Buying Investment Property: August 8-9, 2009

Not at all a passive investment

The market for buying investment property is highly attractive at the moment. Prices have deflated and real opportunities may exist for those with a long-term view. How do you go about investing in property, and what should you look out for?

Types of investment property

when buying investment property there are three different types of property we can invest in, namely commercial property, industrial property and residential property.

Commercial and industrial property refers to property that is leased to businesses from where they carry on a trade or manufacture a product. Commercial and industrial property includes, but is not limited to, warehouses, office blocks, manufacturing concerns and retail outlets.

Residential property, as is obvious from its name, is property where people live.

Getting a return from buying investment property

There are two ways to derive an investment return from property. One is from rental income, and the other from capital appreciation.

Rental income is the income we earn on a monthly basis, directly from the tenant. This amount is normally set on an annual basis, with annual increases.

Capital appreciation is simply the increase in value of the physical building, taking in to account aspects such as the size and location of the physical building.

Is buying investment property a passive investment?

Most first-time property investors believe that property is a passive investment.

It's simple isn't it? You buy a property, install some tenants, collect the rental each month, and eventually sell the property some years in to the future at a tidy profit.

Nothing could be further from the truth.

Investing in property is anything but passive, and if it goes wrong can actually cost you money and be an expensive exercise.

Example of cash flow and returns - buying investment property

You buy a R1 million property, paying interest at 11% over 20 years. Your monthly repayments are R10,322.

Assuming you manage to secure a tenant paying rent of R4,000 a month, you receive R48,000 in rental income.

Assuming also that your property increases in value by 10% to R1.1million, your return for the year is 2.4% (R100,000 capital appreciation + R48,000 rental income – R123,864 loan repayments).

This is not a very attractive return at all, and the bulk of that ‘return’ has been made up by an intangible capital appreciation.

Any money market investment will beat that return, and be virtually risk-free.

You also need to factor in the cost of maintenance, as well as possibly the cost of a letting agent, both of whcih will further decrease your return.

Tenants (and no tenants)

Getting a return from any type of property investment involves tenants and all tenants need to to be vetted because it is difficult and time-consuming to evict a non-complying tenant.

Between tenants, property inspections need to be done to ensure there has been no damage to the property.

Many property investors employ letting agents to handle all relationships with tenants.

This certainly does take some of the hassle out of dealing with tenants, but at an additional cost which (as mentioned earlier) further reducing the return you may make on your investment.

In addition, it could take a while to replace existing tenants, so you need to ensure that you have the financial ability to survive for a number of months without tenants. This further reduces cashflow, and again impacts returns negatively. A lack of cashflow could result in needing to sell your property in a hurry.

Liquid vs solid

Buying investment property is not a particularly liquid asset class.

It can take an indeterminate amount of time to sell the property.

Property transactions attract additional costs that are not normally associated with other investments, such as transfer duty, conveyancing costs, VAT (if the property is bought directly from a developer), stamp duty and bond registration costs.

These costs need to be taken into account when determining the type of investment return you seek from a property investment.

What's the verdict on buying investment property?

Property can be a solid investment, particularly over the long term. This is where the power of compound capital growth really comes in to play and there is much to be said for the security that bricks and mortar can give an investor.

Property investment can also be tax efficient, as certain interest and maintenance costs may be able to be claimed for tax purposes.

As house prices fall, property may be an attractive option.

However, you need to do your sums beforehand, and be aware of what goes in to being a property investor. It certainly is not a passive investment, and this is equally true whether you purchase onshore or offshore property.

Final caveat - balance your portfolio

It is important not to over invest in property.

Diversify your assets away from property into other asset classes such as equities and bonds, as the residential home is often an investor’s main asset.

My advice is that you should speak to independent fee-based Certified Financial Planner who can assist you when making any investment decision.

A Certified Financial Planner will also be able to determine what your optimal asset allocation should be.

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Absa recently reported that nominal house price deflation is set to continue for 2009, with house prices set to decline by 3.5% in nominal terms. If we add inflation in to the mix, this equates to about 10% in real terms.

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Richard Sparg, CA(SA) CFP, is a Financial Planner at Netto Financial Services.

Debbie Netto-Jonker CFP founded Netto Financial Services and was financial planner of the year in 2001.

Her business partner Ian Beere, CA(SA) CFP was the financial planner of the year in 2007.