Are you worried that your property investment expenses will see you resorting to living on baked beans to get by? Your Investment Property reveals five top strategies to get some bounce in your budget.
1. Review your budget
Too many people panic when money gets tight, and make unsustainable cuts to their expenditure. While this might be effective in the short term, it rarely works in the long term – you might be able to cope for a while, but eventually you’ll get fed up denying yourself life’s little luxuries and will splurge – potentially ruining your budget. Instead, it’s worth sitting down and going through your income and expenditure in a methodical fashion.
David Hayward, managing director of the Money Institute, suggests splitting your expenses into three main areas: fixed costs (A), discretionary spending (B) and wealth building (C). He breaks them down as follows:
“‘A’ is basically the expenses that you’ve got to meet: your home loan, investment loan, utility payments, insurance, investment property expenses, and so on,” says Hayward.
“You should aim for this to make up around 50% of your net income. ‘B’ is lifestyle spending: clothes, shopping, going out and so on. This should be around 30% of your net income. Finally, ‘C’ is the spending that will help your financial future – paying off ‘bad’ debt like credit cards and other consumer debt, and cash savings. This should make up the other 20%.”
Hayward emphasises that these percentages are a guide only, and you shouldn’t panic if your expenditures are way out. But you should carefully work through each category to bring your spending as close as possible to the above numbers – and here’s how.
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A: Fixed expenditure
First and foremost, you should look at your home and investment loans: these are likely to be your biggest expenditure, and also likely to be where you can make really major savings (more on this later). You should also look at all your other essential expenses, and investigate ways you can minimise these.
“Do some comparative shopping on your utility costs,” says Hayward. “You can make significant differences by switching providers. Also, it’s important to understand how your bills are calculated, and not just accept the charges at face value.”
Making sure you’re only paying for what you use is important, too. “You may be paying your internet provider $50 a month for 25GB of data, whereas you’re only actually using 3GB,” adds Hayward. “Bring your plan down to what you actually use.”
It’s not only household expenditure you should tighten, either: review your investment expenses such as property management fees. While it’s worth paying a fair rate for quality service,
there are areas where you can make quick gains – landlord insurance is one. “Investors invariably have multiple insurances in place – home and contents, car, health, landlord, and so on,” comments Hayward.
“These are often with different companies. It’s well worth looking at consolidating those products with one provider and asking for a discount on
the premiums.”
Even if this doesn’t save you money, it’s worth shopping around for the best landlord insurance deal. A comparison in the October issue of Your Investment Property found a difference in price of more than $1,000pa between the cheapest and most expensive landlord insurance – though you need to make sure you’re not skimping on cover, as this could turn out to be more expensive in the long run.
B: Discretionary spending
This is everything that’s not essential, and tips on how to reduce unnecessary spending are ten a penny, but some are more useful than others. However, the most effective way to regulate discretionary spending is to monitor it.
“Discretionary spending is a bit of a black hole – it can place a lot of pressure on your budget, especially if you take out cash and fritter it away,” says Hayward. “When you ask people to track their cash spending for a week, it’s amazing how much money is ‘leaked’.” He recommends putting spending money in a separate account.
“Put that 30% of your income into a single account, and spend as much as you want. However, once you get to that level, the shutters should go down,” he advises. “Look at it this way: even if you only save $2.50 a day, that’s $77 over a month. That doesn’t sound like a lot, but that’s nearly $1,000 over a year, which can go towards fixed expenditure or wealth building.”
C: Wealth building
Finally, Hayward reckons it’s essential to allocate some money to areas other than day-to-day survival. “You have to have some kind of reserves in place to leverage off, or in case something goes wrong,” he says. “We suggest 20% of net income, but even if it’s just 1%, that’s a start.”
This money should go towards paying off consumer debt, creating and maintaining a cash buffer, or a combination of the two.
He recommends a buffer of at least 12 weeks’ rent, even if you’re insured against rent default, either held as cash or in a loan account (more on buffers later). If you’ve got consumer debt to pay off, pick off the ‘low-hanging fruit’.
