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 season10$1,500100%
Shoulder season6$1,000100%
Off season36$70050%

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…

  1. What sort of a return (IRR) can they expect over the 15 years they will have owned the property?
  2. 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?

  1. 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.
  2. 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.

    Property value

  3. 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.

    Purchase costs

  4. 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.

    Rent

  5. 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.

    Rental expenses

  6. 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).
  7. 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.

    Interest rates

    Loan type

  8. 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.
  9. 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.

    Building depreciation

  10. 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.

    Fixtures and fittings

  11. 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).

    Tax credits

  12. Growth & inflation: Change the growth & inflation rates to 6% and 2% respectively.
  13. 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.

Bottom line