David Whitburn

Archive for May, 2010

At Saturday’s APIA Budget Buster seminar I presented on how to analyse properties for purchase.  For many newer investors just how to compare properties when they are being purchased to gain a financial return, is a difficult question.  The methods of calculating employed by investors today range from no calculation at all “I just got a good vibe about it” to a former mentoring student who had a masters degree in Engineering and had spent by his own count over 100 hours developing his own Excel/Visual Basic with advanced macros spreadsheet to analyse returns.

There are three main methods which you can relatively easily work out by yourself:

1) Gross Yield – (weekly rental x 52 weeks per year) / purchase price

eg. Brad wants to buy an investment property and has obtained a rental appraisal at $450/week and he can purchase this property at $330,000.  As a result the calculation for gross yield is:

$450 x 52 / $330,000 = 7.09%

2) Net Yield - ((weekly rental x 52 weeks per year ) – expenses) / purchase price

Net yields are more accurate than gross yields as they take into account expenses for a particular property.  This is how the vast majority of commercial property deals are presented as well as many inner city apartment deals (in Auckland & Wellington).  Net Yields do not calculate interest costs nor depreciation.

When looking in different types, styles, classes, age and condition of properties need to be taken into account.  As a result expenses such as rates (local council & if applicable regional council rates for one year are provisioned for), insurance costs (for one year), a provision for repairs and maintenance (on brand new brick & tile homes with a registered master builders’ warranty you may provide for as low as $500/year, however for a large neglected old bungalow you may need to provide for as much as $4,000 to ensure you protect the value of your building and ensure that you can maximize your rental income stream {I know this sounds like a lot but when your roof eventually goes, it is expensive, as is replacing carpets and other floor coverings on a large house, repainting your house – they don’t crop up every year, but overtime you will get a nasty surprise every year and you must budget for this}), outside of major cities that are growing you’ll need to allow for a provision for vacancies, and an allowance for other expenses (eg. cellphone calls for arranging repairs, working with tenants/property manager, apportionment of annual accounting fees, mileage etc).

eg. Brad as above is wanting to analyse buying an investment property for $330,000, with a rental appraisal at $450/week.  Expenses are projected to be rates of $1,300/year (being $1,170/year with the Manukau City Council & $130/year with the Auckland Regional Council), insurance of $300/year (from a Tower insurance quote), and a provision for repairs & maintenance of $1,800/year and an allowance for other expenses of $600/year.  As a result the calculation for net yield is:

(($450 x 52) – $4,000) / $330,000 = 5.88%

Whilst Gross Yield can arguably be slightly useful when comparing similar properties in age, condition, style, size and area, as I tell my mentoring students and those attending my presentations, it is not a good measure of calculating your actual returns from property.  For one, expenses need to be taken into account (otherwise Murupara will look like investment heaven with lots of over 12% yields, but drilling down into detail you have much higher council rates from poor economies of scale, higher vacancy rates which can really hurt your cashflow {I had a client with 22 weeks in one year of vacancies in their Tokoroa rental a few years ago!} and generally higher other expenses as you will invariably be using a property manager, you may be driving to your property to look at it, and have higher amounts of repairs and maintenance as the higher yielding areas have a very strong correlation to poor (low decile) areas, which in turn have a higher chance of your property being trashed.

3) Actual Cashflow

The better way that you can calculate by yourself is to use the Actual Cashflow method.  It is also useful to compare against other investments, however when you use gearing on property, you leverage your capital gains that you will in all likelihood achieve in the long-term, so there are extremely few investments to compare against property.

The Actual Cashflow method is where you build on the net yield and actually look at the interest rate.  I don’t use the 40 year variable interest rate of 5.69% just to make a deal, or the midpoint of a 2 year rate, or a 5 year rate – I take the weighted average interest rate across floating, 1 year, 2 year, 3 year, 4 year & 5 year categories over the past 10 year, which I have worked out to be around 8%.  As a result I take the guesswork out of this and use 8.00% as a basis to calculate interest.

So building on Brad’s example from the net yield section above, we add in interest costs.  If Brad puts in a 20% deposit of $264,000, he will need to borrow the remaining $264,000.  I assume that this $264,000 loan will be on an interest-only basis for calculation purposes, and I apply 8.0% as the interest rate.  As a result I have an annual interest cost of $21,120.