“Psychologically, it’s easiest to hit the smallest debt first, even if it’s a lower interest rate, so you can see results,” he says. “Once that’s paid, you can also take the payments towards that debt and apply them to higher interest debt – meaning the amount you can actually pay off will snowball.”
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2. Revisit your mortgages
One of the biggest expenditures you can look to minimise is your home and investment loans.
The knee-jerk reaction from many borrowers in the face of interest rate rises is to stick two fingers up at their existing lender and look for a better deal elsewhere. However, Justin Hanka, chief operating officer at the rate comparison website www.helpmechoose.com.au, suggests this may not be the wisest move.
“It’s worth trying to negotiate with your existing lender,” says Hanka. “It’s possible to get a better deal than what you’re on at the moment – I know this as I’ve done it myself recently, and was able to save 0.5% on my mortgage. Investors, particularly, have a significant amount of ‘wiggle room’, as typically your borrowings are north of $500,000, and lenders are more willing to negotiate rates over that point.”
Hayward – a former bank executive – agrees, and adds that banks are often willing to provide discounts of up to 1% if a client is highly valued or holds other facilities with them.
Another strategy he suggests is moving a principal & interest (P&I) mortgage to interest-only (IO), even if only for a short period of time.
“Admittedly, moving from P&I to IO won’t save a huge amount of money – perhaps $100 or $200 a month – but if you’re making savings in other areas it can contribute to a bigger difference.”
If you’re getting no joy with your existing lender, then it’s time to look at refinancing. Hanka recommends doing thorough research using both comparison websites and consulting a mortgage broker, in order to get the best loan for your needs. You shouldn’t just limit your search to the banks, either. “As well as the major banks, there’s a host of non-bank and smaller bank lenders out there,” he says.
“What we’re finding at the moment is that non-bank lenders are proving very competitive with pricing and fees. It’s certainly worth looking outside the Big Four [banks].”
Hanka cautions that you shouldn’t just jump at the best rate you find, especially if you haven’t had your mortgage for long. Before deciding to switch, make sure any exit fees aren’t prohibitive. A good rule of thumb is to add up how long it would take to recoup any fees; if it’s longer than four months, it may not be worth switching.
Another key aspect of any refinance on investment loans is to make sure it is structured so that it’s tax-effective. Ken Raiss, director of accountancy firm Chan & Naylor, explains:
“Investors can claim interest on investment loans as tax-deductible if the purpose of the loan can be linked to the investment,” he says. “If the loan is incorrectly set up, this can be lost.
Many investors have been affected by this – it’s a simple mistake with catastrophic results.”
Therefore, it’s worth seeking advice from a mortgage broker, financial planner or your accountant before going ahead with refinancing complex structures.
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3. Increase the rent
Of course, there’s a flip side to decreasing your expenses – and that’s increasing your net income. A simple way to do this is to increase the rent on your investment properties.
Like budgeting, it’s important to take a methodical approach to rental increases. You should make sure you’re keeping up with rental market rates in the first place. If your rental income is below the rate, putting in a big increase to fix this won’t go down well with your tenants, who may be struggling themselves, and may choose to leave.
Admittedly, while this would allow you to charge the market rate to new tenants, there are costs involved in finding new occupants, not to mention lost income from a vacant property. This may not be a risk that financially-stretched landlords are willing to take.
Instead, steadily increase rents to market rates over time. A 10% increase every six months over the course of 18 months will be more palatable to a tenant than a 20% increase in one hit. You should also ensure that the property is well-maintained.
At rent review, ask if there’s anything you could do to make life more comfortable – such as a new air-conditioner – with the proviso that you may have to increase the rent by a bigger margin to recoup the capital outlay. This may help bridge the psychological gap of increasing rent by a large margin for no perceived benefit.
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4. Make the most of your tax benefits
One way to get money for (seemingly) nothing is to make the most of the tax benefits for investors. Most will know about negative gearing but many overlook another benefit: depreciation.
“Not claiming depreciation is almost like not charging rent, so you’d be mad not to,” says Raiss. “The capital works deduction for buildings constructed post-1985 is even more generous and makes these properties attractive from a tax-effectiveness point of view.”
Tyron Hyde, director of quantity surveyor and depreciation specialist Washington Brown, agrees. “Many investors think their property is too old to qualify for depreciation: in most cases this isn’t so,” he says.
