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Thursday 7 July 2016

Investing In Residential Property

Where do I cash out?
In a previous post I discussed residential house price growth in South Africa. It came in at a whisker above inflation, but as you know that is only one part of the returns generated by property - we also need to consider Rental Income. So with this in mind maybe Residential Property is a good investment? Let's check it out...

In short, I view the returns of a Residential Property (Buy To Let) investment as follows:
  • A capital appreciation part, which is the increase in the value of the property
  • A rental income part, which is what tenants would pay you every month
  • Less expenses 
I will first look at an investment scenario where the property was paid for 100% in cash. (Don't we all wish we could be in this situation....)

Capital Appreciation

So looking at the capital appreciation part first. With reference to the post I did on House Price Growth in South Africa I will assume real house price growth of 0.6%. This is a tiny bit above inflation, and the capital appreciation part, on it's own, does not make for a particularly good investment....at all!

Rental Income

But of course the capital appreciation part is only half the story. The other return you get from a BTL (Buy To Let) property investment is rental income. I have two points of reference with regards to rental income. Firstly we have an apartment in Sandton which we are currently renting out, and secondly when we moved to Centurion we became tenants and rented a townhouse. (We have since been in discussions with the owners of the property and they are selling us the townhouse - transfer expected around August and now officially known as Stealthville).

Our apartment in Sandton is currently worth around R1.1 million (according to the highly scientific method of checking similar places on Property 24). We still owe quite a bit on the mortgage, but we are currently renting it out for R8200/month. That works out to a yield of about 0.75%/month or around 9% per year.

Before buying our townhouse in Centurion, we were renting it from the owners for R8500/month. The sale price of the townhouse was R1.12 million. So this means the rental yield on it is around 0.76%/month or around 9.1% per year.

Combining this small subset of data, I estimate you can get a yield of about 0.75% per month, or 9% per year on rental income. (Anyone managed to do better than this or worse than this? I would be very interested to know.). Again this is not even close to a complete set of data and may not even be accurate, but it will give you an idea on how you can perform your own calculations for your particular situation.
Rental income from a property will generate an estimated return of 9% per year.
Unfortunately we need to factor in one of life's certainties - rental income is taxed (at the landlord's marginal rate). You can offset some of the expenses (discussed below) from the rent which will help, but Tax can make or break an investment case. The tax that needs to be paid varies from person to person depending on your total income for the year. But if you are in the top tax bracket you can say goodbye to 41% of your rental income (after deductions for expenses)1.

The last point I want to make about rental income is that there is a very real risk that a tenant may not pay. For every month your place stands empty, you are losing 0.75% of your return (and I am sure there are costs to get them evicted too). You can try control your tenant quality by checking out their bank statements, current employment, and running a credit check on them, but of course there is no way of knowing. I pulled this chart from the latest FNB Monthly Residential Market Risk Overview.

Some people must always ruin it for everyone else
From the chart you can see currently around 18% of tenants are behind on their payments. So do your best to pick quality tenants. We have been fortunate enough that our tenant has always been on time with their payments.
Do your best to pick quality tenants, currently around 18% of them are behind on payments!


Nothing for nothing right. You are going to have to put in some money towards ongoing property costs. These costs may include maintenance, insurance, rates and taxes, levies and commissions.

I am going to assume that you will not use an agent (which does carry some risk) and will rent the place out yourself - which is actually not that difficult to do (assuming you live close enough). So I will ignore the estate agent commissions (personally for what they do, I think estate agent commissions are way too high - but that is a rant for another day). If you use an agent the usual rate is 10% of the rental income as commission (anyone managed to do better than this?).

I only have experience with sectional titles, for which you pay levies. Our Sandton apartment has levies of R1608/month. It also has a rates and taxes monthly bill of R410/month. So in total this works out to about 2.2% of the value of the property per year.

The Centurion townhouse levies and rates and taxes comes to R2036/month. This also works out to about 2.2% per year - seems both places are more or less in agreement.

Then with regards to maintenance, again I can only vouch for sectional titles (but I suspect that free standing houses will be more expensive in this regard, especially those with a pool for example). I have done some reading (see here, here and here) and the general consensus is to budget 1% of the value of the property. I think this is for free standing houses though, because my experience with sectional titles is that it is around 0.5% per year based on the following costs:
  • Sandton apartment -We had to paint it out and repair some plumbing. We also had to replace an extractor fan and repair some cupboard doors.
  • Centurion townhouse - While we were renting, the owners needed to replace the automated garage door and motor.
I thought I would also ask some people about maintenance costs on their properties, so I created this forum topic. Unfortunately people seemed to only give absolute values and not percentages, so I didn't really get the information I was looking for. However again it seems the consensus was that sectional titles are way cheaper to maintain. So I am estimating annual maintenance costs of 0.5%.

Note that I have ignored the costs of buying the property because these vary greatly depending on the purchase price. But that being said they definitely also need to be considered. These can end up around 10% of the property purchase price - so by no means insignificant.