I know that the depreciation rates have changed so I can’t claim depreciation on building structure.  However I can still claim depreciation on many items of fit-out and all items of chattels.

As a result the calculation for actual cashflow is:

This Actual Cashflow calculation, whilst still being an estimate, is far more accurate than by gross and even net yield calculations.  This is because it calculates rates, other expenses, an allowance for interest (some people will still prefer to plug in their rate of interest and ignore the fact that floating rates are going to go up from the 40 year lows they are currently at), and depreciation is estimated too (I left off my formula as it is quite complex and based on much experience and seeing a number of Valu-it reports).

I note that this actual cashflow doesn’t seek to model rental growth, capital growth, inflationary (and GST rise) impacts on expenses – so of course even actual cashflow has its flaws as a model.  I have seen some extremely advanced ones and even they rely on assumptions.  Just how many weeks per year will your tenant pay rent in a ‘strugglesville’ low decile area, and really how much will your repairs and maintenance be over the next decade.  The key is to not get too stuck into the detail, and get pre-approved for an amount, and get the best deal you can buy.  In 10, 20 and 30 years time your rental income should be a very handsome amount and the value of your property should be tremendously higher.

I give my mentoring students my buy and hold calculators and training on how to use them and how to analyse deals, as this is absolutely critical to your success.  Feel free to use my calculations above as a bit of a template for your own property deal analysis.  It is important to be technically strong enough with numbers and basic accounting so you know what returns you can expect.  You really should consider using a technically skilled property investment mentor if you are unable to calculate your returns from property investment correctly.

Saturday 29 May 2010

8:30am start to 6pm finish (registrations from 8am)

Parnell Jubilee Hall, 545 Parnell Road, Parnell, Auckland

The 2010 Annual Budget has just been presented and it implements the largest tax reforms New Zealand has seen in 25 years.  To arm you with the knowledge and tools to succeed in light of the Budget and in today’s market, the not-for-profit Auckland Property Investors’ Association (APIA) have a 1 day seminar BUDGET BUSTER 2010 – Strategies for Today’s Market with tickets at just $49.

The speakers include multiple best-selling Author and NZ Property Investors’ Federation Vice President Andrew King, who provides a State of the Property Investment Nation address, then sets the theme for both newer investors and more experienced investors with substantial portfolios.  APIA’s Treasurer & Chartered Accountant Ann Loudon has the all important topic of tax changes to go through, particularly in light of the depreciation changes and the taxation treatment of LAQCs to have to become aligned to Limited Liability Partnerships.  APIA’s Honorary Solicitor & Property Lawyer Tony Steindle then talks about structures, including the legal aspects of the Limited Liability Partnership, and APIA Vice President, Property Mentor & Trust Lawyer David Whitburn talks about what to buy in today’s market, how to buy it and how to analyse just what is a good deal or not.  APIA President & former NZ Mortgage Broker of the Year Sue Tierney then talks about finance in light of the turbulent global financial crisis we are in, particularly with the highly indebted European Union countries and the relevance of this to New Zealand.  ANZ Mobile Mortgage Manager Vanessa Murch then covers off financing in New Zealand, including why fixed interest rates are so high in comparison to floating loan rates and just how we get our loans approved.  In case this wasn’t enough content, we provide further value to you in relation to tenancy management with APIA Board Manager and Principal of leading boutique Property Management Firm Corinthian Limited Jan Galloway, presenting on how you should manage your property to get the best tenants and lowest vacancy rates.  This is combined with a presentation by Tenancy Practice Lawyer Scotney Williams, giving his expert advice on the Residential Tenancies Act including recent times and also proposals to reform parts of it.

So don’t delay, BOOK YOUR TICKET for Saturday 29th May at the Parnell Jubilee Hall by emailing admin@apia.org.nz now.

Finance Minister Bill English (National Party) has just revealed the Government’s 2010 Budget.  It proposes a number of changes, including the biggest tax reforms since GST was first introduced and other tax rates slashed 25 years ago (under the Labour Party).  These were designed to make the tax system fairer, lift income levels and address long standing economic weaknesses.  Bill English stated:

It continues the Government’s focus on getting long-term, sustainable growth and shifting the economy away from borrowing, consumption and government spending and back towards saving, investing in productive areas and exporting.”

