BOITUMELO NTSOKO: Welcome to the Money Savvy Podcast. I’m Boitumelo Ntsoko. The topic of buy-to-let properties is a contentious one, with investors looking to improve their financial situations, buying apartments, building cottages and bedrooms a plenty. Is this a good idea, though? And can you make money doing it? Stay tuned as Richus Nel, who is a certified financial planner at PSG Wealth, helps us make sense of rental property investments. Welcome, Richus.
RICHUS NEL: Thank you, Tumi.
BOITUMELO NTSOKO: Now, many people see rental property as an easy way to generate a passive income. Is that really the case?
RICHUS NEL: Tumi, so I’m on record with a recent article disputing the easiness of it, of this whole topic. And I think there’s a couple of general assumptions that I think over time [have] actually changed, and that it is not that easy.
And it is not that much more convincing, as it was before in creating wealth. So, I mean, I even hear property developers, and these professional property development firms in South Africa, recognising and acknowledging that the margins of property development have also shrunk. And it is actually quite tricky not to get in trouble with the development and their margins are generally, you know, higher because there’s a conversion of, for instance, empty land compared to just a buy and sell of a particular property.
So, my view is it is not that easy anymore.
I think the general assumptions that it’s a passive type of investment, that it is cheap, that the tenant sort of pays for everything, that property prices just go up, one way up, and that if you generally get a good tenant, and that you’ve got no sort of challenges, I think is far from the accurate view. And then I think many people can attest to it.
BOITUMELO NTSOKO: A few years ago, buy-to-let was all the rage in the property sector. With the higher taxes and rates as well, has this then changed the situation today?
RICHUS NEL: So, I think it’s … always a combination of factors. Sometimes a lot of that … demand drive for something is a lot of the time driven by sentiment in terms of how investors look upon a particular asset class based on past experiences. But if we can reflect on that time – it was in my mind between 2002 and 2007 before the great financial crisis – South Africa was going through a commodity supercycle, with China buying everything that we dug out of the ground. Before 2002, the JSE went sideways for three years; there wasn’t necessarily a great appetite for listed equities at that time. And the South African economy was growing between 4% and 5% per annum. So now let’s look at what the rental or residential property index [did] according to FNB (they prepare a residential property barometer). They reckon that between 2002 and 2007 residential property as a national number in South Africa [grew] by 21%, on average, per annum for almost six years. Now, if that’s the case, then you can imagine that some properties, you know, selected or specific property, did perhaps half of that and other properties did perhaps something like 30%, or 40% in a year. So, you can clearly see why, during that time, you would have seen some, perhaps first-time buyers that were actually just making an absolute fortune by flipping properties within two or three years. But … that is not seen lately.
And in fact, from 2008, which is now after the great financial crisis, that same property barometer from FNB, shows a national average of 3.89% per annum, and that’s over 14 years and that’s not beating inflation.
So you can clearly see it’s a combination of things. It is typically your consumer out there that is also under pressure perhaps from higher taxes, definitely from much lower economic growth. And then the interesting thing, which is quite contentious and perhaps just aggravating what is happening out there, is Eskom’s electricity escalations … just one example. But it’s a very good example of what has happened to the consumer out there and manufacturing and use of products, etc, etc. Because this is in our inflation numbers as they’ve put up electricity prices from 2007 to the end of 2021 by 520%. So, it’s a little bit of chalk and cheese, I think, from what we’ve seen during our prosperous economic years compared to what we’ve seen lately.
BOITUMELO NTSOKO: And just with the current situation with Russia and Ukraine affecting economies, do you think that situation is about to worsen?
RICHUS NEL: So, it depends on what direction … the talks and the negotiations go. I think [Russian President Vladimir] Putin, from my point of view, is in a very difficult position to go home without a victory because Russia sacrificed quite a lot in terms of the sanctions and depreciation of their currency, the ruble. So … to go back and just say we’ve reached the peace deal without much gain, I’m not sure if that’s possible. Further escalation is not necessarily that obvious. And hopefully not that obvious at this stage. So very difficult to say, Tumi. But in terms of war, there’s probably very little sort of benefits to anyone, so hopefully it does not escalate.
