no more than one third of your salary (before tax).
Using this rule for the example above, you would need to have a before tax salary of around $110,000 (or combined salary with your investment partner). 31% of your salary would then be going to mortgage repayments.
This is of course just a rough guide, and you may very well decide that you can afford more or less in repayments based on your own unique situation.
It’s very easy to see though why most people choose to invest with a partner. You effectively double your purchasing power, and in competitive cities like Sydney or Melbourne it can be your only way of getting into the market.
If you intend to rent out your property, then here’s a quick way to estimate your monthly shortfall:
- Weekly rent can be estimated by subtracting the last three 0’s from the property value, which for the above example is $500/wk.
- Yearly rental income should be calculated assuming 4 weeks tenant vacancy as contingency. $500 x 48 weeks = $24,000.
- Convert this to monthly by diving by 12 and you have $2,000 estimated monthly rental income. This would leave you with a monthly shortfall of $2,796 (repayments) – $2,000 = $796.
This is the amount of money you will be out of pocket every month to support your investment property.
(We’ve excluded expenses for now, but we will get to those in the next section.)
Having a rental income obviously makes repayments much more manageable. But you shouldn’t count on it. Consider the following scenarios:
- You decide you want to live in your property
- You want to temporarily live in your property to avoid Capital Gains Tax
- You have no tenants
Other scenarios to consider are if you became unemployed, or if interest rates rose, how you would be able to cope?
Ultimately you need to think about your own situation and choose a property value range that you would be able to afford the repayments for, and always allow for some contingency.
If you’d like some help to work out your price range, I’ve created a simple calculator that you can use to calculate your repayments and expected rental income.
As a starting point you may like to use the Calculate property value button to work backwards from your salary (or combined salary with your investment partner) using the one third rule to calculate your price range. From here you can further tinker with the property value to see what effect it has on repayments.
You can download the calculator at the end of this guide. Before you do though, read on to learn about negative gearing and how to calculate your return on investment.
Note: If you won’t be renting out your property then you may skip the next section. If you’d like to learn more about negative gearing and how investment properties work though feel free to read on.
Positive and negative gearing
No doubt you’ve heard the term negative gearing before. But what is it exactly?
First things first – negative gearing can only apply if you are renting out your property.
Gearing basically means borrowing to invest, and positive gearing is when your rental income is greater than your investment expenses.
Negative gearing is when your investment costs are higher than your rental income
That’s right. You’re losing money. So why is it so popular?
Because when you’re negatively geared, you can deduct the costs of owning your investment property from your overall income – reducing your taxable income.
High-income earners will benefit the most, because they’re in a higher tax bracket.
It’s best to think of negative gearing as a tool for reducing your losses. That way you don’t lose sight of the fact that you are actually making a loss.
Let’s look at an example.
In the previous section you had a $466,411 loan with an estimated rental income of $24,000.
You can then calculate the yearly interest by multiplying the loan amount by the interest rate, which works out as $466,411 x 6% = $27,985.
You also need to allow for some expenses, such as strata fees, council rates, and water charges. Sometimes you can find these included on the property’s online listing towards to the bottom.
If you can’t find them online, it should be on the handout at the open house, and if not then just ask the agent. For this property, the total yearly expenses are $1,156 + $684 + 4x $750 (pq = per quarter) = $4,840.
You can now calculate the Total loss = rental income – interest – expenses
= 24,000 – 27,985 – 4,840
As the name suggests, this is the total loss the property has made in one year.
Note: There are other expenses such as depreciation which we can claim, however this is beyond the scope of this beginners guide. I’m creating a separate guide to cover tax returns, so stay tuned.
Because you have an investment which is losing money, it is negatively geared. You can now claim this money against your taxable income.
To calculate the effective tax saving, first you need to determine which tax bracket you are in. If you visit the Australian Taxation Office (ATO) website you will find this table.
For our hypothetical salary of $110,000 you would be in the fourth row down, and the tax rate would be 37% (it’s just the cent value).
By reducing your taxable income by your total loss you will save $8,825 x 37% = $3,265.
That’s it. You’ve now reduced your loss from $8,825 to an effective loss of just $5,560.
Note that although when you first purchase your property it will likely be negatively geared, it should eventually become positively geared. You achieve this by increasing the rent over time and gradually paying down the mortgage.
That’s not to say positively geared properties are impossible to find. Generally speaking, properties in cities tend to offer better capital growth, and properties in regional areas tend to offer higher rental return with lower capital growth.
