If a Rental Doesn’t Pass This “Test,” Don’t Buy It

One Wellington flip had neighbours pointing boom boxes at it, dumping tyres, and breaking in to steal the appliances. None of that was in the spreadsheet. So, how do you know if a deal can survive when things go wrong? In this episode, Ed and Andrew share the "what if I'm wrong" test – a simple way to stress-test any property before you buy. You'll learn: The five things to checkThe renovation that missed its target price by $180kWhy the goal isn't "does it look great," but "could I survive this"If you stress-test hard enough, no property is perfect. The real question is whether you could get through the rough patches. Let us know your thoughts by leaving us a voice message on the Property Academy Hotline⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ https://www.speakpipe.com/PropertyAcademy For more from Opes Partners: ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠Sign up for the weekly Private Property newsletter⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ https://www.opespartners.co.nz/newsletter-sign-up⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠Instagram⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ https://www.instagram.com/opes_partners/⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠TikTok⁠⁠⁠⁠⁠ https://www.tiktok.com/@opespartners

• 0:08Speaker 00

  Hello and welcome along to the Property Academy Podcast by Ubersponders. I'm your host, Stephen Knight.

• 0:12Speaker 01

  I'm Andrew Nicoll.

• 0:13Speaker 00

  And this is the show that helps Kiwis go from zero to five investment properties. So you can be financially free and stick around for the next 15 minutes because you're going to learn if a rental doesn't pass this test, don't buy it. The real stories about property deals that didn't go to plan and the number one thing investors miss, and look, it's not what you think. Because there was a property investor in Wellington who I met recently and he was doing a renovation down in Wellington. The plan was to sell it as a flipped property. So he's going to buy it, renovate it, sell it really quickly. Now, there's a bit of an issue. The neighbours didn't want the property sold. It wasn't in a very nice area. It was, it was a cheap property on what could be kindly described as not the best street.

• 0:58Speaker 00

  But the neighbours really wanted this property to still be empty, maybe so they didn't have any like neighbours complaining about them. So what happens during the open homes where this poor investor is trying to sell the property is the neighbours pointed a boombox at the house, started blasting music. The dogs were barking. They actually dumped piles of tyres on the property. The investor paid to remove those tyres and then all of a sudden more appeared. And then there was a break in during the night. The appliances went missing. And when I say went missing, I mean they were stolen and none of that was in the property investor's spreadsheet. And I tell this story, not to say, don't go ahead and flip houses, but just to say that

• 1:42Speaker 00

  property comes with risk and sometimes we don't account for all of those in our best case scenario spreadsheet. And so what is that test that you've got to pass before you buy an investment property?

• 1:58Speaker 01

  So I call this the what if I'm wrong test. And this is to say, well, with property investing, everything looks good on a spreadsheet potentially, but life isn't as perfect as a spreadsheet and you need to be compensating for the fact that life puts spanners in the works. So you don't want to have a property deal where it's just scraping by and you can talk yourself into it and then you have just something derail you slightly and now all of a sudden it's not a good investment at all. So sometimes I say to investors, well, what if you're wrong by 10% on this? Does the deal still work? And that's the what if I'm wrong test.

• 2:33Speaker 00

  So how might that work in practice? Well, let's say you had a property that was $600,000. It was renting for 600 bucks a week. That's a pretty good yield, 5.2%. And if you borrow all of the money to buy it, so you don't, you haven't saved up $120,000 to put in as the deposit, you borrow that against your own house. That's what we call the no cash needed method. Let's say it runs at about $10,000 a year negative cash flow because these days the rent from the properties, especially if you borrow all of the money, might not be enough to cover all of the costs. So it might be negatively geared by $200 a week. That's what you've got to use to top up the property itself to make sure all of those costs are covered.

• 3:18Speaker 00

  Now, what you've got to then ask yourself is, well, what could you be wrong about? I mean, give me an example in that situation.

• 3:26Speaker 01

  Let's go with rent to begin with, because obviously that has a major impact on your cash flow. So let's say what you budgeted for was $600 a week rent coming in and the property was going to cost you $200 a week to top up because you borrowed 100% and you want to cover all those things like property management rates, insurance, et cetera. Now, if your rent that comes in is 10% lower than what you budgeted for, so $540 a week, that's a pretty drastic discount, $60 a week discount to the rent. That means your cash flow is going to cost you $244 a week, not $200 a week. Now, you might be thinking, hang on, rent's gone down by $60. Well, how come my contribution's only gone up by $44? Well, that's because there's a difference in the amount of property management that you're going to have to pay.

