Work Your Initial Investment!

Posted by Luke Graham

Leverage is one of the strongest cases in favour of direct property investment but the actual underlying power of leverage is still often overlooked. Reflecting on my own property investment journey recently made me realise how powerful my initial investment actually was.

It is often argued what asset class reaps the greatest annual growth rate. What is more important, however, is your ability to maximise growth on your initial investment. There’s no point making 20 per cent growth on $10 over two years. In other words, how hard can you make your money work for you?

Take the last twelve months as an example. The highest performing city in Australia for residential property was Sydney with 14.6 per cent growth. The worst performing city was Canberra with 2.4 per cent growth. What did a hypothetical $500,000 property do in each of these markets with an initial investment of $60,000?

-$35,000 for acquisition costs (stamp duty, insurance and fees)

-25,000 for a 5% deposit on the $500,000 property

Canberra: $500,000 turned into $512,000 over 12 months

Sydney: $500,000 turned into $573,000 over 12 months

So in Australia’s worst performing market where growth was below inflation, the gross return on investment in one year was actually 20 per cent! On the other hand, Australia’s best performing market saw a gross return of 122 per cent on the original $60,000.

One of the strongest criticisms of direct property investment has been the ‘substantial’ cost of buying and holding the asset. Of particular significance is stamp duty. Because of this we effectively begin with $35,000 out of pocket (see above). Sydney recovered this $35,000 expense within the first six months and Canberra would recover it in an additional 24 months.

Even if a $500,000 property was to grow a measly 2.4 per cent per annum over the longer term, you’re still looking at a value of $633,825 after ten years. See how this operates below:

$633,825 – $500,000 = $133,825 of growth

+ $25,000 equity from initial deposit

= $158,825 of future value

FV = PV(1+r)ⁿ

r = (FV/PV)^1/n– 1

r = (158,825/60,000)^1/10– 1

r = 10.22 per cent per annum over ten years on the original $60,000 investment.

To put this into perspective, the ASX200 has a 10 year annual return figure of 3.28 per cent and financial institutions are currently offering 3.5 per cent per annum fixed term deposit accounts.

Imagine what your rate of return would be in a well-researched property market!

Limitations: This article is for the purposes of illustration only and constitutes opinion rather than personal financial advice. Given that every investor’s personal circumstances vary, ongoing cash flows were not factored into the analysis. These can include rental income, mortgage repayments, service fees, depreciation, maintenance, etcetera. Combining these can result in positive, neutral or negative pre or post tax cash flow. For this reason, every individual scenario should be assessed and stress tested with a qualified professional.

Posted by Luke Graham, on 25th Nov 2014