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How should I use a lump sum for monthly income?

I can either invest it, or I can buy a property to rent out.

I am a single, 55-year old woman. I have R500 000 and I need a monthly income from this amount. Should I invest or buy a small flat to rent out?

Peter Nurcombe-Thorne - Rosebank Wealth Group (Pty) Ltd

Dear reader,

Without fully understanding your personal circumstances, exact income requirements and risk tolerance, it would be difficult to give a definitive answer to your question. I will, however, compare and contrast the two options you have provided in order to highlight some factors that you should consider, before making your decision. I think it is important to fully understand the two options to evaluate which will suit you best.

Income producing portfolio

We would suggest, because you are relatively young, a draw of 4% from an investment portfolio is the highest you should go to ensure that the capital value of your portfolio keeps pace with inflation.

A 4% draw on a R500 000 portfolio translates to R20 000 per annum, roughly R1 600 per month. To ensure that your portfolio maintains its purchasing power over time you would need to earn a return of 10% per annum; 6% to keep up with long-run inflation and 4% to satisfy your draw. Although challenging in the current environment, a CPI+4% return should be achievable over a full market cycle, between three to five years, by investing in a multi-asset portfolio that includes equity, fixed income, property, cash and offshore exposure.

Alternately, you could invest in a fixed income investment and draw down on the monthly interest. If you could earn 8% in interest, your annual income would be R40 000 or R3 200 per month. The concern with this strategy is that your capital would be eroded by inflation and the income earned from the portfolio would buy you less and less every year.

Buying a rental property

The other option you are considering is buying a sectional title property to rent it out. The merits of this route include the following:

  1. Yields in the middle income sector of the market are attractive and could be as high as 12% or R5 000 per month. You would need to factor in rates and taxes, levies (because it is a sectional title unit) and reasonable maintenance. If you use an agent to help you find a tenant, you will also have to allow for the costs of this service. This could reduce the income you receive by up to R2 500 per month which reduces your yield to R30 000 per annum or 6%, which is still more attractive than the income scenario above.
  2. A property of R500 000 falls below the threshold for transfer duty and as such is far cheaper to acquire.
  3. Property has proved to be a hedge against inflation and you could reasonably expect to see the value of the property grow over time by at least 6% (long-term inflation) depending on the area and the health of the overall economy, and therefore your asset would appreciate over time.

While this strategy works for many people, it is significantly more risky than the option outlined above for a number of reasons:

  1. Liquidity risk: A property can’t be sold as easily as a listed security and as such, if you were a forced seller you may have to take a lower price than you would like to turn your property to cash.
  2. Tenant risk: If your tenant fails to pay the rent, it can be a lengthy and expensive process to remove them during which time you won’t be earning an income. Additionally, if your tenant damages your property you may be in for repairs that are greater than a one month deposit.  
  3. Concentration risk: As you will only have one property investment, your risk will be centred around one particular area and the performance of your investment will be dependent on how the area evolves over time.
  4. Friction costs – Buying and selling property involves some costs that you won’t be able to avoid such as agents fees and transfer costs, all of which erode your return.

Ultimately, the choice will come down to whether you can withstand the possibility of not receiving the income should you have a troublesome tenant and whether you favour the certainty of a liquid portfolio over the enhanced return and risk of a rental property.

Do you have any questions you would like answered by registered financial planners?

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