Key Changes from Budget 2010:

• Personal income tax cuts across the spectrum, as below:

• Increasing the GST rate to 15% from 12.5% from 1 October 2010, as expected, and unlike when the Labour Government raised GST by 2.5% 21 years ago, with compensation to beneficiaries and super annuitants as pointed out by Prime Minister when he reminded Phil Goff of what he did as a Cabinet in that Labour Government 21 years ago.
• Reducing the company tax rate to 28 cents from 30 cents from 1 April 2011 (start of 2012 income year).
• Reducing the PIE tax rate to 28 cents, increasing incentives to save money for retirement to reduce dependence on the Government
• Property investment losses can no longer be claimed by those looking to reduce their taxable income to claim Working for Families.
• No depreciation on buildings with a useful life of more 50 years or more (which is the vast majority of rental properties) – ie. 0% depreciation rate on building structure.
• Businesses and Property Investors (building or replacing assets) will no longer be able to claim the 20% new asset loading (accelerated depreciation) on new plant and equipment.  This change will apply to assets purchased after budget day.  Note that the old rules will continue to apply for assets purchased before this date, so you can continue to claim loading.
• Changing the rules for Loss Attributing Qualifying Companies and Qualifying Companies as they apply to property investors, so they are taxed like Limited Liability Partnerships (ie. limiting the amount of a loss that one can deduct through a LAQC in any given financial year to the amount that the shareholder has invested in the LAQC. The balance of the loss would then be carried forward to future financial years.)
• Commercial fit-out depreciation rule changes (details yet to come)
• Changing the thin capitalisation rules for foreign entities who have loaded up their local subsidiaries with a lot of debt, meaning they will have to reduce their interest bearing debts and pay a whole lot more tax in New Zealand.

See http://www.taxpolicy.ird.govt.nz/sites/default/files/2010-sr-budget2010-special-report.pdf for a Guide to the Tax Changes Announced in Today’s Budget.

Tackling Government debt

The Finance Minister reminded us that we are currently borrowing $240 million each and every week to fund Government over-spending, and the interest servicing bill is going up as a result.  Unfortunately we are going to need to borrow more.  This means our net debt as a % of Gross Domestic Product will be nearly 30% in 2014.

This is then projected to go down to an extremely manageable 14% of GDP by 2024, assuming at least a decade of disciplined spending – which will be a challenge as history shows us exceptionally few Governments last over 9 years, and the Labour Party has a strong history of overspending, or as John Key said today ‘spending and hoping’ for things to get better.

Look at the graph below to see the forecast and projected Core Crown expenses as a % of GDP.

Source: NZ Treasury 20 May 2010

My thoughts

On the whole I think that this budget is fine.  Investors lose the ability to claim on building structure (I don’t like this as I do believe commercial and residential properties in fact depreciate – just with high variance amongst properties).  However we are still able to depreciate separately identifiable items (chattels) like curtains, carpets, heat pump, letterbox, which is fair.  In addition any repairs and maintenance expenditure and items under $500 in value are tax deductible.  So if you have to repaint your window sills and fascia, like I do on 1 of my houses before the full force of winter sets in, this will be tax deductible as repairs & maintenance.  In fact it may be smart to spend money on things that need to happen before 1 October 2010 when GST goes up 2.5%.  With tax losses not completely ring fenced I consider that there will be no major fall in property prices as a result of this budget.

An interesting and long-awaited development in the leaky homes saga occurred earlier today with Housing Minister Maurice Williamson and Prime Minister John Key announcing a massive leaky homes bailout package.  This provides that the leaky home-owner pays 50% of the cost of the repairs, 25% paid by taxpayers (the Government) and 25% paid by ratepayers (the Local Councils).  This is only available to those claiming within the 10 year legal liability limit.  The government will guarantee loans to all leaky home owners taking this compensation plan up, and has informed the major banks of the plan.  Obviously these banks are excited at the prospect of more interest income guaranteed by our Government with the powers to tax NZ’s citizens!

