Example 2 – Investing in a holiday unit
Property details:
Consider a new holiday unit on the New South Wales coast that was purchased
three years ago for $420,000 with a three-year rental guarantee (4% yield, net
of expenses) of $16,800/yr. The purchase price included a $30,000 furniture
package and $22,000 worth of fixtures and fittings. The construction cost of
the unit was $170,000 while conveyancing costs were $950.
Now that the rental guarantee has expired, the owners intend spending
another $15,000 on improvements to ensure the unit’s attractiveness to
holidaymakers. Based on their experience of the past three years, the owners
estimate an annual rental income for the unit of about $33,600 based on the
following:
Period |
Weeks |
Rent/wk |
Occupancy rate |
|
Peak season | 10 | $1,500 | 100% |
Shoulder season | 6 | $1,000 | 100% |
Off season | 36 | $700 | 50% |
They estimate annual rental expenses (including management and body corporate
fees) to be about $16,000 per year.
Loan details:
Using the equity in their own home, the owners arranged a loan three years
ago to cover the total cost of the purchase, including the NSW stamp duty
($14,390), transfer fees ($139), conveyancing fees ($950), and borrowing costs ($5,902). The loan ($471,381) was for a term of
25 years, the first three of which were interest-only at a fixed rate of 6.5%.
At the end of three years (i.e. now), the loan reverts to principal and
interest at the going variable rate (7.0%). At this point in time, the bank is
also willing to extend the loan to cover the renovations ($15,000) made to the
building.
Investor details:
The investor’s current annual taxable income is $65,000 per year, his
partner’s is $25,000 and they purchased the property in joint names.
What if:
If rents, rental expenses and their annual taxable income increase in line
with an inflation rate of say 2% over the next 12 years and the value of the
property increases at 6% over the same period…
- What sort of a return (IRR) can they expect over the 15 years they will have owned
the property?
- What will be there after-tax commitment to the property in the coming year (i.e.
year 4 of the investment)?
What are the steps?
- Choose the investment analysis spreadsheet
(Menu: View/Investment Analysis). By default the years shown will be
1,2,3,5 and 10. Change the last two to be years 4 and 15.
- Property price: Click on the “Property
value” row title with the left mouse button and the Property Value dialog
will appear. Change the property price to 420k, the furniture package to
30k and the renovations in year 3 (i.e. the end of year 3) to 15k. If you
wish, you can specify the property address and description for later
reference (these items would then appear on any reports that you generate
from the spreadsheet). You can use the arrow keys to navigate from field
to field or simply use the mouse to click on the appropriate field. Click
on OK to return to the main spreadsheet with the changes you may have made
in the dialog. Note that the property value will show $420,000 (not
$440,000) as the “property value” normally includes fixtures and fittings
but excludes furniture.
- Purchase costs: Click on the “Purchase costs” row
title and the Purchase Costs dialog will appear. Change the conveyancing costs
to $950 and ensure that the spreadsheet is using the current New South Wales
scales to calculate stamp duty (if necessary, click on the Reset Scales button
to change them) and title transfer fees. Click OK to return to the spreadsheet.
- Rent: Click on the “Gross rent /wk /yr”
row title and the Rent dialog will appear. Choose the “Holiday Letting”
option and note that the seasonal rent template will be activated. Specify
the seasonal duration, rents and occupancy rates as specified above and
click OK to return to the main spreadsheet. Now the problem we encounter
here is that the seasonal rents we specified pertain to year 4 whereas the
dialog pertains to year 1. To fix this replace the amount showing in year
4 on the main spreadsheet with the amount given in year 1 ($33,600). The
rental guarantee for year 1 to 3 is for a net rent of $16,800. The
simplest way to simulate this is to directly insert $16,800 in the rent
cells for years 1 to 3 and set the corresponding years’ expenses to zero.
- Expenses: Click on the “Rental expenses”
row title to bring up the Rental expenses dialog. Click on the button
“Annual and Special Expenses” and change the expenses in year 4 to 16,000.
Then change the numbers in years 1 to 3 to zero and click OK to return to
the main spreadsheet.
- Cash investment: Change the current
amount in the Investments input column to zero to indicate that all costs
are to be borrowed (i.e. the investor used equity in another property as
supplementary collateral for the loan).
- Loan: Click on the “Loan amount” row
title to bring up the Loan Amount dialog. Note that there are no cash
outlays and that the total loan reflects the total of all costs associated
with acquiring the property. Click on the Loan Costs button to bring up
the Loan Costs dialog and simply make all values except “Other loan costs”
zero. Change Other loan costs to $5,902 and hit the Enter key. Click on
the OK button to return to the Loan dialog with the updated loan costs and
note the change to the loan amount. While still in the Loan dialog, click
on the Loan Type button to bring up the Loan Interest & Type dialog.
Choose Interest Only loan type and change the term from 40 years to 3
years and the interest rate to 6.5%. Note that Principal & Interest is
assumed for the next 25 years. Change this to read from year 4 to year 25.
To correctly specify the interest rate for the later years, click on the
“Annual Rates” button and change the rate for year 4 to 7%. The change
will be projected forward for all later years.
- Click OK to return to the Loan dialog
and click OK again to return to the main spreadsheet. Note that the
“Interest” row title will now have the suffix “(I/O, P&I)” to indicate
the combination interest only and principal and interest loan types. Note
also that the “Investments” row title will have changed to
“Investments/principal” and the columns from year 4 will show the annual
amounts paid off the loan principal.
- Building depreciation: Click on the
“Deprec. - building” row title to bring up the dialog. Change the building
costs to 170k and hit the Enter key. Note that, by default, any building
depreciation claimed as a tax deduction will be taken into account in
calculating any capital gains tax liability if the property were to be
sold. Click OK to return to the main spreadsheet.
- Fixtures and fittings: Click on the
“Deprec. - fittings” row title to bring up the dialog. Note that the
furniture cost of $30,000 will already appear. Change the value of General
fittings to $11,000 and the Low-value pool of items to $11,000 and hit
enter. If the value of individual categories (carpets, curtains, etc) is
known, it is possible to specify the individual values and rates for each
category. Click OK to return to the main spreadsheet.
- Tax credits: Click on the “Tax credits”
row title to bring up the dialog and change the investor’s taxable income
to 65k and the partner’s taxable income to $25k. Note that the method for
tax credit calculation will be using taxable income rather than simply
assuming that all tax credits accrue at the specified marginal rate.
Choose “property in joint names” and click OK to return to the main
spreadsheet. Note that the row title will have changed to “Tax credit
(joint)” and the input column will show $90,000 (i.e. 65,000 + 25,000).
- Growth & inflation: Change the
growth & inflation rates to 6% and 2% respectively.
- Projected years: Lastly, click on the
number of years showing in the top right-hand column (10yrs) and change to
15 (if you have not already done so) to give us an IRR calculated over 15
years from the time of purchase.
What’s the bottom line?
The estimated after-tax internal rate of return should show 14.47% (This
assumes the tax credits are calculated using the 2016/17 Australian tax scales).
Their contribution in the fourth year jumps to $19,330 (about $372 per week),
having been around $150 per week for the first three years. The main reason for
the jump is not the rental guarantee expiring but rather the increased loan
(renovations) and the switch to a principal and interest loan, with significant
principal payments ($9,649 in year 4) that now have to be made. The equity built
up in the property after fifteen years is estimated to be $725,316.