Buy and Hold
As the name suggests, under this strategy you buy a property and then hold it for the medium to long term. In the meantime you rent it out to hopefully good tenants.
You make money using the ‘buy and hold’ strategy, when the value of your property rises or alternatively you have more rental income than property and finance expenses.
Let’s look at a buy and hold example…
Imagine that you purchased the median priced property in Melbourne back in March 1996. With the benefit of hindsight, let’s see how your investment would have turned out assuming:
- You paid $144,300 (per REIA statistics)
- Closing costs were $8,000
- You borrowed 80% on a five year fixed interest-only loan at 9% per annum
- The average rent over the period was $190 per week
- The property has been let 98% of the time
- The annual property expenses, including management fees, is $3,000
- We ignore taxation implications
- Agent’s commission and other sale costs are a flat 3%
Over that five-year period you would have:
- Received $43,316 in rent
- Paid $15,000 in property costs
- Paid $51,948 in interest costs
Today your property would be worth $256,300 (per REIA statistics), so imagining that you sold today, how much profit would you have made using buy and hold?
- Capital gain = (Price Sold – Agent’s Commission) – (Price paid + closing costs)
= ($256,300 * 97%) – ($144,300 + $8,000)
= ($248,611) – ($152,300)
- We also need to subtract the ongoing income loss that we made each year, which comprises (rental income) – (interest + property expenses)
= ($43,316) – ($51,948 + $15,000)
- Our overall profit was $72,679, which is an average annual cash on cash return of:
((Profit / (Deposit + Closing Costs)) / 5 years)
= (($72,679 / ($28,860 + $8,000)) / 5)
= 39.44% per annum.
(Please note that an alternative to selling the property would have been to retain it, have it revalued and then looked to redraw or refinance so to get access to the equity).
What are the critical success factors?
To effectively use the buy and hold strategy, when buying a property you need to decide what is more important – capital gains or income returns, because it’s difficult to find a property that offers both – especially in a prime location.
Depending on your buy and hold strategy, the following factors are important:
The better the location then the better the chance of capital gains. For example, a property that is close to amenities such as schools, parks and shops stands a much better chance of rising in value than something that is less well positioned.
If you’re looking to bank on location using the buy and hold strategy, then you’re probably likely to shop for the worst house in the best street.
The type of property that you should be looking to buy will dictate the type of tenant that you are going to attract. For example, a studio one-bedroom Inner City apartment is not built to cater for a family – so the proximity of schools isn’t likely to be important.
All manner of tenants will apply to rent your property, but the real challenge is to find the right tenant for the right property. Pre-qualifying tenants is essential to your success. If you want to know more about how to pre-qualify tenants then check out Buyer Beware in the resources section.
The construction and condition of the property is also important. Brick homes are generally worth more than their weatherboard counterparts and period style homes attract emotional charm that generally ups the price too.
But what’s critical to know about the property is what you can’t see… for example, I’ve heard of seaside homes built with nails that’ll rust, which is a big disaster waiting to happen!
Being a savvy buy and hold investor means making sure that you know what you’re buying. A great property inspection template that has saved many investors thousands of dollars can be found in Buyer Beware.
There’s no point buying a property under a buy and hold strategy if you can’t afford to own it for the long-term. That’s why it’s important to avoid buying on emotion and gut feeling and instead focus on the facts, which really means that you need to complete a full analysis of the numbers.
But if you’re financially challenged or crunching the numbers make you squirm, then it’s all the more important as you’re probably the sort of person that’s most at risk of making a poor financial decision, and maybe should consider if the buy and hold strategy is for you.
Make sure that you avoid buying based on the best case scenario too. See what effect a change in interest rates and a movement in rents does to your profit margin and ability to hold on to the property if it starts making a loss.