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Investing in property: The good, bad and the ugly

Property is a great diversifier in a portfolio. However, like any asset, be mindful of the price you pay for it.

I would like to make a statement. Residential property can be one of the best investments you can make. But it can also be one of the worst. The devil is in the detail…

South Africans love their property. During the 80s and 90s and early 2000s, we experienced phenomenal growth in residential property values. You could literally buy a property anywhere and you were almost guaranteed double-digit returns over the next two decades.

The strong run of property values up to the end of the 90s came to an abrupt end when interest rates spiked with the prime rate topping out at 24% in mid-1998. Bond rates spiked and many properties were seen posting “for sale” signs. Property values went into freefall. By the year 2000 interest rates normalised and we saw demand for high-end properties increase to levels not experienced before.

With the rand touching R12.00 to the USD at the start of 2001 and plenty of property on the market, SA became the hunting ground of global property investors driving prime properties to new highs. Prime SA coastal properties became sought after by many foreign investors who could buy prime property at bargain prices using their USD, euros and GBP.

From early 2000 to 2007 property demand broadly picked up and prices crept up again until the onset of the GFC (Global financial crisis). Globally banks tightened their lending criteria and SA was not spared. Obtaining bank loans during 2008 and 2009 was almost impossible and house prices moved downward again.

From post-GFC to today the increase in property values has been mediocre across SA. Does it make sense to still buy property?

At this point, I want to differentiate between the value of owning the property you live in and owning an investment property. Irrespective of how volatile the property market has been over decades, the intangible value that you experienced by living in your property cannot be overestimated. Calculating the actual value that you achieved from your investment property is a totally different story and much will depend on the following:

  • Did you buy the property cash?
  • What gearing (loan) did you attach to the property?
  • How much interest have you paid over the term of the bond?
  • What was the average net yield (rental) that you received during your time of ownership if you rented it out?
  • How much have you managed to claim from the taxman?

I would like to make a second statement. A holiday home is inherently a bad investment if you reserve it for your own use. An investment that does not derive a decent income or that does not appreciate in value well ahead of inflation is a loss-maker. Unfortunately, South Africans are guilty of placing far too high a value in owning a holiday home that they refuse to rent out.

One of the biggest mistakes many investors make is to overspend on their primary residence. We regularly have discussions with investors when they “upgrade” their homes. If your financial position is such that the home you are purchasing represents less than 25% of your net wealth or requires less than 25% of your monthly free reserves then it’s fine to indulge in the upgrade. Often the comment is made that the house will be sold when the retirement age is reached and the surplus funds that will be forthcoming when they downscale will be added to retirement funding.

Reality check. Taking selling costs and purchasing costs into consideration the “profit” that so many rely on after the two transactions have been completed often disappoints. Unless the differential between selling the property and purchasing a smaller property is more than R5 million in current value after all costs are taken into consideration, the cost of the “feel good” that you experienced while living in the house is questionable. The R5 million that I refer to will be sufficient to provide you with roughly an additional R20 000 a month of income in retirement. When running the numbers, owning the more expensive property with the intention to downscale later and use the proceeds for retirement funding, often has a worse outcome than if you owned a more modest property and rather invested the additional cashflow or capital you would have saved during the period of ownership.

In principle, we exclude the investor’s primary residence as an asset when we embark on the path of investment planning. South Africans tend to place a far too high value on their primary residence. We often find clients overestimating the value of their primary residence. The value of your residential property in simple terms is the price that a buyer is prepared to pay the day that you decide to sell it irrespective of what agents tell you it’s worth. You will not know the real value of your property until the money is in the bank.

Most investors I consult with boast about the fantastic returns they achieved by owning property during their lives. Young investors also often state that they want to invest in property because their parents experienced phenomenal returns with the property they owned.

Two examples come to mind (do the math on your own property and let me know what the outcome is).

Property A was bought in 2002 for R630 000, today the value is estimated at R4 100 000.

Property B was bought in 1986 for R680 000 (several R100 thousand was spent on renovations over the period) and has just been valued at R23 million.

