I have a confession to make: one of my guilty pleasures is occasionally watching the tv show Grand Designs.
For those who have never seen it, this is a dramatised reality show about property development.
The basic premise of each episode is a couple with a dream for a “Grand Design”, lots of money, and little sense; decide to become amateur property developers. They typically attempt to save money by doing some/all the work themselves, while living onsite throughout the (often lengthy) build.
Invariably things go off the rails: Planning permission problems. Nimby neighbours. Slipped deadlines. Overrun timescales. Blown budgets.
For added drama often the developers end up pregnant before the build concludes… it appears there isn’t much to do in the evenings when you’re living in an unheated caravan, and house poor!
Eventually the build completes, with the “Grand Design” being presented like a display home.
Anecdotally once the cameras stop rolling more than a few of the marriages break up, with the recently completed “Grand Design” hitting the property market at a significant discount. Unsurprisingly few of those “perfect for us” bespoke design elements and quirky features that so inspired the original owners appeal to the general population.
It would be fascinating to know the conversion rate between projects started versus episodes aired. Property development is an attritional game at the best of times, without the added dimension of potentially failing in front of a television audience!
There are several reasons I enjoy the show.
Partly it is for the property porn.
There is an element of voyeuristic thrill in watching “car crash television”, providing a strong reminder that perhaps renting isn’t so bad for now, as building a dream house is difficult.
In my experience, successfully getting more than one person to agree on what constitutes a “dream” anything is harder than juggling a dozen Sabatier knives while riding a unicycle that is on fire!
However the main thing I enjoy is how inspiring it is to watch the developers throw caution to the wind and really go for something they are passionate about.
No safety net.
No plan B.
Succeed, or go broke trying.
Occasionally one of the designs is genuinely beautiful. Often they are downright awful. Yet always there is something compelling about the passion the developers exhibit in pursuit of their dream.
I woke up this morning and discovered I owned a house with purple wall(s)! Who knew?!?
The ownership of the house wasn’t a surprise, I purchased it as an investment several years ago.
However I have another confession to make: I have never set foot inside this property.
Property investment is a numbers game.
In theory it is possible to identify areas with strong capital appreciation prospects via online research.
Determining the market price can be performed from afar.
Google street view makes it possible to virtually “stroll” around the local neighbourhood without getting off the couch.
Building inspections can (and should) be outsourced to somebody who knows what they are doing, and has sufficient professional indemnity insurance coverage for when they make a mistake!
From an investment perspective all of this research worked out nicely. However as any manager can attest, when you staff out things sometimes the unexpected happens.
Like the surprising purple walls, which nobody had previously mentioned. One of those quirky design elements that makes properties harder to sell, but possibly helps to explain why the purchase price I paid was so attractive!
At the risk of letting facts get in the way of a good story, I must disclose that I also happened to own a neighbouring property with an identical floor plan and similar fixtures and fittings.
While I believe in numbers-driven decision-making, I also like to verify what they tell me!
Today I will use the (unexpectedly) purple-walled house as a case study to walk through my investment process.
Top down research
The first, and in my view most important, step in successful property investing is identifying an area that has the long term potential to appreciate in value faster than the prevailing market.
As per the cliché: the three most important property features are location, location, and location!
Why is this important? When it comes to property it is cash flow that makes you feel rich, but capital growth that actually makes you rich.
Buying a nice property is a shitty location might seem like you are getting a bargain. However when the time comes to sell, unless the area has drastically improved, that nice property will still be located in that same shitty location!
Identify areas that possess strong job opportunities.
Excellent transport links.
Located near good schools and healthcare facilities.
With ready access to shopping and entertainment.
Ideally identify areas that don’t yet enjoy all of these, but soon will do. It is the introduction or improvement to this type of infrastructure that should see property prices rise faster than the rest of the market.
In the case of the purple-walled house, when I bought it the local neighbourhood had a single primary school, a small medical clinic, and a tiny shopping precinct containing just a small grocery store, a newsagent, and a kebab shop.
However zoning and development approvals had been sought, and recently granted, to significantly improve the area.
Today there are three primary schools and a high school nearby. A Westfield style shopping centre has opened, along with two office buildings. The city’s light rail network has been extended to the shopping centre. A sports stadium is currently being constructed.
These improvements have had a significant positive impact on the land values of nearby properties.
Another property cliché is to try and buy the worst property on the best street.
The idea is that a rundown property may trade at a discount to its nicer looking neighbours. If it is possible to improve the property for less than the discount, then you come out ahead.
When choosing a property, always look for opportunities to create value.
Common examples include:
- gaining planning approvals
- consolidating titles
- demolishing and rebuilding
Ensure the numbers, not wishful thinking, prove the viability of each of value-adding option.