Williamson says the scale of the leaky homes issue is equivalent to a “natural disaster of huge proportions” and it is having a considerable impact on the wealth and health of many thousands of New Zealanders and their families:

Affected homeowners have been stuck in a complex and costly disputes process for too long with little prospect of being able to fix their leaky home”

Affected homeowners will need to make a claim under the Weathertight Homes Resolution Services Act to access the financial assistance package once it is launched.  In the meantime, homeowners can apply to the Department of Building and Housing to make a weathertight claim.  If their claim is accepted, that stops the clock on the 10-year limitation for claims.  Williamson says the financial assistance package will be voluntary and in addition to the current disputes and litigation process.

Forgo right to sue Councils

Since the Crown and their territorial authorities (councils) are contributing, leaky building owners that choose to participate in the package would “forgo the right to sue local authorities or the Crown in exchange for a combined government and local authority direct payment of 50 per cent of agreed repair costs.”  This means that leaky homeowners will still have the option to pursue other liable parties such as builders, developers and manufacturers of defective products – indeed if they are still standing, and if they have the funds to litigate.  Whilst the full details have not been working out just yet, the intention is that homeowners who currently have claims in the weathertight system yet to be resolved will still be able to apply for the financial assistance package.

Williamson’s statement concluded with “owners of leaky homes who would like more information should visit www.dbh.govt.nz or phone 0800 116 926.”

Criticism of this compensation plan

I listened to NewstalkZB yesterday before and after the Auckland Property Investors’ Association Board Meeting and noted concerns on a a few fronts.  The ones I noted were:

1. Why the Government is getting involved when it has no liability?
2. Why wasn’t there a bailout to Blue Chip, Merlot and other investors in failed finance and property development schemes as these investors clearly suffered financial loss?
3. Why wasn’t there a bailout to investors in failed finance companies?
4. Why are we socialising (making the Government responsible) for private sector losses, to increase our debt burden even further?
5. Where has the personal accountability and responsibility in New Zealand gone – why don’t people just accept blame for their mistakes, rather than blame everyone else?
6. Isn’t this an urban problem?  Why should we hard working farmers and rural communities pay for city dwellers fancy housing – we don’t have a problem with our preferred style of housing; so we should we have to pay for their indulgences!

These are mainly political questions and depend on your personal wealth, attitude and own individual circumstances.  I see some real merits in this proposal as the stress involved for many leaky home-owners is immeasurable, the health and wealth impacts are often significant, and the Government itself is only offering 25% compensation, and this is forecast by the Department of Building & Housing to be around $1 billion over the next 5 years.  The leaky home owners will be suffering the most still as they have to pay 50% and in many cases simply will have to borrow this money and pay interest to banks.  This will tidy up this late 90s and early-mid 2000s housing issue, to mean this problem goes away.  The devil is always in the details, but on balance so far, I quite like this initiative.  Lets hope it works out well for leaky building owners and our great country, New Zealand.

The is still much uncertainty across the globe.  With investors looking for a place to put there money and not have capital eroded, and in fact have healthy prospects of a financial gain, many are obviously putting their money into Gold.  Gold doesn’t in itself produce an income stream of it as a company (or indeed equity security) does with dividends, term deposit (debt security) does with interest, or real estate does with rents.  It is safe haven buying, as in our world of mega insurance companies and banks, and a lot of money from compulsory superannuation countries and still many trillions of dollars of wealth globally invested, the stakes are high.  Lets take a look at the Eurozone countries that have been over-spending and covering their indulgences by heavy borrowings:

The US Government has also been overspending and the bank bailout (TARP) didn’t help this.  The US Government were at 97% external debt as a percentage of their country’s GDP recently, which is around half the level of what struggling Japan is at.

With fears of a double dip recession and a country like Ireland or Portugal needing a bailout soon, or worse (but thought to be less likely) a large country and economy like Spain defaulting on its debt obligations and needing a massive European Central Bank bailout, there are a lot of buyers searching for a “safe” investment.  This is perceived by many to be gold.  Lets take a look at Gold’s performance (in USD).

Gold Price Rise

This table shows Gold rising steadily in price from sub US$300 an ounce to just over US$400/oz in 2005.  Then a pretty sharp climb form 2005 – 2008 where it briefly hit US$1,000/oz before retreating to below US$750/oz in the midst of the global financial crises, before investors then sought haven again in Gold pushing it rapidly up to nearly US$1,250/oz today!

