Podcast: The Numbers You Really Want to Look At When Investing In Property | Ep. 238

Posted by Ed McKnight on 08/05/20
The Numbers You Really Want to Look At When Investing In Property 001
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Show Notes

What's Covered in the Show?

In this episode, we discuss the numbers you really should be looking at when you invest in property ... Return on Equity and Return on Cash.

When you invest in property there are two parts to your investment – the equity you initially put in, and then any cash you invest to top up the mortgage. It makes sense then to base your investments on these two factors, given that we each have a limited amount of cash and equity.

We also mention our upcoming property investment webinar, which is happening next Tuesday at 7pm. Sign up to here.


Transcript of the Podcast

Ed McKnight: Hello and welcome along to the Property Academy podcast. I'm your host, Ed McKnight, and I'm Andrew Nicol, and today on the show we're talking about the numbers that really matter when you're looking at an investment property, the numbers that really matter.

Now, this is something very, very close to our heart because when we're talking to a lot of investors the first thing, the number one thing we hear that investors are looking for is yield or cash flow. The cash that the property is actually producing. Now, this makes a lot of sense.

A lot of people eventually want to build passive income, eventually want to live off their property portfolio, but look, you can only really be a very successful yield investor when you've already accumulated a lot of equity, a lot of cash, which will of course bring down your mortgage repayments and allow you to get cash flow out of your property. But when you're building a portfolio, when you're in growth mode, you really don't need to be as obsessed with cashflow as you otherwise would. And instead, what we'd recommend is that you look at, the key metrics, are return on equity and return on cash. And the reason we'd recommend you look at these is, because those are the two things, property investors are primarily putting into their property portfolio.

So, what do we mean by return on equity? Primarily we mean that when you go and you leverage your own home or another investment property in order to pull out the deposit and go and buy an investment property, if you're putting that equity up, you want to know, well, what's the return I'm getting on that equity? Similarly, if you're purchasing negatively geared properties and, or properties that turn out to be negatively geared, once you've got all of the structures in place and perhaps if you're borrowing at a hundred percent, that's where it would typically be negatively geared. If you're putting cash in, you want to know, well, what's my return on that cash?

You see if you just look at cash flow you're not going to get that idea of how much that investment that you're making is actually returning and as investors, we need to know what's the return I'm getting for that investment. Cash flow doesn't tell us that. Return on equity and return on cash do tell us this.

Now, this became very apparent to me, that just last week while I was scrolling through Facebook and I saw a comment in one of the investment groups we're a part of, and they were walking us through a cash flow in this post and they were saying, look, I'm about to buy an investment. It's in central Auckland. I'm going to get a loan of about 406,000 and it's going to be a brand new property renting for $650 a week.

Now I got all excited because I thought, oh my gosh, something that's renting for 650 a week. It only costs 407,000 it's free hold in Auckland, you know, these are the things it said in the post. And I got all excited because I was going to come on here and tell you all what it was so you could all buy one for yourself, because those are some fantastic numbers, especially freehold in Auckland.

And now as I start reading, commenting back and forth, it turns out that this person and good on them for doing something, please don't think I'm admonishing them, that this person's got a piece of land, it's probably worth about 400,000 we're going to assume for these scenarios that we're going to walk through today, so it's probably worth about 400,000 and its mortgage free, so they've got a mortgage free property sorry, section that they're going to spend about 450 K once you include interest cost, probably about 450 K in order to build a property and then they're going to have it as a long term rental.

And then the main question I was asking, well, why are you looking at the cash flow for? Cashflow, of course, is important. It's very important, but what's going to tell you whether something's a good investment or not is actually what the return on equity is. What's the return on the 400 K that you're putting in to this because of course that's what you're putting into the investment, how much you got to get out of this.

So what we're going to do in this episode is Andrew and I have three scenarios in front of us. The first is we're going to assume that this 400 K section with a 450 K build is going to net out to be about an $850,000 property. And we're going to walk through, first of all, what would happen if you just went out and bought an 850 K property, brand new, a hundred percent lending and treated that as an investment.

What's the return on the equity you're going to get? And by return, we mean in 15 years after a certain amount of capital growth if you were to sell the property, how much equity do you have left, and what is that as a return on what you initially put in. We're then going to walk through this scenario of the build, and then we're going to talk about an alternative about what else could you do that would actually get you a high return on equity than build a property and just hold it for 15 years.

So look, in scenario one, we're going to assume all the usual figures, so this person's buying an $850,000 brand new home. We've got some start-up costs in there of three and a half grand, 3.5% interest rate. Rental income of $800 per week, and all of our usual assumptions. And hey, if you want to know what our usual assumptions, we've got a whole webinar on it, that I'll try and remember to link in the show notes.

So this property, if borrowed at a hundred percent, you're borrowing all of the money to purchase it, it's going to be negatively geared $23 a week. You're going to put it into this and for that, over 15 years at 5% capital growth, that property is going to be worth in 15 years, just shy of 1.8 million. And you've got projected equity of about 900 K. So what did you actually put in? Well, as well as your $23 per week, you also put in, I think about 170 K worth of equity. So that 20% deposit, even if you've leveraged it against your own home, we want to count on that because that's something you could potentially do something else with.

