Just as the Sydney and Melbourne property markets have locked out many first time buyers, they have also restricted many second and third time buyers from upgrading. Even if these existing homeowners sell and then buy in the same market, the moving costs and additional loan commitments can be significant.
Once you take into account selling costs of around 3% and then buying costs of about 5%, along with removalists, utility costs, storage etc. you could be looking at taking a big hit to your equity.
If you go down the upgrading path, you are locking yourself into more non-deductible (bad) debt and restricting your capacity to invest into income producing assets. Remember that the journey towards financial freedom involves reducing non-deductible debt whilst building an investment portfolio that pays you a passive income, using deductible (good) debt.
As an upgrader, you could Rentvest as a more effective strategy to maximise your investment potential and achieve financial independence much sooner. This strategy would involve turning your existing home into an investment property and then renting a more suitable property yourself.
Let’s have a look at an example to demonstrate the difference between upgrading and the Rentvest strategy:
A typical couple own a 3-bedroom house in the northern suburbs of Sydney and would like to upgrade to a bigger 4-bedroom house to accommodate them and their growing kids. Their house is currently valued at $1.2 million and they owe $600,000 on their mortgage. Their current loan repayments are $743 per week and home expenses are $123 per week, so it costs them $866 per week to live where they are.
They would need a budget of around $1.6 million to get a larger house that suits their future needs. Selling, buying and moving costs would be about $120,000. This would leave them with $480,000 as a deposit and therefore a new loan of $1.12 million. Assuming the same home expenses but with higher repayments of $1,387 per week, it would cost $1,510 per week to live in the bigger house.
Rather than sell and buy, they could rent out their existing home for $800 a week and then rent somewhere bigger themselves. Let’s look at the cashflow calculation to see how their home would perform as an investment:
As you can see, their after-tax position would be $4,024 positive after the first year, based on interest only repayments. Assuming that our couple continue to pay principal repayments off their loan of $8,600 per year, their existing home would cost them around $4,600 each year to hold, or $90 per week.
Note: the rental yield they could achieve is 5.5% based on $800 rent per week over their original purchase price of $750,000 (not the current valuation).
With yields around 3% on homes in Sydney right now it is significantly cheaper for someone to rent a bigger house than buy it. Our couple could rent a home that is worth $1.6 million for around $1,000 per week and keep their existing house as an investment. This equates to $420 less per week than buying the equivalent home!
What’s more, they could use that $420 per week and the $120,000 of equity they didn’t spend to invest into a portfolio of investment properties that could accelerate their wealth much faster.
Let’s have a look at the difference in accessible equity between the two options to demonstrate the opportunity cost of buying a bigger home:
As you can see, by selling and buying a more expensive home our couple are giving up the opportunity to leverage into a much bigger investment portfolio. In addition to spending $420 extra per week, they could be missing out on investment capital growth of at least $40,000 a year!
A more expensive home could create more capital growth than their existing house but coming off the back of a boom in prices, it is unlikely that this will occur in the short term. Their additional accessible equity would be better used to diversify their portfolio into areas that are primed to grow sooner.
Thinking of upgrading? Compare the numbers on both options and make a more informed decision before you commit to that bigger mortgage. You could Rentvest yourself into a better home.