Tip: If you expect to make a loss on your investment property you can apply to the ATO for a Pay-As-You-Go (PAYG) withholding variation to give you more cash in your pocket throughout the year.
For example, if you’re salary is $110,000 a year, but you expect to make a total loss of $8,825 from your investment property, you can apply to reduce your assessable income to $101,175 instead.
In doing so you can reduce your effective monthly shortfall from $796 to $524.
For more information from the ATO including how to apply you can go here.
Return on investment
Now that you know what you can afford and how to reduce your losses, it’s time to look at how to calculate if the investment will be profitable or not.
It was mentioned in the first chapter that the Australian property market long term national average growth is around 7%.
The benefit of property over shares or savings accounts is that when you invest your deposit of $51,900 for a $500,000 property, you are making 7% on the property value as opposed to the deposit amount.
A 7% return on $500,000 is $35,000. That’s a 67% return on your deposit. It’s powerful stuff.
So now you understand the money making potential of capital growth. But without a crystal ball, 7% long term annual growth is no sure thing.
Wouldn’t it be good to know how much capital growth you need for your investment property to be profitable? Luckily it’s not too hard to work out.
First you need to consider what you could have done with your deposit money instead of buying property.
Say you put your $51,900 deposit into a long term savings account with a 6% interest rate.
It would earn $3,114 in 1 year, and after tax that’s a hassle free profit of $1,962. That’s OK.
Now you have an effective loss (after negative gearing) of $5,560 that you need to recuperate, plus a further $1,962 that you could have earned had you put the money in the bank instead.
Therefor your investment property needs to earn more than $7,521 in a year to be profitable.
Allowing for capital gains tax were you to sell the property (multiply your tax rate by half the profit), then your profit line is $9,229, or a 1.85% increase in property value. Definitely very achievable.
Even better, if you are able to avoid capital gains tax, then your profit line comes back to $7,521, or a required capital growth of just 1.5%.
Putting it all together
So to wrap it all up:
- You’ve invested $51,900 (10%) deposit in a $500,000 property
- Repayments will be $2,796/month plus expenses of $4,840/year
- If you rent it at $500/week your monthly shortfall is then $796
- Using negative gearing you can peg this back to an effective monthly shortfall of just $524
- You need to achieve 1.5% capital growth or better for this to be a profitable investment
The first years are the hardest. As the rent increases and the mortgage is slowly paid down, the shortfall decreases and decreases and after a few years hopefully you will have a positively geared investment.
And in the meantime, you know that you’re paying off a physical asset that’s growing in value each year.
That’s the crux of the Buy and Hold strategy. Finding a property with a combination of high rental yield to improve cash flow and high capital growth to maximise profits.
While it’s not necessarily more of one in exchange for the other, it is a bit like that.
Properties delivering higher rental yield will quickly become positively geared if not already, giving you a (taxable) passive income which is cash straight in your pocket. But the value down the track mightn’t be much more than when you first bought it. This is typical of properties in regional areas.
Properties delivering higher capital growth on the other hand tend to cost more to maintain and take cash out of your pocket. You are speculating that the temporary pain will lead to a future gain. This is more typical in large cities.
Although potentially significant in size, capital gains aren’t physical cash like with a positively geared property. You can only really access this money by either selling the property, or revaluing the property and refinancing your loan. But that’s a topic for another day.
High yield or capital growth, which is better? Which one you value more will depend on your own financial situation and goals.
The next step
Congratulations! You now know the why and how of investing in property. You understand common investment strategies, the first home owners grant, negative gearing, return on investment, as well as a having a good idea of the price range you can afford.
The critical factor for success in all of this is of course buying the right property, in the right place, for the right price.
Now it’s time to start thinking about where you want to buy. Inner city, or in the suburbs? By the beach, or up the coast?
You also need to consider what you want to buy. Apartment or house? How old or new?
Searching for property is for most people the longest and hardest stage of the entire process. Very soon I’ll be producing some new content to help you out, including some untapped resources other prospective homebuyers aren’t using.
In the meantime have a think about what and where you want to buy, and then start attending open house inspections to get a feel for your target market.
BONUS: As I mentioned before, I’ve created an investment calculator for you to use right away.
What you’re getting is a spreadsheet I created to help you calculate your price range and return on investment, including repayments and negative gearing.
Download your free calculator below
Note: You may want to show this to any sceptical friends or relatives you have. I actually originally made this spreadsheet just so I could show my Dad exactly how much it would cost me per year to maintain my investment property, and the return on investment.