Pros and cons of building an investment property

Pros and cons of building an investment property
We'll go over the pros and cons of buying vs building an investment property and how you can get the right loan when you're ready to begin construction.
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Buying vs building an investment property

If you decide to go down the investment property route, you've got two options: you can either buy an existing investment property (which is the more common option) or you can construct a new one. 

If you choose to build an investment property then you should be aware of the pros and cons of doing so. 

Advantages of building over buying 

Build to meet market demand

Doing your research and talking to real estate agents and architects can help you gain a thorough understanding of what kind of property the market is in demand right now, which can boost the home's value and rental yield. Finding out what type of property in your target suburb can also go a long way in securing long-term tenants.

Tax minimisation

There's a number of deductions you can claim for investment properties, but newly built properties also let you claim the depreciation on internal fixtures and fittings (such as blinds), which can reduce your taxable income.

In addition, as your home does not exist yet, stamp duty is usually only payable on the land value, as opposed to the property as well. While land usually makes up the bulk of the cost of the total property, it could deliver thousands in savings.

While you’re paying interest on the home loan, interest payments made during construction can also be tax deductible at your marginal income tax rate, which could deliver more savings.

As always, it’s recommended you speak to an accountant to see how you could further minimise your tax burden when building an investment property.

Building could be cheaper than buying existing property

Although not always the case, getting a good land and building deal could result in the overall price being cheaper than buying an existing property.

There are a number of reasons why this is the case, but one reason is a lot of people aren't willing to go through the task of getting the house designed and built - they'd rather get straight into it. This is only the case for the right property, so don't assume you'll automatically pay less. 

You can build equity instantly 

Depending on how good of a job you've done purchasing the right land and building an attractive property, you can go back to your lender after everything is done and get the property re-valued. If the home is re-valued to a price that's higher than the initial value during your application (more on this later), you have instantly added some equity to the property.

Related: Understanding equity in your home

Disadvantages of building over buying

Locations are limited

This goes without saying, but how many empty blocks of land do you drive past in any suburb in major cities? This might not be as much of an issue in rural areas, but land is pretty limited in most established areas, so you might have to take what you can get. 

The alternative is to knock down an existing property or look further out if you can't find one in a good area, but neither of these might be preferable to you. In areas close to the city, council permits can be onerous, and you’ll also have to deal with ‘heritage listed’ or ‘special interest’ properties that you may not be permitted to knock down. So you will probably have to look hard to find a vacant block in a desirable area. 

Other developments can harm your property's value 

In newly-established areas, there's always the chance a big apartment block could go up in front of yours, blocking its view and lowering its price. Or maybe some undesirable businesses open nearby, or a bunch of the new neighbours start defaulting on their mortgages. 

In addition, too much supply in the area (lots of new houses) can also lower the value of your house since price tends to be inversely related to supply. None of this is guaranteed, but it's worth thinking about. 

Might not be a cheaper method

How often have you seen an episode of The Block or Grand Designs and seen the cost of building a new property blow out of budget? Materials and labour can easily be more expensive than first thought, and depending on what’s happening in the world, certain materials may be in short supply. This could be more likely the more elaborate your build is.

Aside from the house itself, you’ll also have to deal with council building permits, rates, and other expenses, all while the house is being build and earning no rental income yet.

As Murphy's Law says, "anything that can go wrong, will go wrong". You might have a set budget for constructing your home, but how often does everything go 100% to plan?

You might be able to get a fixed contract from your builders so you pay a fixed amount of money for construction, but there are still other costs that can be added on, not to mention the initial time frame can be extended too. You never know when it might rain for weeks on end, for example.

It can involve a lot of work

Obviously, there's more work involved in building a house from scratch than just buying an existing one: you have to speak to architects, builders, electricians, plumbers, painters...the list goes in. 

Most of this should already be taken care of when you buy an already-built house.

You get no rental income until it's done 

Houses take a while to get built - a minimum of a few months, usually more than six months or even a year. This is all time you're making loan repayments without earning a rental income when you otherwise could be if the house already existed. 

To get a loan for building a new property you usually don't get a regular home loan - you can get what's called a construction loan, which is slightly different.

How does building an investment property work?

If you’re building your own investment property, your first option is usually to secure a construction loan. A construction loan is a type of short-term home loan used to fund the cost of building a new property. They usually last for about as long as it takes for the home to be completely constructed, and when the loan term is up, you convert to a regular mortgage product set by your lender.

Construction loans provide finance across six steps of the construction process, including:

  • Deposit
  • Slab down
  • Frame up complete
  • Lock-up
  • Fixing
  • Practical completion

These steps are explained in further detail below. You might be able to use a standard home loan for building a new house if you have enough equity in an existing property to begin the construction process, but this usually involves a rather large chunk of money.

Other options - turnkey packages and buying off the plan

There are other options than going for a construction loan. These options usually involve new sites in greenfield estates yet to be developed.

Turnkey

As the name implies, these are are house and land packages designed to be moved right into. Usually everything is included in the fixed price you see. Many others also include options, which is not dissimilar to buying a new car and adding on extra features.

While these types of developments present convenience, you’ll most likely want to pore over the contract. Despite the advertisement of ‘fixed price’ - the price may not actually be fixed at all. Buyers can be caught out by builders ‘get out clauses’ in the contract that could add to the cost if time taken to build blows out.

Off the plan

Again, buying off the plan involves doing as the name implies. It involves buying a property not yet built. Developers may offer discounts and other incentives to buy within these estates, and there might also be stamp duty savings, as well as being able to access various government grants.

However, the trade-off is, off the plan carries similar risks to ‘turnkey’ projects. Be sure to read the fine print of the contract. In addition, early investors could see their homes lose value as more houses pop up in the area that are virtually exactly the same.

How do construction loans work?  

Repayments on a construction loan are interest-only, before reverting to principal-and-interest upon completion, unless otherwise agreed.

Unlike a home loan, construction loans cover the expenses you incur as they occur. Loans.com.au uses a six-stage process: 

Stage Typical Components
Deposit Paid to the builder to commence work
Base Concrete slab complete or footings and base brickwork complete
Frame House frame complete and approved by inspector
Lockup Windows/doors, roofing, brickwork, insulation
Fixing Plaster, kitchen cupboards, appliances, bathroom, toilet, laundry fittings/tiling, heating, fixing/internal doors, etc., plumbing, electrical, painting
Practical Completion Fencing, site clean-up, final payment to builder

These stages are commonly referred to as ‘progress payments’, and you’ll only be charged interest based on the amount that you use for each progress payment.

If you've been approved for a $500,000 construction loan, but that first 'base' stage costs $100,000, the lender will only charge you interest on that $100,000, until the next progress payment is released.

How to apply for a construction loan 

You'll need all the usual items required for any home loan application, like:

  • Identification 

  • Employment information 

  • Payslips and pay summaries

  • Lists of assets and liabilities 

  • A savings history 

But in addition to all of this, you'll need to present professional plans for the property, including an expected valuation. Having a larger deposit can help too. 

If you’re interested in building a new home, speak with one of our lending specialists today to get pre-approved for a construction loan.

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Tags: building an investment property | construction loan

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