The five step approach to property investment decision making

by Andrew Walsh Director - Wealth Management Andrew Walsh is a Director within the Wealth Management Investment Advisory team. Andrew specialises in managing portfolios for clients in an integrated and tax aware manner. Andrew also has expertise in estate planning and personal risk management. Contact Andrew

Mutual Trust provides advice across multiple asset classes including: cash; fixed interest; shares; alternative assets and property. Often clients will come to us with existing property assets which typically will include lifestyle orientated assets such as a family or holiday home. Whilst these are increasingly taken into account in strategic decision making as the baby boomer generation downsizes, the focus of this article is property acquired purely for investment purposes.

Many of the basic tenents of investment decision making apply when assessing property investment opportunities. However with property, the focus shifts slightly, and in most cases, the following five step process should prove useful:

1. Identify objectives and constraints

This will often include defining the level of risk you are prepared to accept. This may be high for development assets and relatively low for a fully let commercial building with a long tenancy profile. The desired level of return usually will inform this decision.

The investment time frame is often a potential constraint given the relatively illiquid nature of the asset class. The high cost of entry and exit and the timing and nature of cash flows are also important considerations.

2. Consider macroeconomic conditions

The primary considerations here include the outlook for national and state economies (often rental income is a derivative of economic growth) and interest rates. If purchasing property outside of Australia, currency factors need to be taken into account. This includes both the currency in which you are investing and the Australian dollar versus that currency. Foreign income flows are also a factor, which is topical with evidence that currently foreign buyers are a significant proportion of the buying interest in the domestic property market.

3. Identify the investment opportunity

The above two steps will be useful in defining what attributes you are looking for in the investment and whether the timing is appropriate. Other key considerations here often include a review of the tenant (the security of the rental income), lease terms and conditions, the frequency of rent reviews, the payment of outgoings and inclusion of ratchet clauses, location and an appropriate level of gearing (this often depends on the type of asset). It is useful at this stage to consider potential exit strategies, with multiple strategies being preferable.

Ideally a portfolio approach, i.e. having multiple investments, will be taken in order to reduce specific asset risk. Building a portfolio may include both geographic diversity (where the properties are located) and property type (commercial/office, retail, rural, other). Any new purchase should be reviewed against whether it will complement the existing assets.

4. Apply investment techniques

Reviewing the investment using several techniques is considered prudent as each may offer its own insight. The most often used techniques are:

  1. Replacement cost – This can be used when purchasing existing/non development assets. It is defined as the actual cost to replace a structure. The original cost to build the structure may be useful.
  2. Comparable sales – Simply, the recent selling prices of similar properties in the area.
  3. Capitalization of Net Income – “Cap Rate” (The ratio of Net Operating Income (NOI) to property asset value e.g. if a property was listed for $1,000,000 and generated an NOI of $100,000, then the cap rate would be $100,000/$1,000,000, or 10%). This is perhaps the most commonly quoted comparison technique.
  4. Discounted cash flows “DCF” – As the holding period for property investments is often greater than 5 years, discounting future cash flows to the present day is useful. The setting of an appropriate discount rate is an important consideration with this step. The discount rate will be specific to each investment and will vary with the level of risk you are prepared to accept.
5. Make the decision to invest or not

Each decision should be reviewed with the above in mind. In most cases the combination of quantitative and qualitative inputs will prove useful. Should a decision to purchase be made, it will be important to place the investment in the correct entity. We often see returns unnecessarily diminished and asset protection risks overlooked through poor planning and we would encourage investors to seek advice prior to investing to ensure that the asset is placed in the correct vehicle.

Successful investing is often a function of making the fewest errors. Considering each property investment on its individual merits and applying a disciplined investment process reduces the risk of error, thereby enhancing the prospect for potential returns.

Mutual Trust Pty Ltd ACN 004 285 330 (AFSL 234590). Liability limited by a scheme approved under Professional Standards Legislation. For participating members (other than for the acts or omissions of Australian Financial Services Licensees). This information is general in nature and subject to change. It does not constitute tax, legal or financialadvice. We recommend you seek advice specific to your circumstances before taking any action. Copyright © 2014 Mutual Trust Pty Ltd.
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