There is one underlying reason for this – FEAR.  No-one wants to lose their capital.  As a result there is been a steady migration into Gold which many think will continue surging over US$1,500/oz.  Others think it is fundamentally over valued and as soon as stability hits the global financial markets (in 12-24 months time) that Gold will crash down to below US$1,000/oz eroding hard earned capital.  You make up your own mind on this. The reason I don’t currently invest in Gold is that I like to receive a cashflow from my investments, I have no control over the market and my financial destiny with this asset class, and at current price levels there is more speculative risk.

New Zealand is following its economic big brother Australia and is doing well in recovering from the depths of the long recession we had.  The major news for New Zealand last week was that our unemployment rate dropped from 7.1% to 6.0% in a single quarter.  This was a stunning turnaround, and I am now very worried that Reserve Bank Governor may take this important statistic as a signal to reduce the fiscal stimulus that a low OCR provides (lower funding costs to businesses, and less punishment to a weakened housing sector at present) and raise the OCR by 0.25% early than 16 September as I thought likely, to 26 July or possibly even on 10 June.  Last Thursday night and Friday saw most of the major banks raise their 6 month, 1 year and 2 year short term fixed rates.  I am personally predicting 26 July for the first rise in the OCR right now.  One thing is for certain – floating interest rates and short term interest rates are going upwards.

As the All Whites have named their squad and head to South Africa for the FIFA World Cup for the first time in 28 years, we are going to be fed a diet of the beautiful game.  Whilst I haven’t played outdoor soccer for 3 years now, I have been enjoying playing Indoor Soccer (FIFA Futsal to be pedantic) at the ASB Stadium in Kohimarama.  Why this is relevant is that Auckland is blessed to have so many people from a number of countries around the world.  In our Masters League (must be >30 years old) we have players from Spain, France, Italy, England, Greece, Germany, Denmark, Sweden, Wales, Scotland, Ireland, Uruguay, Chile, Brazil, Argentina, Bolivia, Columbia, USA, China, Japan, South Korea, Indonesia, Singapore, Malaysia, Thailand, Australia and of course plenty from New Zealand.  I got thinking after the games about the various countries in the world really struggling, particularly those in Europe.  Grecian rioting about cuts to pensions and Government workers’ wages, and Greece’s mega bailout by the European Union is highly topical.  With more debt defaults and concerns raised about Portugal and Spain’s Government looking in peril, this caused a lot of fear in the market.  These events saw the Dow Jones industrials to a loss of nearly 1,000 points (to below 10,000 points) in less than half an hour, with a few thousand computer aided trades processing many hundred of trades in a single second, providing a red herring to the core issue of global financial instability. Gold prices soared to record highs at US$1,248.60 per ounce (12 May 2010).

Greece’s economic collapse

Will the Euro collapse?  I don’t think so.  Greece has been a scare, and Spain and Portugal are making bankers nervous.  However the economic  powerhouses of Germany and France wouldn’t want to see that, and the epic meeting by the 16 finance ministers of the EU full member countries came up with a 110 billion Euro bailout of Greece, in return for Greece’s Austerity Plan.  Greece’s welfare state where they promised the earth to their pensioners and looked after their civil service extremely well, has at last had to come to an end.

The riots will still likely continue as the EU have imposed stringent conditions on the bailout.  Prime Minister George Papandreou said that this will involve “great sacrifices” and signal an end to their failed welfare state.  The austerity plan aims to achieve fresh budget cuts of 30bn euros over three years – with the goal of cutting Greece’s public deficit to less than 3% of GDP by 2014.  It is currently a massive 13.6% of GDP.

The measures include:

• Increasing VAT from 21% to 23%
• Banning increases in public sector salaries and pensions for at least three years
• Scrapping bonus payments for public sector workers
• Capping annual holiday bonuses and axing them for higher earners
• Raising taxes on fuel, alcohol and tobacco by 10%
• Taxing illegal construction

Finance Minister George Papaconstantinou stated that Greece had been called on to make a “basic choice between collapse or salvation”.