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Tuesday, 6 August 2019

Is Property A Quick Cut To Financial Freedom?

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A home for your investments?  
Recently I have been seeing some complaints around how the 4% rule is a pretty inefficient approach to financial freedom.

The argument is that you can achieve your required “freedom income” a lot quicker by investing in a couple of rental properties. And I must say, the thinking and reasoning seems pretty solid!

For example, consider someone who has estimated that in order to be financially free, they would need their investments to generate them R30,000 a month.

Those of you familiar with the 4% rule (rule of 300) will quickly plug R30,000 x 300 into your calculators and find that this person would need an investment worth R9 Million to be financially free.

Those keen on buy to let properties will say, well you could generate R30,000 a month by owning, say, three properties and renting each out for R10,000 a month (after levies etc.). You could probably get the required R30,000 a month with 3 x R1.5 Million properties.

So in our (somewhat watered down) example, financial freedom could be achieved in one of two ways:
  • A R9 Million investment portfolio consisting of a mix of equities, bonds and listed property and then applying the 4% rule OR
  • A R4.5 Million investment consisting of a few buy to let properties.
So, in short, going the property route seems to be twice as efficient as the 4% rule because you can achieve financial freedom with around half the amount of money.

Maybe the 4% rule needs to take a step back?

The Case For Investment Properties

On the surface, buy to let property seems like a no-brainer. And to be honest, every-time I see the benefits being listed, it really does create an investment itch I badly want to scratch! So much so, that I did in fact scratch it using our old 1 bedroom apartment after we moved a few years back (more on that here)

An investment property can be really cash generative, and of course you get access to gearing which can really put a firecracker up the ass of turbocharge your investment returns.

And then there are also these really great benefits:
  • The interest portion of a home loan on an investment property is tax deductible. This means you not only get to benefit from gearing, but you also get to write off any interest expense against Tax. Who wouldn't want SARS to help  pay for some of the interest bill!
  • Yes, rental income is taxed at your marginal rate, but if you start making a "profit" on your property you can re-bond it, which not only gives you cash for your next investment property, but will increase your tax deductible interest expense. In this way you can build your property portfolio pretty quickly.
  • And then the property investors all time favourite – you get to use OTP (Other People’s Money) to fund your investment. For example, you probably only need a R120k deposit to fund the purchase of a R1.2 Million property - the bank gives you the rest of the money to fund your investment.
So on the surface it seems that property is a great way to get you to financial freedom in double quick time. What’s not to like?

Let's dig a little deeper...

The Problem(s) With Investment Properties


Income Tax Is The Worst Tax

I certainly hear all tax advantages of property. Yes the interest is tax deductible, and yes you can re-bond a property to fund another, and yes you can shield it all in a company. But at some point, the bottom line is that there is going to be rental income landing in your pocket.

Once the properties are paid off, and you plan on living off your investment, there will be no more interest tax deduction. Even if the properties are in a company, if you want to get access to that income, the company is going to need to pay it out to you, and you are going to pay tax.

In other words, if you plan on retiring using the income from investment properties, you are going to be feeling the full wrath of income tax, right at the point when you want to start living off your investment.

And the problem with income tax, is that it is the worst tax to pay. While you will never pay more than 18% Capital Gains Tax, or 20% Dividends withholding tax, income tax can go as high as 45%. So, if we consider the example given at the start of the article, for R30,000 a month of income, you would actually require +-R37,500/month to compensate for the R7,500/month income tax bill.

No Tax Flexibility

This is related to the point above. Rental Income is taxed as income, that’s just the way it is. There is no ways to try manoeuvre around it.

An investment portfolio on the other hand can be crafted to try take advantage of the many different tax exemptions and tax types.

For example, you can sell off some units in your portfolio to and take advantage of the R40k a year CGT exclusion. You can also make use of the annual R23,800-R34,500 (depending on your age) interest exemption from the Bonds/Cash part of your portfolio.

And then the real sweetener - if you put some of your investments in a TFSA, that part of your investment will be totally tax free. Which brings me to the next very important downside to investment properties.

No Tax Protection

Unfortunately you cannot put your properties into a TFSA, or an RA or your companies pension fund. Unfortunately there is no legislation allowing this. On the other hand, there are some great ways to take full advantage of these tax wrappers if you invest in a stock/bond/listed property portfolio.

And you can start getting really creative, for example, some people take the tax rebate from their RA and plug it into a TFSA – pretty powerful stuff and a great way to show SARS the middle finger.

No Protection In Down Markets

One of the great benefits of using the 4% rule is that it has been tested to be incredibly reliable no matter what. It has been through (and survived) some of the worst times in human history – we talking the Great Depression, World Wars, Oil Crises, and dot com busts.

