Pick a House; Any House!

Setting:

It’s late 1998. We’ve only been living in Alice Springs since March. I’m ready to buy an investment property. I search Alice Springs and I’m shocked at the unreasonably high prices. I start looking elsewhere. I stumble onto a deal with the Defense Housing Authority (DHA). Buy the house and they lease back for many years with annual rent reviews. They take care of maintenance; but owner pays higher management fee. The deal is touted as a headache free property investment opportunity. It looked good to me. So, I bought. Not just one – but two of them. Were they good investments at the time? Probably not. But, were they good investments over time? Absolutely. Read on and find out why.

Pick a House; Any House!

“Which one would you recommend?” I asked the Defense Housing Authority (DHA) representative.

He was located in Adelaide, I was in Alice Springs. He had sent me list of houses the DHA had for sale under their leaseback program. They would sell the homes then lease them back for a period of nine years or more. He was only selling homes in the Adelaide area.

“I’d take the one in Greenwith.” The DHA representative answered back with confident assurance. “It’s got the two car garage, two bathrooms, large lot and it’s located right near the base. And Greenwith is one of the up and coming areas in Adelaide. The other houses are located in less desirable areas like Elizabeth and Salisbury.”

That’s all the convincing I needed. “Ok, let go with the one in Greenwith.”

That’s how we bought our first DHA home way back in late 1998.

Pick Another House!

Our second DHA home purchase decision was even more “sporty.” (e.g. bought on a whim!)

Looking through the DHA brochure, I found myself on a page showing properties for sale in Brisbane. So, I called the Brisbane office.

A very excited sales lady answered the phone. We exchanged greetings and then she proceeded to explain the great DHA deals on offer.

“The houses on Bliss Street are a real bargain. I just picked one up myself. You can’t go wrong for the price.” The lady blurted out over the phone. Then she continued. “I’ll send you a floor plan. These houses are great and they won’t last. I’ve got people buying from Sydney. They don’t even bother coming up here, they just buy. So, you better be quick!”

I was ready to buy right then and there. But, I let her post me the floor plan. Then I looked at it. Then I called her back. Then I bought.

So, in early 1999 and we’re the proud owners of two DHA houses; one in Adelaide and one in Brisbane. We had never seen either house. We saw pictures of the Adelaide home but not the one in Brisbane.

Don’t Try this at Home; Not Recommended

I wouldn’t really recommend anyone investing in property this way. But, that’s my story. That’s what happened. And, in the end, both investments have worked out exceedingly well. Was it lucky? Somewhat. But, there’s also more to the story. The DHA leaseback deal was pretty rock solid; meaning it was pretty safe. But, that doesn’t mean it stacks up financially. Have you ever noticed how overly safe deals are usually the most boring and the least profitable? Say for instance, your passbook savings account with the local bank … how profitable is that?

Why Buy?

Why did we buy these properties? What was my thinking? Why did I buy them without even walking through them? Why would anyone buy property sight unseen? To start, let me say, these are all good questions and ones that need to be addressed!

The DHA Offer:

First, it’s probably a good idea to explain the DHA offering. This is the cornerstone of the whole investment decision. Without the solid DHA lease back program, I would have been a lot more leery of buying over the phone. So, what was the offer?

The DHA was offering an investment where you buy one of their homes and they lease it back long term. The deal has many positives as follows:

Long term lease: The DHA would lease it back for at least 9 years. Then they had an option to lease back for another 3 years. So, the house would be happily rented for up to 12 years.

Market Rent: The DHA would pay market rent for the property. Again, this is attractive in that the rent stays in step with inflation.

Guaranteed Rent: The DHA guarantees rent payment regardless of whether or not the property is tenanted. Again, this is a plus for investors concerned about keeping the place rented. As long as the DHA has the lease, you’ll get your rent.

Perks: The DHA will take care of all property maintenance and management. This is great benefit. Makes the headaches of investment ownership a lot less stressful.

But, have you ever heard the saying, “For every positive there’s a corresponding negative?” Well, there were some negatives with this deal too.

a. Healthy Management Fee: The DHA charges a 15% management fee. This is about 5% higher than the top private sector management fee. They justify this by saying the maintenance is included. But, 5% on a $20,000 annual rental is about $1,000. So, DHA makes a thousand bucks a year even if they do no maintenance. Not too bad for them, especially if there’s very little maintenance which there won’t be on newer homes. They were selling this feature to prospective buyers as “peace of mind.”

b. Market Rent can Go Down: The DHA will get a market assessment of the property and adjust the rent accordingly. When selling the property, the DHA touted this as huge benefit. Then in 2002 or so new DHA owners in Darwin got hit with a rent reduction which shocked them back into reality. They were hoping for a rent increase to ease their tight – and usually negative – cash flow situation. Instead got shouldered with more holding costs as the rent was adjusted downward. There was nothing they could do as the market had softened.