• 4:08Speaker 00

  And that's because property management and letting fees, those are based on the rent that you're actually charging.

• 4:14Speaker 01

  And whenever an investor's looking at the numbers based on, you know, a rental appraisal or something, I normally recommend going on the lowest amount of that range, not the midpoint, because that gives you some flex in those numbers.

• 4:25Speaker 00

  So for example, when you get a rental appraisal, the property manager will typically give you a range and it might be $550 to $600 per week, or it might be, you know, 600 to 620. If you use the lower of that amount, then you are already baking in some conservatism, I want to say, to your numbers. Now, test number two would be, well, what if interest rates go up? So this is another way of thinking about the what if I'm wrong test. So let's say that the average interest rate at the moment for the one year is about 4.8%. What if you're wrong by half a percent? What if it's 5.3%? What if it's 5.8% per year? So an extra half a percent or an extra 1%.

• 5:07Speaker 00

  If you're taking out a $600,000 mortgage, well, every half a percent increase, if you're on an interest only mortgage, has got to cost you about $3,000 per year. So if your interest rate is half a percent higher, that's about an extra $60 a week because it's three grand per year. If the interest rate is 1% higher, that's an extra 114 bucks a week, $6,000 worse off per year. And when I say worse off, you've got an extra $6,000 worth of interest costs. Now, you've got to be careful not to talk yourself silly, right? And what I mean by that is if you count lower rent and you're wrong by 10% on that and then your interest costs gone up by 20% because rather than a 5% interest rate, you're paying

• 5:52Speaker 00

  a 6% interest rate, you can scare yourself silly to some degree and think, oh my gosh, no property works under these conditions. So what we're trying to do here is balance the need for thinking about what could go wrong and could you handle that situation with also not being so worried that you don't make any investments at all and, and move towards improving your financial future. I mean, what's another example though of the what if I'm wrong test?

• 6:23Speaker 01

  So let's go with test number three and that's what if house prices don't go up for the next three to five years? Now, I really think this is an important one to test yourself on before you go investing in property because so many people expect, you know, okay, well, if we model out 5% growth per year for the next 15 years, again, life is not going to be as perfect as the straight line on your spreadsheet or whatever you're using to model this out. In fact, most cases, you're going to see the property prices don't go up much for a whole period of time and then they're going to spike all of a sudden. And that's just the nature of the reality. But if you're topping up a rental property and you're expecting it to go up year on

• 7:04Speaker 01

  year, if you haven't got that right in your head, then you might get a few years in and just give up. And then that's the worst thing you can do because then you're going to end up selling that property and, and have a big transaction cost for selling it.

• 7:16Speaker 00

  The truth of the matter is that there can be long periods where property prices don't move at all and then they boom and they catch up and then you get that average out at five or six percent or 4% per year, whatever it happens to be. But you've got to be prepared that there are going to be some flat years as well. And another example of the what if I'm wrong test that I sometimes think about is, well, what if house prices don't go up by what they have in the past? What if in the past, house prices have gone up by 6% per year on average and it's not that in the future?

• 7:52Speaker 01

  Yeah. So say, for example, we get actual capital growth of 4% per year over, over say a 10 year stretch. Now, your growth on a $600,000 property at 6% growth over, over 10 years is $475,000. Now, if you only get 4%, that's about $290,000. So it is significantly less. And again, as I'd said before, you don't want to scare yourself out of doing a deal. Like I, I spoke to an investor the other day and we're using a really high inflation rate for him. So we're using 3% for inflation rate, but then he wanted his capital growth rate to be 3%. So it cancelled each other out. So while he was trying to model out worst case scenario from a cash flow in his mind, he also modeled out worst case scenario from a capital growth standpoint and basically

• 8:37Speaker 01

  couldn't get his head around, well, why should I do this then?

• 8:40Speaker 00

  Well, the other thing you'd have to do as well, if you stress test one asset class with really conservative assumptions, you want to make sure that you're applying that evenly when you're thinking about all of your various asset classes. So what you wouldn't want to do is say, okay, I'm going to be really conservative with shares. I think that I'm going to buy shares and they're only going to go up by 5% per year, even though they might've averaged at about eight and a half percent per year over the last 30 years, but I'm going to be really conservative on shares. But nah, property, I think it's going to be six or seven percent. I'm just going to use what it's been in the past. Well, now you're not comparing apples with apples because you're trying to be really conservative on managed funds and not conservative at all on property.