The beauty of the 4% rule is that it was created to be able to withstand a total shitstorm the absolute worst market conditions. And better still, it even allows you to increase your income by inflation each year even as the world around you falls apart.

The 4% rule has been purposefully designed to see you through the really tough times.

And here is where there is a real risk when it comes to retiring on just rental income. I think many South African property investors have been truly spoilt. If you are a property investor younger than around 45 years old, you have never experienced what happens when property prices decease for a sustained period of time. Check out the chart of the South African Housing Index (thanks Trading Economics) and you’ll see what a one way street Property in South Africa has been over the last +-25 years.


It’s no wonder that many people are convinced that property is the best investment despite the huge risk of it being a single asset class. I mean check the chart, “property prices always go up”. Right?

Well….

Compare this to what a more normal property market looks like, for example, the American house price index.


(Ignore the noisier signal, that is just because the Americans sample their housing data more frequently than us). As you can see, housing markets can (and do) go through ups and downs - just like the stock market. Check out that massive 4 year decline from around 2005 – Eina!

Now I am not saying that South African Property is about to crash and burn, all I am saying is that these things do happen in normal housing markets, and you would be extremely naive to think that it couldn’t happen here. And this is exactly where, in my view, the 4% Rule kicks the sh!t out of an investment property portfolio.

If you use the 4% rule, then even when markets are crashing and burning, you simply continue drawing and increasing your income. If the property market pulls a similar wobbly, your rental property portfolio will hang you out to dry.

What do you suppose happens to your R30k rental income if property prices drop 10% in a year? Yes, it means you are going to get around 10% less income the following the year. So now you have R27,000 income to cover R31,500 worth of expenses (don't forget about inflation - in this case 5%). You are now R4,500 short every month.

And this means now you would need to be able to jack up your rent by a monstrous 22.5% the following year just to get back to being able to cover your original expenses (And if property prices haven’t risen, good luck trying to push an increase of that size through to your tenant without them running for the hills.)

Expense Lucky Packet

When it comes to expenses, the 4% rule is pretty predictable. You know the cost of the products you are invested in, and you know it is not going to change (or if it does, likely to the downside - I’m looking at you Satrix Top 40 ETF gliding so delightfully down to a TER of just 0.1%).

Investment property does not enjoy this luxury. Yes expenses can be budgeted for, and that can help, but what happens when you get slapped with a R30k special levy (yours truly had the pleasure of this just a few months ago). There goes a full month worth of income…

Then there is all the usual stoves malfunctioning and showers leaking (both of which may or may not have happened at our rental property in the last year or so…)

And then of course the one that can really sink you - vacancies. It is something which is often overlooked, and it is often assumed that a good paying tenant will always be in place. But what if a tenant leaves one of your properties and you are unable to fill it? Or worse still, what if a tenant decides to stop paying and also refuses to leave (this happened to a colleague of mine at work – no one should grey that fast in 8 months - which is the time it took for him to go through the motions required by law to get the non-paying tenant removed. He didn’t mention a figure of what it all ended up costing him, but judging by some of the profanities I heard, I know it wasn’t small change…)

Poor Diversification

The other big problem with investment properties is that they are hugely concentrated. A rental property is one asset, in one location, generating income from one person in one currency. That sounds incredibly risky!

Yes by owning more than one investment property, you can spread your risk a teeny tiny bit – but you still have only one asset class in one country using one currency.

Compare this to a diversified investment portfolio, which will consist of a host of different asset classes, in multiple countries, generating income in multiple currencies from customers all around the world. Ask yourself which is the more diversified (pronounced safer) option?

Make no mistake, the property concentration risk could pay off in the long run, in which case I am pretty sure I am going to get a lot of told you so’s. But then again, if a risk doesn't materialise, does it make you smart, or does it make you lucky?

Reducing The Risk Of Investment Property

There are some very real downsides to achieving financial freedom via a portfolio of investment properties. So how do you mitigate, and compensate for the risks, uncertainties, and lack of tax flexibility and protection ?

Well…

You can make sure you generate income over and above what you need, so you have a bit of a buffer to cover for the shortcomings of a property portfolio – i.e. you can increase the size of your property investment portfolio (i.e. own more properties).

How many more?

As a thumb suck, I reckon that double your income requirement is probably sufficient to cover the extra tax bill, unforeseen expenses and lack of diversification?

In other words, for a R30,000 monthly income, you should probably up your property portfolio from R4.5Mil to R9 Million…

And guess what…We are back to the amount the 4% rule gives!

Okay, so honours even then?

No. There is still one caveat…

A big property portfolio doesn’t really diversify you that much more than a small property portfolio, and it can still all blow up in your face…

So, if despite all this, you still choose to skip the only free lunch in investing (diversification), then you need to accept that there is a very real chance you could go hungry…





Till next time, Stay Stealthy!
 - ~ - ~

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