Both the above properties achieved fantastic growth. Or did they?

The annual gross return (capital appreciation) for Property A is 9.82% per annum.

The annual gross return for Property B is 10.58% per annum.

The above returns may seem satisfactory, but the calculation does not end there. The costs mentioned below that are associated with the properties need to be deducted from the returns which result in returns of low single-digit numbers. The higher the bond value and the resultant interest rates are, can lead to results where the actual return provides a negative real return and as I always state, the objective of investing is to achieve inflation-beating returns at the very least. Since the GFC residential property has broadly failed in this objective.

Return detractors:

  • Buying costs (registration costs, legal costs, municipal costs).
  • Interest on bonds (can double the initial price of the property).
  • Rates and taxes, services costs.
  • Levies.
  • Maintenance.
  • Insurance costs.
  • Selling costs (agent commission and legal costs).

The good

There is however a caveat to the above and that is buying an investment property and gearing it to the maximum. Be very careful though. Make sure you can afford the monthly repayment by calculating the repayment at least at 5% higher interest than what you manage to negotiate with the bank.

Why is this different to the figures mentioned previously? It is simple, someone else pays your bond and you get the tax deduction on all interest, maintenance, levies, insurance, and any other cost incurred on the property.

The main swinger in the calculation is that instead of using the full price as the start value, only the deposit amount should be considered as the start value because all the other costs are borne by either your tenant or by the receiver of revenue. At some point you will start paying tax on your rental income, Sars only allows approximately three years of losses, thereafter they become quite sticky and insist on a rental stream that will provide a net taxable income. Be careful not to test the system, Sars won’t hesitate to ringfence the property and reclaim all previously allowed expenses.

If we go back to our previous examples how will the figures look now?

With a 10% deposit, the start value of Property A would be R63 000 resulting in an annualised growth of 23.22% per annum. This figure will be substantially higher because the rental income will escalate over the period of ownership and eventually be more than what the bond repayment amount is.

Health warning: Be careful not to embark on a “property accumulation” spree. There are many obstacles and complications in the residential rental property market. Do not end up like many before you where cashflow becomes a hindrance forcing you to sell at below market value…

When we invest in property, we must distinguish between commercial property in the form of listed property which can also be packaged as Reits (Real estate investment trusts, which is similar to a unit trust), and residential property.

Although one cannot “gear” the purchase of a listed property or a Reit, gearing still has a profound effect on listed property values. The same applies to commercial property values as in my gearing example of residential rental property. Listed property companies use gearing for exactly the same reason as I explained. By using investor funds as well as the gearing provided by banks, they have the liquidity to expand their portfolios. This is all good until the property sector takes a smack as it did during the 2008 GFC. Just to remind you, the GFC was largely caused by the property sector…

Why is there a difference and why is this riskier?

Banks lend money to property companies subject to a covenant. This covenant stipulates what an acceptable loan to book value may be and this may not be breached. Although property companies were well within the covenant restrictions at the onset of the GFC, many soon breached the covenant due to property valuations dropping. When this happens, fund owners have to sell properties to rebalance the loan to book ratio. When there is an oversupply of property the natural thing happens. Property values keep on dropping, we refer to this as “fire sales” where property is sold at any cost. During this phase, many property companies mainly in Britain and Europe went to zero value during the GFC…. Therefore, don’t for one moment think that you cannot lose all your money when investing in property…

Covid-19 has thrown many curve balls at the global economy and the property sector was far from unscathed. We will have to see to what extent recovery will take place. Over the last year, the property sector recovery has been phenomenal with a sector return north of 60% and far exceeding all other asset classes. The seven-year figures however are still negative. Will the sector recover to be the best of all as it was for several years some three years ago? We will have to wait and see….

Property is a great diversifier in a portfolio. However, like any asset, be mindful of the price you pay for it. Before embarking on accumulating a property portfolio, speak to an investment specialist. As much as gearing can work in your favour, it can also turn out to be a nightmare…

ADVISOR PROFILE

Marius Fenwick

WealthUp (Pty) Ltd

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