c. Market Rent can Go Up Less Than Market: The DHA carries out the annual rent reviews via private and unbiased third parties. But, I wonder if the rent review reflects the true market or if the DHA somehow gets the numbers to come up on the lower side. In other words if the market is $350-$400 per week then does DHA come back with $350; the low side of the market? I started wondering this recently when the rent review for both my DHA properties came back with a rent reduction. Yes, the markets had softened, but not to the degree suggested by the rent review. I questioned one of the valuations and hired another agency to carry out a second independent rent review. The DHA accepted my higher valuation and adjusted the rent accordingly. It cost me $300 for the valuation. It meant a rental increase of $25 a week so over a year the valuation cost is absorbed. But, why did their valuation come in so low?

d. Very Handsome Selling Price: The DHA home prices are relatively expensive. No bargains here. They set the price and that’s it. No negotiating. I found this a very unsatisfying buying experience. The DHA left no room for the buyer to negotiate a better deal. Essentially, it was a “take it or leave it” proposition. And, most savvy investors would probably just leave it as the asking price for the homes are too high in relation to the rent. Most of the DHA deals represent a pretty substantial negative cash flow situation. But, the DHA is targeting generally un-savvy investors who are mainly focused on security and low risk. You show me somebody focused on security and low risk and I’ll show you someone who doesn’t invest!

What was the Deal Anyway?

Let’s go over the numbers. Why? To justify my statement above. What do I mean by the house is priced too high in relation to the rent? So, here’s a rundown of the first DHA deal.

House at Golden Grove

The house in Golden Grove South Australia came with a price tag of $156,000. For this price we got a very nice 4 bedroom home, with a double lock up garage on a 761 square meter block of land in a very nice development about 22 km northeast of Adelaide. The DHA was offering a 9 year lease with a three year option. The rent at the time was $185 per week. We got a 6.8% interest only three year fixed loan from Adelaide Bank. Let’s run the numbers to see how the cash flow stacks up.

Rent per Year: $185 x 52 = $9,620

Interest Per Year: $156,000 x .068 = $10,608

Shortfall: $988

Stop! That’s as far as we need to go for this exercise. The numbers show us the rent doesn’t even cover the interest. We’re short by about $1,000 just to cover the interest charges. Now, add to this expense the other holding costs such as insurance, taxes, water and property management. The cash flow picture is not exciting.

House at Enoggera

The house in Enoggera, Queensland set us back $164,000. Located only 8 km North of the Brisbane central business district, it boasted a great location. Again, it’s a four bedroom home, with a double lock up garage in a good neighborhood just outside the Enoggera Army Base. The starting rent was $210 per week; we again locked in with Adelaide Bank at 6.8% interest. The DHA was offering a 12 year lease with an additional three year option. I liked the idea of a longer term lease. I was looking long term. It’s a good thing too because the numbers weren’t pretty for this one either as follows:

Rent per Year: $210 x 52 = $10,920

Interest Per Year: $164,000 x .068 = $11,152

Shortfall: $232

The shortfall isn’t as bad this time, but it still represents a substantial negative cash flow when you add in all the other holding costs.

Again – Why Buy?

Looking at these deals now, I probably wouldn’t buy if given the opportunity today. The numbers don’t stack up. But, at the time my situation was different and my thinking was different. Let me first describe my situation and then hopefully that will make it easier to describe my decision to buy these properties.

I was working for a company that provided my housing as part of my salary package. I had no mortgage payment. Therefore, I reasoned it would be smart to take the money I wasn’t using for housing and put it into some kind of property investment. I figured if we could keep buying properties until the negative shortfall was about the same as an average mortgage payment. Hopefully, over a few years the shortfall would go away and we would just keep buying more properties. As long as the shortfall fell within the range of the average mortgage payment, I was ok with long term investing in quality residential property.

Was I looking for negative cash flow properties? No. But, I couldn’t seem to find anything out there that was neutral cash flow or better. Maybe I wasn’t looking hard enough or maybe I was looking in the wrong places. But, I felt compelled to buy. I figured it was better to get a solid residential investment that cost me a few bucks a week, than to keep waiting for the perfect deal to come along.

Turned Out Well

It turns out these properties have done well for us over the years. Today, they’d easily sell for well over $400,000. And, now the Golden Grove property rents for $375 per week; the one in Enoggera fetches $420 per week.

No Guarantees

But, this growth was not guaranteed and the market could have gone the other way. If you don’t think so, look what happened in the US following the Global Financial Crisis (GFC). Prior to the GFC, if you told folks in the US that their property values could go down, they would have laughed you out of town.

What’s the lesson here? Buy smart from the start. Make sure the deal adds up from day one. I was lucky with these two deals because capital growth took over; house prices and rents have risen significantly since I bought. But, what if they didn’t? I probably would have had the capacity to weather the financial storm but it would have been painful. And, it would have put a stop to any further investment.