Many of us have been urged by well meaning family and friends to “Get a foot on the property ladder” as soon as possible. Are you considering rentvesting but are unsure whether it is the right move?
Young professionals often need to move frequently for career progression, and so home ownership is not an obvious choice. Unless the property meets strict criteria it is better to rent than buy. Others may want to live in an area they cannot afford to buy in (yet).
This article will cover the rentvesting pros and cons to consider when deciding whether to execute this strategy. Find out more about opportunity cost here.
What is Rentvesting?
Some choose to continue renting, whilst purchasing property as an investment elsewhere. This is known as “Rentvesting”.
How Does the Strategy Work?
Rentvesting is traditionally recommended for those that want to buy whilst still maintaining the lifestyle that comes with living close to a capital city.
Properties in large Australian capital cities are unaffordable for most first home buyers. Because of low rental yield (~3% of purchase price), capital centre properties tend to be significantly cheaper to rent than purchase.
As rental income contributes to calculating borrowing power, buyers can often buy a more expensive investment property than principle place of residence (PPOR).
Traditionally, rentvesting involves buying cheaper properties further away from capital city centres, with a higher rental yield.
The idea is that the rentvestor rents, whilst holding an investment property in a less desirable area, that grows in value over time.
This strategy uses the rentvestor’s borrowing ability in the short -term. Hopefully an increase in investment property and salary over time eventually allow the rentvestor to purchase a PPOR.
In the meantime, they have grown their net worth far more than if they were just renting.
Rentvesting Cons – Why may Rentvesting be a Bad Idea?
Whenever considering a financial strategy or investment, it is best to consider risk in investing first.
Interest Payments Can be “Dead Money” Too
The most obvious challenge in this strategy is that buyers are likely buying lower capital growth potential properties.
Not every property value will grow above inflation. Some will fall in value. There is no guarantees fallen values will recover in a reasonable time frame.
Those that brought during the WA mining boom have had a painful journey as property prices slumped for many years. Hopefully, prices are finally recovering. But it’s not obvious which of the current property booms are actually bubbles, about to pop.
A common warning from parents is that ‘Rent money is dead money”. Interest payments on underperforming property is just as dead as rent money. Perhaps worst, as it may prevent you from buying further property if you have more loan than property value.
You May Want to Purchase Your First Home Earlier than Anticipated, and Not be Able to.
An investment property will utilise your borrowing power, and limit future borrowing.
Life seems to change far more quickly than many of us anticipate. Using up your borrowing power on an investment property can mean rentvesters are then unable to buy their first home when circumstances change.
Loss of First Home Buyers Grant Eligibility & Capital Gains Exemption
The other obvious challenge with rentvesting is that buyers lose out on the first home buyers grant. They also miss out on the capital gains exemption they would benefit from in buying a PPOR.
To be eligible for the first home buyers grant, a buyer must move into the property as soon as practicable after purchase. The first home buyers grant should not influence your choice of property or strategy. It is often priced into the asking price (particularly with house and land packages). But it is a bit of a disappointment to miss out, all else being equal.
Your home, as long as you have moved into it once purchased, is exempt from capital gains tax on sale. Many of our parents’ properties have tripled, quadrupled or more in value over 30+ years. Not a cent was paid in tax on that gain, which is unbeatable value in investing.
Any property brought and rented out will be liable for capital gains tax on sale, which creates a substantial dent in profit.
In an ideal world, you would own your PPOR in a high capital gains area, hold for the long-term and sell for a tax free profit decades later.
Taxation on Rental Income
Any rent recieved will be taxable income. This will eat into the difference between the rent you recieve on your investment property, and the rent you pay for your home.
As you progress in your career, and consequently move up tax brackets, tax will become more substantial. 45% of income is lost in tax if the owner earns more than $180,000.
If you are paying more investment property interest and other expenses than you recieve in rent from your rental property, it will be “Negatively geared”.
This means, each month you will have to put money into the property for the benefit of owning it. This can obviously impact on your current lifestyle, and type of home you can afford to rent.
Tax benefits soften the loss, and these become more substantial the more you earn.
The most important thing to consider here is that you can definitely afford to hold the property long-term. Needing to sell a property before it has grown enough to recoup costs is financially detrimental.
Rentvesting Pros – When is Rentvesting Worth it?
Capital City Renters Who Can’t Afford to Buy Where they Want to Live
Rentvesting suits those that have a long-term plan not to buy a PPOR. The strategy will suit those on moderate and stable incomes, as taxation of rental yield will not eat into the strategic advantages.
