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Risks to consider before investing in buy-to-let property

Be sure you know what you are committing to financially.

Investing in buy-to-let property can be a sound investment, although it is a decision that should not be entered into lightly. The more educated you are about property as an investment, the more you will be equipped to mitigate the risks faced by landlords.

While property is perceived to be a more stable investment than shares – and therefore appears to be less volatile – being a landlord can be onerous and there are costs involved that may not be obvious at the outset. Supply and demand, together with factors such as crime, increasing debt levels and escalating unemployment, are just a few factors that can impact a landlord’s ability to generate positive cashflow from his investment. Other risks facing landlords include:

Barriers to entry

Unlike investing in equities, there are high barriers to entry when it comes to investing in a rental property – investing in property is therefore not an option for everyone. Upfront costs payable by the buyer of a property include a deposit, transfer duty, attorneys and deeds office fees and bond initiation costs. Having said that, financing a property provides financial leverage to effectively purchase more with less in the sense that you can purchase a R3 million property using a deposit of only R300 000, while the bank loans you the rest. The transfer costs on a R3 million house will cost the buyer around R163 000 in transfer duties, while conveyancing and bond costs will be around R34 000 and R40 000 respectively.

Ongoing costs

Naturally, your primary purpose for owning a rental property will be to generate a passive income. However, before purchasing a property, do your homework carefully to ensure that the ongoing monthly costs do not eat into your profits. Be sure to take into account the costs of maintenance and repairs, security, garden services, levies, insurance and insurance excesses and rates when determining your net rental income. It is the exception rather than the norm to own a rental property that looks after itself with little intervention from the landlord, so be sure you know what you are committing to financially.

Rental increases

In a saturated rental market such as the one we are currently experiencing, you may find it difficult to put through annual rental increases without the risk of losing good tenants. In the current rental property environment, landlords have accepted that they cannot push through the same annual rental increases as they did in the past. If your rental income cannot keep pace with year-on-year inflation, this can have a detrimental effect on your financial position. 

Liquidity

Unlike trading shares, the process of buying or selling is generally quite lengthy and this can cause liquidity problems especially if you need to access your money quickly. If you encounter liquidity problems, a forced sale of your investment property may mean you have to drop your selling price and ultimately compromise your investment.

Tenant vacancies

It is important to factor in the possibility of tenant vacancy to ensure that you are financially geared for this eventuality. If a tenant dies, falls ill or is retrenched, you may suddenly end up with an unlet property and no rental income. According to Michelle Dickens, MD of TPN Credit Bureau, almost 9% of tenants are in technical default status (more than three months in arrears) and 25% of new tenants default in their first four months – these being the results of a study that included 1.9 million rental property in South Africa. There are a number of insurance companies who offer rental insurance to landlords and property rental agents, but this type of cover comes at a price. In general, these products cover three months’ rental, capped legal costs and some malicious property damage at a cost of around 5% of the monthly rental. However, the tenant application and vetting process for this type of cover is very onerous and can scare off perfectly suitable tenants.

Disruptive tenants

While your tenants may be good rent payers, there is always the possibility that they are difficult tenants which can make your life a nightmare. Overly demanding or litigious tenants can cause enormous emotional and financial stress which may result in you having to incur legal costs to resolve tensions. In addition, disruptive tenants can cause damage to property, tensions with neighbours, problems with law enforcement and community policing forums, and potentially fines.

Interest rates

If you are servicing a bond on your rental property, interest rate increases can put pressure on your cashflow. Other factors such as tenant vacancy, unpaid rent or breakages can compound your cashflow problems and can cause you to incur unwanted debt or dip into your savings.

Lack of diversity

If your rental property is your only investment, be aware that lack of diversity in itself is high risk. Factors that are specific to South Africa, such as high crime rates, expropriation without compensation and rental legislation which very often favours tenants, may serve to heighten the risks associated with property-only investing and it may serve you well to diversify into other investment types. 

Management

As a landlord, you may prefer to outsource the management of your rental property to a rental agent. In general, upfront advertising and tenant placement fees are between 8% and 10% of the value of the lease. For the ongoing management of the property, rental agents can charge from about 8% of monthly rental upwards which covers the cost of managing the rental agreement, handling all landlord-tenant correspondence, invoicing for utilities, and ensuring the rental is paid on time. On-site inspections by the rental agent are often charged separately. These upfront and ongoing costs should also be factored into your calculations when making a purchasing decision.

The foundation of investment property, which is based on capital growth and rental income, makes perfect sense in theory. In practice, however, the job of a landlord is made more complex against the backdrop of rental property legislation, rising unemployment and market saturation. It is prudent to ensure that you undertake careful due diligence before purchasing a rental property and that the asset forms part of a well-diversified portfolio.

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