BOITUMELO NTSOKO: And then for someone who’s then still considering going into buy-to-let, what financial position should they be in before going down this route?
RICHUS NEL: So hopefully, in a more affluent position than someone more or less just breaking even. I think another misconception is that the tenant sort of pays for most of the bills, which is actually, if you do a projection accurately, you will see that there’s a lot of chipping in from the property owner over the first 10 years, while something’s perhaps mortgaged, for instance.
So … first of all, just in terms of interest rates, I think investors should consider that interest rates can go up 3%, perhaps, and that a projection is most likely more rational at that interest rate level.
I would also regard it necessary that the owner can financially survive without that rental income for probably three to six months, which I think is again … on the prudent side.
Even with resources [so] that if you get into some sort of dispute or legal fallout with a tenant that you can actually do something about it and afford legal action.
And then perhaps just the last one is the taxability of rental or other sources of income. Again, it comes back to your projection and to go and have a look what a net tax rental income is actually going to look like and whether that is in line with the risk that you’re taking up. So, [for] people that are typically taxed at the highest level … rental income is not the most tax-efficient way then to earn income and also to create wealth in terms of physical property.
BOITUMELO NTSOKO: You touched on rental projections and a few items that should be included in that. What other things should be in there?
RICHUS NEL: Yeah, so I think this is actually the contentious issue: that a lot of people perhaps have rental properties and that a lot of people have views on rental property or physical property. And if I compare this with alternatives, I always say that we’re not talking about primary residence here. It’s a very distinct difference that we need to make. We’re talking about an investment property. So, you’ve got an alternative to either going to physical property as an investment or into an alternative as an investment. But the contentious issue is, I think, the projections are actually a very difficult exercise to do accurately because there are a lot of moving parts. There is sometimes, as I say, just the taxability from one individual to another gives you a completely different outcome. So, in my mind, the way to approach this is to, first of all, just [be] tongue in cheek meticulous, careful and then conservative in terms of the assumptions that you make.
Richard Branson always says look at your downside and manage your downside; the upside will take care of itself.
And I think this is typically where you would rather want to be prudent and conservative: make the projections, speak to people that are in rental property, look at their projections. If they haven’t got projections, you’re talking to the wrong person perhaps. So, it has to be run like a business.
There is a real profit or a real loss that is going to be the result of the management of that physical property.
And then perhaps things that [are] a little bit less obvious to include in those projections [are] obviously things like maintenance and that is individual, specific to each type of property or the one that investors will then consider investing in.
I think it’s prudent to make a provision for non-rental payment.
And it can be a slight provision. But I think it’s rational to think that even between tenants, there’s perhaps months that something isn’t occupied, or rented, and tenanted.
[Also] provide for the agent’s commission, I think. Again, it’s like most things – if you haven’t done this before, you aren’t that sort of affluent and confident and you [haven’t] proven yourself in the past, you will probably need to make use of an agent. So, provide for that fee.
And then lastly, is the time spent. Many of us are actually to an extent exchanging time and knowledge for money as a career. So, if you end up spending more time on your rental properties, then surely you need to be compensated to an extent. So even if someone is professionally skilled and selling time, or whatever the case might be, I think it’s prudent to actually include that in the projection and to see if it actually makes sense getting involved with something like that.
BOITUMELO NTSOKO: And what should you look for when purchasing a rental property?
RICHUS NEL: So first of all, I think, again, I [would] involve people in conversation [who] have done it quite a few times. But the highlight for me is, location, location, location.
A good investment, a good initial investment, has got the tendency to remain a good investment. And a bad initial investment tends to remain bad, specifically with property – it’s a very difficult one to turn around.
So, in my mind, rather buy in a better location smaller, than buying a bigger property in a different area.
I think it’s important to understand what someone can actually utilise that property for. Is it something that can be converted? If you look at what’s happened, for instance, during Covid, many people have actually converted properties and they are actually working from home. So, you look at opportunities of how that property can be utilised and what it will be worth to someone. Again, I will cite partners with good agents or find out who are good agents in that area and engage with them, not taking everything that they say … as gospel, but to actually ask whether they have got some projections.