So what's the return on that? Well, if you put in, in total, including that cash flow that you're putting in and the equity, you put that all in, it would be about $188,000 and for that $188,000, your projected equity, you're getting about 914 K. So that is a 4.87% return. So a 487% return. Now, let's just compare that to what this person's planning at the moment. So putting in quite a substantial investment of about 400 K in terms of that land, all of the same assumptions, $800 per week rental all the same costs, now this property would actually net $247 cash per week.

So it would be paying out. And actually this is really important because this is what I was saying about yield properties just a couple of minutes ago, that you've got to have some substantial equity to put into an investment for it to become cash flow positive. Because although this property had all of the same usual operating costs. The finance costs were much lower because the mortgage was much lower. You see, in scenario two where you're building, you've only got a mortgage of about 450 K as opposed to 850 K if you're borrowing the whole thing.

So this property, if you're going to build it, is going to be at cash flow positive by about $250 a week because you've got significantly lower finance costs. Now, in terms of what it ends up being worth in 15 years, it's worth exactly the same amount. So about just shy of 1.8 million, you've got a much lower mortgage, and so you've got projected equity of about $1.3 million versus 900 K in the scenario we first talked about. Now within this, you've actually got a much higher return on equity.

Now that's not, I should rather say return on investment because although you put in 400 K worth of equity into the property in terms of that initial land, because it is positively geared, there's about 190 K worth of cash that offsets that. So the return on equity and cash in the second scenario is 6.33. So you've got a much better investment in terms of what you're getting back because you've got those lower finance costs.

But then of course in this scenario, in both of these scenarios, scenario one, you're investing and you're only putting in the minimum amount for that 850 K property. Scenario two, we're putting in 400 K, so we're getting a high return on that equity. But Andrew, I suppose between these two scenarios, we're not really comparing apples with apples because in scenario one, we didn't put in a lot of equity.

Scenario two, we put an a lot of equity. So really, what we should be looking at is what else could you do with that money and why don't you just walk us through what you would potentially do if you were in this situation. You've got a piece of bare land with 400 K no mortgage on it. You're going to develop it. What else could you do and what could potentially give us a better return on equity if this was you in this situation?

Andrew Nicol: So, Ed what I looked at in this scenario was, let's say you went out and you got rid of that section, and you took your 400 K and you diversified that over four rental properties. So I worked on 550 being purchase price of a standard rental property and 550 a week rent, and I put a hundred thousand dollars into each of those investment properties.

So a hundred thousand dollars cash, so got rid of the land and took the hundred thousand dollars into each of those properties, had four rental properties, and then we applied all those same costs, you know, allowing for vacancy, allowing for maintenance, allowing for rates, insurance all the rest of it. And it came up positively geared by $208 a week.

So pretty close to that 247 positively geared in the second scenario that Ed was talking about there, and then what we looked at is, okay, well that $208 again, erodes the initial investment over time. So that drops it down to 237. And the return on equity and cash comes out to be 1161% which is huge. And projected equity is $2.75 million.

So it's double what you got in that second scenario, which on the surface looked really good. But when you look at it against other properties that we would consider normal, I think you can get a better return.

And certainly $2.7 million is a lot better off than $1.3 million.

Ed McKnight: And this is why we're really keen on the return on equity and return on cash because if you just look at cash flow, and if your test for whether something's a good investment or not is whether it's positively or negatively geared, you're looking at the wrong numbers.

You've got to look at what is the highest return I can get from the investment that initial start-up equity or the cash that you're able to put in. What is the highest value that can go for? And that's the test of a good investment.

Because of course, you know, in this first scenario, you'll walk away at the end of 15 years and you know, you would feel really chuffed with yourself. Look, you made $1.3 million in equity. But if you could actually make, you know, $2.76 million worth of equity by doing something different and diversifying, then isn't that a better investment? Well, yes, it is because you're getting a higher return on the equity in cash you're putting in, and so that's why what we're really keen to try and do and attempt is to say, look, change your metrics that you're looking at.

Cashflow is important. You want to make sure that you're not going to be in a position where you're forced to sell a property, but your test shouldn't be just whether it's simply positively or negatively geared at a certain imagined interest rate, it should be, well, what's the return you're getting based on what you're actually putting in and to be a really sophisticated investor, that's what you want to start looking at because you want to get the highest return possible for your investment.

Otherwise, what are we doing investing in the first place? So I think that's something really key to look out for return on equity and return on cash. And this was something we actually talked about in that previous webinar I mentioned before. So I will try and remember to put that in the show notes.

Now let's wrap it up there, Andrew, but please don't forget to rate review and subscribe to the podcast. It really does help us get the message out to more people. And hey, if you want to check out that webinar, I'm going to drop a link to it in the show notes. So just tap or swipe over that cover art, it'll take you right there.

Thanks for listening to the Property Academy podcast. I'm your host Ed McKnight, and I'm Andrew Nicol, and we're going to be back again tomorrow with even more daily strategies, tactics, and insights to help you get the most out of the New Zealand property market.

Until next time.