The problem with renting instead of buying is often that the extra cash not spent on repayments often disappears into unnoticed discretionary spending. Check out this article on DINKS and the incredible efforts marketing departments make to sell you things you don’t need.
It may also suit those who have purchased a property previously, and so are already ineligible for the first home buyers grant.
The investment property should be selected with extreme caution. It should have reasonable capital growth prospects, as well as rental yield. You want to be sure the property will be worth more than it is at purchase in a few years, and that you can afford to hold it long term.
This does not suit those who could just do better by purchasing a smaller property with good capital gains prospects, and upgrading in a few years.
Traditional Buy Well and Upgrade Strategy
Buying a basic property in a good area and upgrading over the years is the traditional route. People aim to get their “Foot on the property ladder” with a basic property with the purpose of growing equity and moving (sometimes several times) to get into their ideal home.
No tax is paid on profits, which is a big motivator for those following the traditional route.
Being a multimillionaire on paper is all very well. But if all your net worth is tied up in the property you live in, it provides little freedom.
Equity from your PPOR can, however be used to fund other investments to start building passive income streams.
This strategy will work well for those wanting to live and work in capital cities, with great capital growth potential.
Reverse Rentvesting – A Strategy for Doctors
Reverse rentvesting is taking the traditional concept and turning it on it’s head. This strategy is suited to those living rent free, or subsidised rent, moving regularly or living in an area with poor capital growth expectations.
Accommodation for workers in rural areas is sometimes provided free or cheap. Health care workers are often paid extra to work in remote areas, making this a powerful strategy of geographic arbitrage.
This strategy aims to buy a better quality property as an investment than the home the buyer lives in. It exposes the rentvestor to strong capital growth markets, even if they don’t live in an area where this is relevant.
It also suits those with careers that require them to move regularly. Doctors in training often move every year for several years, making buying a PPOR impractical.
With no intention to settle in a particular area for several years, buying in a strong capital growth area will allow the buyer to leverage savings.
By purchasing high quality property with capital growth potential ,they can utilise tax benefits of negative gearing. The equity produced by increasing property value can compound tax-free for years before the property becomes positively geared.
An Alternative – Share Market Investing + Renting
An alternative to rentvesting, is simply to take the extra cash freed up by renting in stead of buying and invest in passive index funds.
This strategy can be worked out over a weekend and involves a lot less asset selection risk.
If renters can tolerate the volatility of the stock market, it also preserves liquidity so investments can be cashed in for a property purchase at a later date.
This is definitely an easier option, and involves less commitment. It also is likely to be less profitable than a well selected property, due to a lower level of leverage.
An Alternative – Serial Buying and Converting to Investment Properties.
This is a favourite amongst professionals required to move regularly. They purchase where they work, take advantage of the first home buyers grant and meeting all eligibility criteria before moving out.
After moving out of a home, owners can maintain their capital gains exemption eligibility for up to six years if they occupy the property again before sale.
On moving workplaces, they rent the old place out and buy again in their next location. It is a low hassle way to build an investment property that can work out well.
It can also easily build a property portfolio filled with poor quality If working and living in regional areas, the likely outcome is poor (or negative) growth in value, and rental income that is increasingly taxed as the owner progresses up pay grades.
The critical issue, is again, asset selection.
If purchase locations are selected carefully with an investor mindset, this can be a strong strategy. This strategy is not likely to work out well for high income professionals working in regional areas. If able to buy and live in strong capital growth areas, this strategy can supercharge wealth building.
How to RentVest.
The first step in making any major financial decision is working out your long -term wealth building plan. Working out whether home ownership is the right choice for you at the moment should involve maths as well as emotions. Then, decide whether an investment property should be part of your asset portfolio.
If you decide to purchase a property, location and asset selection are critical in ensuring the financial outcome is a positive one. A lot of research and/or professional advice should be involved.
Storing your emergency fund, and additional savings in a mortgage offset, rather than paying off the home loan maintains flexibility and maximum tax deductibility potential.
Most important of all, don’t just buy any property. Remember interest payments can be dead money too.
Have you rented and invested? What’s your choice of strategy and why does it suit you? Comment to help those still trying to calculate the best move.
Aussie Doc Freedom is not a financial adviser and does need offer any advice. Information on this website is purely a description of my experiences and learning. Please check with your independent financial adviser or accountant before making any changes.