• 9:24Speaker 00

  And the reverse is true as well. You wouldn't want to say, okay, I'm going to be running property on really conservative numbers and then I'm going to say, oh, but shares have done 13% over the last 10 years. I'll go do that as well. You'd have to be similarly conservative. So you're looking at it on a like for like basis. And the truth of the matter is the more conservative your numbers are in terms of capital growth rates, in terms of how fast houses or shares might go up in value, or the more conservative you are in terms of the cash flow of your rental properties, the effect is really... To make the same amount of money that you want for your retirement or your financial future, you're going to have to take more money out of your own pocket and put that

• 10:09Speaker 00

  towards the investment. Whether that happens to be in shares or KiwiSaver or managed funds or gold or property, the effect of saying, well, I don't think that investments or assets are going to go up in value as fast in the future as they have in the past. The effect is you've got to put more of your own money in if you want to create the same level of wealth. In other words, you've got to save more of your own money. That is what being conservative really means. Either that, or you bring down your goals and you have more conservative goals. All I'm trying to say is that when you start pulling these levers as part of the what if I'm wrong test, is that has an impact on you as well in terms of how you're going to react to that. And it typically means you're going to have to take more money out of your own pocket

• 10:52Speaker 00

  to put into whatever investment you are wanting to make. Another example, if I'm thinking about that Wellington investor and how they might use the what if I'm wrong test is what if that renovation costs me more money? What if the bathroom doesn't cost me 20 grand, it costs me 30 grand? What if it doesn't take me three months to do the renovation, it takes me four months? What if it doesn't take me four weeks to sell the property? What if it actually takes me eight weeks to sell that property? So adding in 10 to 20% contingency to any renovation budget or budgeting an extra two to three months of holding costs beyond what you think it might be, those are all

• 11:35Speaker 00

  ways to use the what if I'm wrong test. And I'll give you an example of this. I was recently speaking to an investor who's actually very experienced. He specialises in leaky homes. So he goes to an Auckland property, he bought it for 700K, the property was leaky, he knew that it was leaky. He budgeted about half a mil for renovations, so $500,000, man, that is a lot of money. And he hoped to sell that property for $1.5 million. So he was going to be all in $1.2 million, hoped to sell for 1.5 and make a pretty tidy profit on that. Now he ended up selling for $1.32 million. Now that's a lot of money, you know, a million, a million 320 grand.

• 12:21Speaker 00

  But he missed the price by 180K and that's going to be most of his profit because by the time we take off the lawyers fees, the real estate agent fees, he's put in $1.2 million, take off 5% for all of those costs and six months of paying the mortgage while that property sat there because he was borrowing some of this money. And that can quite quickly erode your profit. That's not to say this guy's an idiot, it's just to show you that bad things can happen in property and we've just got to consider it, right?

• 12:52Speaker 01

  And one bonus mistake that I think people make is running their numbers as if Airbnb is a reliable source of income for the long term because councils are cracking down on Airbnbs and you've got to be able to accept the numbers on an investment property as if the council knocks on your door and says, you know what, your time is and Airbnb is over, we're changing the rules, you can no longer rent this property out to short term stayers. Now, if your numbers don't survive without that higher amount of revenue, well then it might be that you're not buying the right investment.

• 13:26Speaker 00

  And so the way you'd use the what if I'm wrong test is to say, well, even though I plan to use this as an Airbnb, I also want to see what do the numbers work as if that property was a long-term rental? That's how you would use the what if I'm wrong test in that situation. Now, what I want to know is have you ever walked away from a deal and been glad that you did? I want you to leave us a voice message down in the description. I've got a link for you that you can tap on and leave Andrew and I a voice message and we might play some of them on the show.

• 13:58Speaker 01

  And actually, I'm keen to know whether or not you've walked away from a deal, you've talked yourself out of a deal that later on you've regretted.

• 14:05Speaker 00

  Okay, so either a deal you were glad you walked away from, or also the deal you walked away from, but now regret. And over the last 15 minutes, you've learned if a rental doesn't pass this test, don't buy it. The real stories about property deals that didn't go to plan and the number one thing investors miss and it's not what you think. Right, let's wrap it up there, but please don't forget to rate, review and subscribe to the podcast really does help us get the message out to more people.

• 14:36Speaker 00

  Thanks for listening to the Property Academy Podcast, I'm your host, David Knight.

• 14:39Speaker 01

  And I'm Andrew Nichol.

• 14:40Speaker 00

  We're going to be back again tomorrow with even more daily strategies, texts and insights to help you get the most out of the news on the property market. Until next time.