Hyde suggests that investors not currently claiming depreciation should find out if they can. Several websites – including the ATO’s, Washington Brown’s and the Your Investment Property website – have depreciation calculators.
“If you’ve forgotten to claim depreciation you can backdate it,” adds Hyde. “But check with a financial advisor as to the exact amount of time you can backdate the claim. If you do go ahead, the cost of a quantity surveyor’s report is also deductible in the year you complete the report.”
If you’re already claiming depreciation, it’s worth reviewing it.
“I’d advise people to understand what’s in the depreciation schedule they already have for their property,” he says.
“As investors update or repair part of their property they should ensure that they claim any balancing adjustment they’re entitled to.
“Let’s say a client bought a unit for $300,000 and in that unit was carpet valued at $3,500. If that carpet was replaced seven years later, but within the depreciation schedule the carpet still had $1,000 left to run, that $1,000 can be claimed in full the moment you replace it. You can start claiming the value of the new carpet, too.”
Another ‘quick win’ as far as tax benefits go is the use of a PAYG Withholding Variation. This allows investors to spread the tax refund that would normally be paid at the end of the year throughout the course of the year, simply by filling in a form. Rental property deductions including negative gearing, depreciation, agents’ commission, management fees, repairs and capital works can all be claimed.
This is an effective way to improve monthly cash flow, says Hayward. “If there’s one single thing I’d do to improve cash flow, it’s filling out a PAYG withholding variation form,” he says. “It’s an effective way to manage your cash flow in the short term – even if it only gives you an extra $250 a month, that could cover some or all of the increased mortgage payments as a result of an interest rate increase.”
Both Raiss and Hyde stress that it’s vital for investors to claim every tax benefit they can to maximise cash flow. But Raiss urges an element of caution.
“Investors need to be proactive in managing their affairs to ensure their portfolios stay tax-effective, and there is an ever-changing range of deductions and perks available,” he says. “However, investors should be mindful that the ATO has a dim view on strategies whose main purpose is to reduce tax.”
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5. Dip into a buffer
Finally, line of credit (LOC) loans commonly used by investors are often set up to provide a buffer facility in case of financial hardship.
“LOCs are an important form of ‘self-insurance’ for investors,” says Raiss. “They allow the borrower to borrow more safely as the buffer can be drawn on in times of financial stress, or to lessen the lifestyle spending burden.”
The buffer works like this. An investor buys a property for $300,000 and takes out a loan of $270,000 at the time of purchase. After several years of capital growth, the property is valued at $400,000. This means that, even if the loan is still worth $270,000, there is now $130,000 of equity in the property. With a line of credit facility, the owner can hypothetically increase the loan value to $290,000, and use the extra $20,000 cash to fund lifestyle or investments. If the monthly shortfall is $500, this would give enough to cover the shortfall for well over three years.
Interest is only paid on the cash drawn down. If used for an investment shortfall, such as a negatively geared property, it could be tax-deductible. But Raiss warns that it may not be as easy as it appears to access equity in a property.
“While LOCs are still available, they are harder to attain than before the GFC,” he says. “In this environment, we’d recommend investors explore options such as income protection insurance, insurance on the mortgage and other strategies for a rainy day.”
These other strategies could include accessing mortgage payments made in advance or borrowing against spare equity, which can potentially act as cash buffers, adds Raiss.
Cold hard cash can also be useful in a situation where a buffer is needed.
“If accessing equity is not an option, cash savings accruing interest can be effective,” he says. “In a higher interest rate environment this option becomes more attractive. The use of a full-offset account in these circumstances is very tax effective and leaves the door open to use the funds for personal expenditure, without reducing the tax deductibility of the investment loan.”
However, Raiss urges caution when using surplus cash – especially if it’s already been used to pay down a loan. “Many investors pay down loans with surplus cash, only to be surprised when they pull it out and their accountant tells them that interest on the now-increased loan amount is not fully tax-deductible.”
The most important thing to remember when using any buffer, cash or line of credit, is that eventually you’ll need to replenish whatever you take out – or at the very least keep building it up in case of future need.
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