Don’t be put off by minor cosmetic problems that could be easily and cheaply remedied. I never cease to be amazed at the number of prospective buyers who walk away from a good deal because they can’t see past hideous 1970s bathroom tiles or the current owner’s dubious decorating choices.
Those purple walls could easily be repainted within a couple of days.
Tread cautiously when considering sinking money into renovations that won’t add value. Decorating in the latest trendy materials may help a property sell faster, but are unlikely to shift the needle on the sales price you ultimately achieve.
Run the numbers
A good property must be capable of being self-funding.
If not, then you will be subsidising the living costs of your tenants. Which is charitable of you, but hardly the route to riches.
You may currently occupy the property yourself. However there is a reasonable chance that at some stage you will wish to move, potentially renting your property out to tenants.
A good investment property is self-funding before any tax offsets or deductions are taken into account. The rules can (and do) change, so if your investment only makes sense due to tax deductions then you’re screwed if they do!
When running the numbers make sure you factor in a reasonable safety margin for interest rate rises, void periods, management fees and maintenance costs.
Margin of safety
The United Kingdom’s long term bank rate is around 4.7%. Within living memory, it reached as high as 16%.
Occasionally the property gods will smile and you will experience a seamless handover between tenancies.
More often there will be a void period.
During this time you are on the hook for all the ongoing utility bills, mortgage payments, and property related taxes. In addition to those, you also incur the costs associated with seeking and vetting a new tenant.
Even if you are planning to manage the property yourself today, that may not always be the case. It is better to ensure the property can afford professional property managers upfront, rather than getting an expensive shock at a later date when life happens and your plans change.
Properties incur maintenance costs.
Things wear out. Tenants break things. Water mains burst. Showers leak. Mice eat electrics. Fires occur.
You can’t know exactly what will go wrong, but rest assured something will semi-regularly… often on a bank holiday weekend when plumbers charge penalty rates to attend!
Occasionally there may be good exceptions to this general rule.
Personally my approach has been to ensure my property portfolio in aggregate is always self-funding, though at times individual properties have needed to be propped up by the others.
A property undergoing improvement works might be one example.
Another might be while putting together a title consolidation deal, selling a group of neighbouring houses to a property developer so they can be demolished and replaced by an apartment building.
Case study: the purple walled house
For the purple-walled house I factored in a 4 week void period per year, which in my experience is the upper end of average. This meant my income figures were based on a 48 week rental year, rather than the 52 week calendar year.
Property management fees vary considerably by location. The purple-walled house is managed for 5%. I’ve had a property manager in London try and charge me as much as 15%.
Maintenance is a tricky one. I budget on maintenance costs being 10% of the gross rent. That more than covers most properties most years, but has proven insufficient to cover larger irregular jobs like repainting a whole house or replacing the flooring.
When combined, these figures give me a conservative view of what the property should earn, and what it will cost to own.
This provides an initial triage point, whether the total investment return (before financing costs and taxes) warrants further investigation. Would it make sense to invest capital into the property, or would it perform better elsewhere?
In this case the purple-walled house passed that test.
First the finding, then the financing
Next I ran a multitude of “what if” financing scenarios, looking at permutations of Loan-To-Valuation percentages, loan terms, and interest rates.
To ensure I don’t miss anything, I test all the options ranging from risk-averse owning the property outright through to a very risky 100% interest only mortgage.
I then stress tested those numbers assuming using an 8% interest rate. This is a lot higher than rates currently are, but I’m old enough to remember interest rates in the mid-teens!
In this case I contributed a 20% deposit, and financed the remainder with a flexible Home Equity Line Of Credit.
For this particular property I didn’t invest any cash at all, preferring to use accumulated equity from another investment property as the deposit. This meant my out of pocket expenditure on the purchase was limited to the conveyancing costs and loan establishment fees.
I did the victory dance when I discovered the jurisdiction covering the property’s location had recently abolished stamp duty, replacing it with a far more equitable value driven land tax!
Returning to the present day, the property has performed largely as expected.
The neighbourhood improved, resulting in a one-off surge in property values. This took longer to complete than I had initially expected, an economic slowdown resulted in several of the infrastructure projects being mothballed for a couple of years.
Since then values of grown roughly in line with the prevailing market.
For the duration of my ownership, the property has been strongly cash flow positive.
The excess cash flow thrown off by the investment has been channelled into paying down the loan, reducing the gearing levels from an initial 80% to just over 40%.
Nobody would ever accuse this uninspiring suburban property of being a thing of beauty. The grand design lies in the financials.
All going well, within a few years the tenants will have successfully paid off the mortgage in full. The extracted equity I used as the deposit has been similarly repaid.
Should this occur, the purple-walled house will have be a good example of “making your money work for you” in action.
I would be in the fortunate position of owning outright an income producing asset, that has financed itself fully (once the initial buying costs were paid).