Investment in Property - Not Just Bricks and Mortar?

The Weekender / Business Day 17 / 18 June 2006

Investment in property - when treated correctly - can be a fantastic option. It offers something tangible, which in itself is very comforting, and it provides growth in capital value as well as an income stream that can keep pace with inflation.

It is also the one asset which the bank will always lend you money to buy. If the rent covers the interest, you could end up with a valuable asset in twenty years’ time, with little financial cost to yourself.

Property investors are also not faced the daily price fluctuations faced by investors in shares. This, we believe, creates a “lock in” that enables long-term investors to do well over time.

In this article we will NOT consider what type of property is a good investment – that’s something for the 'investment in property' experts.

History has shown us that in the medium to long-term, investment in property and equities offer the best returns of all the asset classes. However, investing in property involves some homework.

The average investor believes it is a passive investment - which is false. This is usually forgotten in markets that are buoyant due to changing interest rate levels, as we have seen in the past few years.

Returns from investment in property have three components.

The first component is that of rental income earned; the second is the increase in the capital value; and the third is the effect gearing (read this as multiplication factor) that property offers.

Let me explain the components by way of an example. If you bought an investment property of R1m using a bond and received R4,000 per month in rental, your rental return on the property is R48,000 per annum which equates to a rental yield of 4.8% a year.

You then need to provide for rates, insurance, maintenance, levies and agents’ fees, where applicable. This could cost in the region of R15,000 a year. This assumes that you have neither levies nor agent. You now have a net rental of R33,000 a year towards paying the bond of R112,000 a year. You will therefore need to subsidize the investment by R79,000 a year, or R6,583 a month.

The good news is that the rental income, and the costs, will escalate by inflation, while the bond payment could remain static, if interest rates do not rise.

With inflationary increases each year, your net rental will cover the bond in 32 years time.

Although the capital growth may make this all worth while, capital gains tax – about 10% of the gain – and the cost of subsidizing the bond must be taken into account in determining your total return.

The astute investor will buy a property with a high net rental yield, which will pay a larger portion of the bond from the outset.

Rental guarantees are sometimes offered on new developments. This means that the developer will pay you a rental if you are unable to find a tenant.

While this is a sensible comfort, the cost of this guarantee will have been added to the cost of the property. It is also subject to the developer’s ability to pay.

In certain instances interest costs on your investment in property may be tax deductible but may not be worth the trouble.

If the above property grew at a rate of 10% a year, at the end of the first year the property would be valued at R1.1m.

Future capital growth depends on the economy as a whole, but as stated previously, in the medium to long term, offers a meaningful return from the initial investment. When the rental returns and capital returns are added together, this equates to an amount of R148,000 after the first year.

However, if the interest costs are deducted this reduces to R55,000 or 5.5% a year.

In isolation, 4.8% is not a good return, even when compared to a low-risk money market account.

One of the main determining factors in the attractiveness of an investment in property is the ability to gear the return on money laid out at the initial investment.

Let us consider our initial example again. Assuming a deposit of 10% on the initial sum, the return on this amount of money is far greater than 4.8%.

Before making an investment in property, it is important to consider that property is not a liquid investment if you need some capital or can no longer afford it, and should not be considered as a “quick-buck” short term investment.

Investment in property may also require more effort than other investment types. The work can be delegated to an agent for a fee, but this will further erode your returns.

There are also other costs to take into account when purchasing a property, for example, transfer duty, conveyancing fees and bond-raising fees.

On the above property this could be a gob-smacking R45,000, and value-added tax may be charged when property is purchased directly from the developer. The effects of these costs are substantially reduced and play less of a role the longer you hold onto the property.

An extremely important aspect to consider is your tenant. It is a long and expensive process to evict a defaulting residential tenant. It is not uncommon for landlords to pay a defaulting tenant to leave the premises as this is sometimes cheaper and faster.

So screening and vetting tenants is an important part of the management of your investment.

You may be better off accepting a lower rental from a reliable tenant than seeking out the top rate from the first bidder who may damage the property and default on the rent.

My tip is that you should speak to independent, fee-based, certified financial planner who can assist you when making any investment decision. It is important not to over invest in any one asset class, and to diversify your portfolio into other assets such as equities and bonds. Remember that in most instances, property is an individual’s main asset.

A certified financial planner (CFP) will also be able to determine what your optimal asset allocation should be.

Debbie Netto-Jonker, CFP™, is founder of Netto Financial Services and was financial planner of the year in 2001.