Australia’s property market seems to be Teflon-coated, as they say. And it has proved itself again. According to CoreLogic’s statistics, despite a global-wide recession, Australian median house prices have climbed to a record high again – a 3% increase from one year ago, before COVID hit.

While the RBA is expected to hold the cash rate (interest rate when banks borrow from the RBA) at its current record low of 0.1% until 2024, experts are commenting that the current price boom is probably sustainable. So are you thinking to invest in rental property now? You need to make sure all the risks are analysed. And the expected ROI (return on investment) should be calculated before a decision is made.

Most existing ROI calculation guides tend to ignore the effect of taxation, which shouldn’t really be ignored at all, especially when the investor is a high-income earner (over $180k taxable income). Basically, if you are a higher income earner, whatever rental profit you make in a year, nearly half of it would be gone just for paying taxes; also when you sell the property in the end, more than 20% of your capital profit will go to the taxman too.

To help you work out the most accurate ROI for your potential investment, I’ve compiled this post to guide you through the calculation step by step, including both components of income tax (on annual rental profit) and capital gain tax (on capital growth upon disposal).

First of all, what’s ROI?

ROI is short for Return on Investment (in this case, investment property). It measures how much money, or profit, is made on investment as a percentage of the cost of that investment. It allows us to evaluate whether putting money in a particular investment is a wise decision or not. ​

What is a good ROI for rental property investment?
There isn’t a clear answer to this one. But it is said that anything above 10% is good property investment in Australia.

ROI in rental property comes from two areas:
yearly rental profit and capital gain/growth.

Yearly rental profit: is the income you expect to receive each year from the tenant deducted by any expenditure that you would have paid for the property, such as council rates, land tax, mortgage interest, repairs etc.

Capital gain: basically is the appreciation of the market value of your rental property, which gets accumulated each year and eventually realised when the final sale happens.

Now let’s do the calculations with an example:

Tim is considering to buy an investment property in Kogarah (a suburb of Southern Sydney). It is a house and priced at $1 million Australian dollars. He plans to rent it out and sell in 10 year time. So he wants to calculate his return, as accurately as possible, on this property before making a final decision.

Step 1: work out your cash investment (cost of your investment) – A

The cash you put down as a deposit plus any incidental costs (eg. legal fee) paid out of your own pocket rather than from the mortgage loan.

Remember mortgage money is not your own money, hence NOT part of your investment cost.

Tim will put $200K down as a deposit, and borrow $800K (interest-only loan) from the nab to cover the remaining balance. Additionally, he will also pay $45K out of pocket for legal fees, borrowing costs and stamp duty.
Therefore, his cash investing cost A = $200K + $45K = $245,000

Step 2: work out your expected annual rental gross income – B

Depending on which area it is located and the type and condition of the property, you would have investigated how much rent you can collect weekly or monthly. Simply times 52 weeks or 12 months, is your gross rent. But you may wanna factor in a couple of weeks vacancy period.

Tim is expected to collect $750 weekly rent from the property, and he allows 2 weeks vacancy per year.
So his expected annual gross rent income B = $750 x (52-2) = $37,500

Step 3: add up all the expected expenditure – C

Here is a comprehensive list of expenses that you need to include:

  • advertising for tenants
  • agent management fee
  • council rates
  • water rates
  • strata fees (if it is apartment or unit)
  • landlord insurance
  • land tax (each state is different)
  • pest control
  • cleaning
  • gardening
  • electricity & gas
  • repair and maintenance
  • mortgage interest ( some people tend to include mortgage repayments here but technically only the interest part is related to annual net rent yield)
  • leasing fees
  • accounting fee
  • amortised borrowing cost (claim mortgage establishment fees over 5 years)
  • other

Tim is expected to pay $20K annually for mortgage interests and $8K for other rental expenses.
C = $20K + $8K = $28,000

Step 4: calculate expected yearly net profit D

D= B-C = $37,500 – $28,000 = $9,500

Step 5: calculate the income tax on your expected net profit from rental property

Tax = D x your marginal income tax rate

Tim’s normal annual taxable income is $200K, hence he is taxed at the top marginal rate of 45% for the extra rental profit. He also has to pay an extra 2% for the medical levy.
Tim’s tax on net rental profit = $9,500 x (45+2)% = $4,465 (nearly half of his profit!)

Step 6: calculate the expected after-tax rental profit E

E = D – Tax = $9,500 – $4,465 = $5,035

Step 7: work out your annual return from after-tax rental profit R1

R1 = (after-tax rental profit / cost of investment)%

R1 = (E / A)% = ($5,035 / $245,000)% = 2%
which doesn’t seem high but remember, there is also capital growth which is not monetary realised each year but will get paid when he sells the house.

Step 8: calculate capital growth on sale of property G

G = (sale proceeds – any selling incidental fees) – (original total purchase price + incidental costs)

10 years later when Tim sells this property, the market price is expected to be $1.5 million.
he expects to pay a legal fee $2K and agent commission $30K.
G = $1,500,000 – ($2,000 + $30,000) – ($1,000,000 + $45,000) = $423,000

Step 9: calculate capital gain tax (CGT) on the capital growth

Remember that there is a 50% CGT discount for individuals and trusts. But foreign residents can no longer claim this discount for properties purchased after 8 May 2012.

Tim’s expected capital gain tax:
CGT = G x 50% x marginal tax rate = $423,000 x 50% x (45+2)% = $99,405
which is a quarter of his gross capital gain!

Step 10: calculate net capital growth after paying capital gain tax H

H = G – CGT = $423,000 – $99,405 = $323,595

Step 11: annualise your capital growth R2

R2 = (net capital growth/investment cost) / number of years between purchase and sale

For Tim:
R2 – (H/A) / 10 years = ($323,595 / $245,000)% / 10 = 13.2%

Step 12: and finally, work out your total expected annual ROI = R1 + R2

For Tim, his ROI = R1 + R2 = 2% + 13.2% = 15.2%, which appears to be a great return on an investment property in Sydney.


Conclusion

As you can see from Tim’s example, tax can work out pretty high on the returns of a rental property. So before deciding to purchase a rental property, it’s in your best interest to include tax estimations into your ROI calculation.

As each person’s circumstances are different, you may want to speak to your tax agent or contact us for a free 20 minutes initial consultation to see how we can help you with the ROI calculation.

 


Disclaimer:
Please note that this post is intended to be a general guide only, and should not be seen to constitute legal or tax advice. Where necessary, you should seek a second professional opinion for any legal or tax issues raised in your personal or business tax affairs.

Emma Zhao

Emma Zhao

Chartered Accountant | Registered Tax Agent | SMSF Speacialist™ emma@sencilloaccounts.com.au