My simplified estimation of the total expenses is therefore 2.2% + 0.5% = 2.7%/annum.

Putting It All Together

So based on my very simple model, I calculate the following. A buy-to-let property will get you the following real return (note real return accounts for inflation):

Total Real Return = (Real return from capital appreciation) + (Return from Rental Income) - (Expenses)
=> Total Real Return = (0.6%) + (9%) - (2.7%)
=> Total Real Return = 6.9%
An estimation of the total real return of an investment property is 6.9% per annum.
A real return of 6.9% is certainly not to be laughed at. However if you consider the purchase costs, tax on rental income and the risk of the unit having no tenant, then it maybe does not look as good?

Also bear in mind that I previously calculated historical equity real returns of 9%. So my simplified model leads me to the conclusion that a cash purchase of a property may not be such a good idea as a long term investment, and my preference would be to invest in low cost ETF's.

Financing a Buy To Let With a Home Loan

So that covered the 100% cash purchase of a property, and as we all know, that is the exception rather than the norm. Lets now consider the case of buying a property with a 10% deposit and 90% finance (which us ordinary schmucks usually have to do). The argument is that the loan will leverage the capital returns and rental yield of the property, and boost your total returns.

For this scenario I decided to borrow the numbers I had calculated from the 100% cash purchase scenario and use them to run a calculation of what would happen if you purchased a Buy To Let property using a home loan. So here are the details of the scenario:

Purchase Price - R1 000 000 (I like round numbers remember)
Deposit - 10%
Interest on Loan - 10.5% (current prime interest rate)
Inflation - 6.28% (from Stealthy Wealth Numbers page)
Equity Returns - 15.28% (from Stealthy Wealth Numbers page)
Real House Price Growth - 0.6% (from my previous calculations)
Rental - 0.75% of house value
Levies - 2.2% of house value
Maintenance - 0.5% of house value
Duration - 20 years (usual length of a home loan)

I also assumed a Bond and transfer cost of R40 000 and Bond Initiation fee of R5 700 when buying, and selling costs of 5% of the sale value (for agents commissions and electrical compliance). These are of course all estimates.

Importantly I am ignoring tax on the rental income and any capital gains which would arise during a sale. What does count in favour of financing a property is that you can offset the interest portion of the bond repayments against the rental income, so while you run at a loss the tax is irrelevant.

Then as a comparison I checked what would have happened if the money put into the house was instead invested in equities.

At some point during the loan repayment on the house, the rental income would exceed the bond payment, maintenance and levy costs. At this point the additional income was invested in equities, but counted towards the investment returns of the house.In my scenario the house started generating cash after the 9th year.

If you would like to see the spreadsheet and full calculation, get in touch and I can send it to you, but, in short, after 20 years the house investment would be worth around R4.68 million while the pure equity investment would be worth around R5 million. So the results are actually pretty close (but Tax on the rental income will decrease the property returns somewhat). And of course the calculation is highly sensitive to any of the inputs and varying them can give you a host of different results. Small changes in some assumptions can result in big differences to the outcome.


So to conclude a rather lengthy post....

Buying an investment property for cash does not look like a good investment to me, especially when you factor in the tax on the rental income. I think you can do better in other asset classes.

Buying a property via finance looks like a better proposition, but it may still under perform equities. Also what you need to remember is a Buy To Let Property can concentrate your risk and offers little diversification (one geography, one asset class). Furthermore, leverage (via the home loan) can enhance returns, but it can also enhance losses and concentrates your exposure and risk even more.
Buying a property concentrates your risk, especially if it is leveraged with finance.
In my opinion, it would probably be better to first establish a sizeable portfolio of other asset classes before considering a Buy to Let Property. In that way your risk is far less concentrated and a BTL can actually add some diversification to your investment portfolio. If you insist on property but would like increased diversification maybe you should consider a Listed Property ETF instead (for example the Coreshares Proptrax 10 ETF)?You get exposure to a number of different property types (Commercial, Industrial and Retail) in a number of different locations throughout South Africa and abroad.
If you starting out and want property exposure, consider a diversified property ETF.
Another important lesson I took while researching and writing this blog post is that each property, area, and situation is very unique, and assumptions can vary greatly - so you should always validate any assumptions as thoroughly as possible and then do the calculations and see if it is worth your hard earned money. Run the numbers, it's the only way to know.

Wow, half of 2016 gone already and we find ourselves in July! Blink and you might miss the second half.

Till next time, Stay Stealthy!
 - ~ - ~

1 On the other hand earning more than 700k a year (which is what you need for the top tax bracket) is a very nice problem to have! Out of interest the tax rates for individuals is available on SARS website over here.
2 Of course when this positive cash flow situation was reached the surplus could have been used to pay off the current bond quicker, or towards a second property or any other investment - but for simplicity I just assumed it would be invested in equities.
3 This ETF invests in 10 Listed property companies and include companies which manage properties in overseas locations, so some decent currency and geography diversification.