The 4 big assumptions to look at when you buy an investment property

Are you looking to buy a property through Opes?

You’ll analyse the property using our Return on Investment spreadsheet.

Often, investors ask: “What assumptions do you use?”

I’m happy you want to dig deeper. Not everyone appreciates a good spreadsheet, and it’s important that you ask about the assumptions.

You can make any investment property look deceptively good (or bad) by the numbers you use. There are lots of numbers you could change, but only four assumptions (unknowns) make a massive difference to the outcome.

In this article, you’ll learn:

• what our long-term assumptions are
• why we chose these assumptions
• whether you should change them
• and what happens if you do

#1 – Interest rates

Interest rates are one of the most critical assumptions. This impacts the cashflow of your property.

Our spreadsheet creates a 15-year cashflow forecast. This gives you an idea of what could happen to the property over time.

To create that forecast, we need to guesstimate where interest rates will go. There is a lot of uncertainty around interest rates at the moment. So, we regularly update our interest rate predictions here. This includes how we’ve come to these forecasts.

Right now, our assumptions around interest rates are:

However, if you are uncomfortable with our standard assumptions ... you can change them.

If you use a higher interest rate, your mortgage will cost more. So, the cashflow will be worse.

But, if you lower your interest rate forecast, the cashflow will look better.

If you change the assumptions, keep in mind that they are all related.

For example, if you estimate that interest rates will stay higher for longer, that will be because inflation is high.

So, you might like to increase both the inflation and rental inflation assumptions because higher inflation means your rent will go up more quickly.

You can put whatever interest rate you like into the spreadsheet, but be careful.

Don’t use unrealistic assumptions that make you think you are getting a better (or worse) deal than you are.

#2 – Capital growth

The next big assumption is how quickly your house goes up in value. This heavily impacts the estimated return you get from your investment.

House prices may go up slower than they have in the past. That’s why we use conservative capital growth rates.

Auckland house prices have gone up by 7% a year on average since 1992. So, we assume that Auckland house prices will increase by 6% a year.

Rather than doubling in value every 10.3 years, we assume Auckland prices double every 12 years.

House prices in the rest of the country have historically gone up by 6.2% a year. We discount this to 5% a year.

Rather than doubling every 11.6 years, we assume prices outside Auckland will double every 14.4 years.

But that’s only if you buy a growth property. If you buy a yield property (like an apartment), take another 1.5% off per year.

What difference does it make? If you assume that house prices go up faster, your returns will look better.

Put the assumption down, and your returns will look worse.

Here at Opes, we take a cautious approach to capital growth. We use a lower capital growth rate than many other property investment companies.

If you compare the properties we give you with other companies, our numbers may look worse. That doesn’t mean our properties are worse. It’s that we’ve used more conservative projections. So make sure you use the same capital growth rate before you say, “Their numbers are better.”

The numbers may look better, but they may not be realistic.

#3 – Inflation

Inflation is currently 4.7%. It’s too high. The Reserve Bank is working to get inflation down.

Their target is to get inflation between 1-3%, and they target the midpoint of 2%.

That’s why we use a long-term assumption that inflation will be 2%.

Over the last 20 years inflation has been between 1-2% most often, but in the short term, there will be some ups and downs.

If you increase the inflation rate (and change nothing else), your returns will look lower.

That’s because our spreadsheet shows you the returns you get after inflation. So, more inflation means your returns look smaller.

But if you increase inflation, make sure you change the other assumptions, too. Higher inflation means your rent will go up faster.

It also means that house prices will likely go up faster, and interest rates will be higher.

It’s OK if you want to change our assumptions to create a scenario that feels more “realistic”. Just make sure you change the other assumptions too. Otherwise, your scenario may not be realistic at all.

#4 – Long-term rental inflation

The last big assumption is how quickly your rent goes up.

Over the last 20 years, rents have gone up by 4.7% - 5% a year (on average). It depends on which measure you use.

That’s why we also assume that your rent will go up by 4.7% a year.

To be clear, that doesn’t mean your rent will go up by exactly 4.7% a year. (It will be in the spreadsheet but not in practice).

Sometimes, your rent will grow faster. Sometimes, it will go up slower.

This also assumes that you will put up your rent to the market rate every year. If you keep your rent at a below-market rate to have your pick of tenants, this assumption won’t hold.

If you assume rents will go up faster, your returns will be higher.

If you decrease the rental inflation rate, it will make your returns look lower.

Can I rely on these assumptions?

Some investors ask: “Do your numbers end up being accurate over the long term?”

The short answer is: “No.”

This is because house prices won’t go up by exactly 5-6% a year. Rents won’t go up by exactly 4.7% a year, and interest rates won’t do exactly what they say they will.

When you look back in 10 years, your returns will look far bumpier. Some years will be good. Others will be bad. That’s what happens when you invest.

But asking, “Are your projections accurate?” is the wrong question because the point of creating a forecast isn’t to get it 100% perfect.

The point is to:

• choose the best property based on a consistent set of assumptions and
• get a sense of what could happen and prepare for it

The forecast won’t be perfect, but it can help you make a good long-term financial decision. And creating an imperfect forecast is better than buying a property and guessing.