Researching how to invest start investing in property can be like revisiting your high school maths class, except the class, is being taught in some new foreign language.
The terminology can be daunting and who wants to ask questions when they don’t know the language for asking, or can’t understand the response.
Here we’re going to demystify some of the industry’s more technical terms so you can converse like a property expert (or at least like someone who has some idea).
You’ll often hear the word feasibility or “feaso” show up early in the property investing process. Feasibility is basically a process that determines whether a project (in your case the investment) can, or should be done. It determines if the process is viable, most specifically from a financial perspective.
Detailed feasibility will essentially tell you whether a proposed investment or development will be an outstanding success or a dreadful flop. The feasibility forecasts all of the property investment costs and revenues, including an assessment of when the cash inflows and outflows will occur.
A feasibility should outline exactly how much an investment costs, how you will fund it, how much capital (your own money) you will need, how much income the property will generate, what your ongoing costs will be, and whether you will need money to maintain the cost of keeping the investment over time.
LVR – Loan to Value Ratio
LVR is a common term that gets thrown around when we’re discussing how to finance an investment. A bank will often refer to their LVR for investment loans. But what is it?
The Loan to Value Ratio (LVR) is the number of your borrowings relative to the value of the property.
So, if your bank offers you lending of 90% LVR, that means they will loan 90% of the value of the property.
For example, if the property is valued at $800,000 and the LVR offered is 90%, the bank will loan 90% of $800,000 or $720,000. That means that to purchase, you would still need $80,000 of your own capital (e.g. cash or other equity that the lender will accept).
LMI – Lender’s Mortgage Insurance
Another term thrown around at the borrowing stage is LMI. Lender’s Mortgage Insurance (LMI) is an insurance that lenders take out in order to be able to lend to borrowers who have a smaller deposit (this is generally with then amount you are lending is more than 80% of the property).
Even though the insurance protects the lender, in case you default on your mortgage, this cost is passed on to the borrower and added to the loan amount (as if the bank is going to for it right?).
So, in most cases, if your LVR is over 80% (you are borrowing more than 80% of the value of the property), you will also need to pay LMI in addition to the full loan amount.
Comparison of Interest Rate
Interest rates can seem simple – just compare 4% with 5% right? But once you throw in all sorts of fees and other costs they can become a big confusing mess.
So, in Australia lenders have to publish what is called a Comparison Interest Rate. The comparison rate is designed to let you easily compare the true cost of one loan versus another. It’s calculated by combining the loan’s interest rate with other costs and fees involved. So much more helpful than the basic interest rate.
Negative gearing describes the situation where the costs of owning an investment are greater than the income that you receive from the investment. This can apply for all assets including investment properties. Negative gearing can be a strategy used by some high wealth investors to lower tax, or some investors negative gear in the short term, hoping their income will eventually be greater than their expenses.
If all of the costs of holding the property – interest on your loan, repairs, and maintenance, management fees, etc are greater than the income you receive (typically in the form of rent), then your property is said to be negatively geared – it is making a loss in that year.
In Australia, the loss your property makes in a financial year is deductible from your taxable income.
Capital Allowance is a tax deduction for the decline in value (depreciation) of capital assets, such as your investment property.
But you buy an investment property hoping that the value goes up (appreciates) am I right? Yes! However, from an accounting and ATO perspective, constructed assets that are income-generating (the house/unit/shop/office you rent out) technically decline in value as it ages and wears out. You claim this loss in value as a capital allowance.
Just like a business can claim the depreciation of machinery, or a vehicle, a property investor can claim depreciation of their investment property.
What does it mean when experts recommend buying a property for capital growth? Capital growth is simply the increase in the value of your property over time.
If you purchase a property valued at $500,000 and in 5 years’ time it is valued at $600,000 then capital growth over that 5 year period has been $100,000 or 20%.
Calculation: 600,000 – 500,000 = 100,000. 100,000/500,000 X 100 = 20%.
Capital growth is definitely seen as desirable, and many property investors who are investing for the long-term seek out areas they believe will have strong capital growth over the long-term and may be less concerned about yield in the short term.
When experts aren’t banging on about capital growth, then they’re often discussing yield. Rental yield is the amount of money you make on an investment property by calculating the gap between your overall costs and the income you receive from renting out your property.
Rental yield is the rent return a property earns before accounting for any property expenses. It’s basically the annual rent you earn as a percentage of the property’s market value.
To calculate this gross rental yield:
- Add up the total annual rent you would expect to receive from a tenant.
- Divide that annual total by the value of the property
- Multiply that figure by 100 to calculate the percentage of your gross rental yield
For example – you receive $40,000 each year in rent, and the property is worth $900,000. Your gross rental yield is:
40,000/900,000 X 100 = 4.4%.
You can use this yield information to help compare the performance of the properties you are assessing.
Investors may focus more on yield if the property doesn’t have great capital growth forecasts. Ideally, good yield and capital growth are the best combinations.
When you apply for finance your lending is definitely going to consider your loan serviceability. This is where they assess your ability to be able to afford and make the repayments on the loan they are offering.
A typical serviceability assessment will calculate your income, and deduct expenses, household expenditure, and the new loan repayment.
The exact factors that define serviceability vary between financial institutions, but they will generally establish what they call your debt service ratio – which is the proportion of the applicant’s income that can go towards paying off a loan.
Capital Gains Tax (CGT)
Why is everyone so worried about Capital Gains Tax, and what is it anyway? Capital Gains Tax is simply the tax you pay when you make a capital gain. Selling assets such as real estate, shares, or managed funds investments can generate a capital gain if you have sold it for more than it cost you to purchase it.
In very simple terms, when you make a capital gain, it is added to your assessable income and will increase the tax you need to pay in that year.
However, calculating capital gains can be a far more complex process when taking into account the many discounts, exemptions, and other factors that can influence the actual acquisition and disposal costs. You should always seek the advice of a professional accountant or the ATO when it comes to calculating capital gains and capital gains tax.
Do your research
Investing in property is not something that should be done lightly or impulsively. It can be a lot of money to risk if you don’t know what you are doing. Hopefully, we have helped to make the process easier by defining some of these lesser-known terms for you here.
There is a ton of information available and we suggest you do some reading or watch some videos before embarking on your property investment journey.