Look at the numbers of particular areas, particular properties, and get to the nitty-gritty of it.
Get all the information about financials, what does it cost to be the owner of that property? A lot of the time there [are] hidden costs. People don’t necessarily ask about all the types of costs that’s involved. And then lastly, obviously, is the maintenance: look at the roof, walls, flooring, corrosion effect, if you are close to the sea, etc, etc. Look at the services; is it old or is it new?
There’s really a lot of factors that’s involved and perhaps it is good to get some sort of, I almost want to say evaluator, that can actually go with you looking at the structural savvy and soundness of structures, because those are the parts and the elements that will actually break a deal if you need to fix structural damages or faults.
BOITUMELO NTSOKO: Richus, in your recent article on Moneyweb, you said the only time physical property can measure up in monetary growth terms versus listed shares is when your initial cash investment or loan deposit is aggressively scaled by way of bank finance. Could you please explain to our listener why that is?
RICHUS NEL: So, it’s called the leveraged effect. So, if you have got, for an example, R100 000 as a capital lump sum you are, as a scenario, able to put that in, let’s say, listed financial markets and earn a return on that based on the asset class underneath. Or you can go and you can leverage that R100 000 as a deposit on some sort of a mortgage bond for instance, and you can perhaps borrow a million rand and acquire a million rand property. So, if you do the second option, if you get 5%, so let’s say half the return per annum in terms of a percentage, if you get 5% capital growth on your purchased property, it translates into R50 000 capital appreciation over one year compared to the 10% on the R100 000, which is nearly R10 000. So, you can see that starting off with a bigger base, even if you in future are earning a lower growth rate on that capital, in monetary terms, you can actually make faster headway. Now, what is interesting, and this is the exercise that I’ve actually done prior to writing the article, is that that was presumed to be superior way to wealth creation than just starting off with a smaller amount into listed, for instance, listed equities.
But if you take the cash flows, that it costs a, let’s say, property owner, just to get off the mark, and that is basically the shortfall between the cost of ownership and that mortgage payment versus the rental income that you receive. If you take that shortfall, because that is what [it] is going to cost you to acquire that property, and you put that onto your initial deposit and you invest that annually in listed equities, the leveraged effect option is not that convincingly better and fast in wealth creation over 20 years.
And that is where I’m saying it all comes down to what are the numbers? What is the specific property? What is this specific property’s rental income and escalation opportunity? What is the cost of ownership? How are those going to escalate? What are the interest rates, etc? How is someone taxed? Is it a free-standing property? Is it in a security complex? All those facts are going to determine whether someone is going to have a better, I almost want to say true passive investment, in a financial market investment, or a physical rental property with everything that goes hand in hand with that. And I can tell you from what I’ve seen, it is a very, very close outcome between those two scenarios over 20 years. And over 40 years, hands down financial markets [is] the better outcome.
BOITUMELO NTSOKO: Now, if I’ve just realised that rental property is going to be too much work for me, what other possible alternatives can I have as opposed to owning buy-to-let property?
RICHUS NEL: Yeah, so I think the challenge of it, Tumi, is perhaps it’s a little bit of a dissatisfactory answer, but it is basically starting small and an invest[ment] into financial markets. If you, because this is clearly a long-term investment plan, we’re talking about both physical property and listed equities. So, you will need to adopt an aggressive listed equity portfolio, investment portfolio, start small [and] stay disciplined with the amounts that physical property would have cost you – to also put that into investment on a monthly basis.
But I can tell you, what I do see is individuals that are able to focus on their careers 100%, focus on their speciality, focus on their self-development, that they are able to actually earn as much as possible in their career, take those earnings, put [them] in financial markets in a disciplined way, looking after the health, you would probably not find a failed financial outcome following that route.
So, you are asking about alternatives. The alternative, as I say, is perhaps a dissatisfactory answer: [it] is starting small, staying disciplined, staying the course taking the investment risk in terms of listed equities, and focusing on your earnings capabilities in your career, rather than side-tracking with different ventures.
BOITUMELO NTSOKO: Alright, thank you so much, Richus. That was Richus Nel, who is a certified financial planner at PSG Wealth.