Property's Place in your Portfolio
South Africans have a love for property as an investment. The common adage goes “buy a house, and let the tenants pay for your bond”. If it were this simple we'd all be property tycoons having this discussion from beach chairs overlooking the Bahamas, alas, we are here trying to weave our way through the complex realm of investments.
Property is viewed as a core growth asset (along with equities) in traditional unit trust portfolios, however this reference to property is generally retail, commercial, and industrial. What this article seeks to explore is the wild jungle of residential property, how to tame it and make it a valued addition to one's investment portfolio.
What property can offer
If you are here looking for terms like ‘guarantee’, ‘consistent returns’, or ‘safe asset’; look elsewhere - we will not be feeding beasts of hearsay here. Rental property is no longer the mint that it once was. One of the greatest advantages of an investment property, for the average investor, is that you can use gearing or leverage. Gearing is the simple concept of borrowing money in order to purchase an asset that will bring you greater income than the overall cost of borrowing. This is a technique used by many investors in all types of investments, but it is most common in the domain of property, namely in the form of the ever-prevalent mortgage bond. With gearing as a tool in one's pocket, anyone who can get a decent loan, mixed with the right ingredients of property and management can find themselves cooking up quite a tasty investment portfolio.
Residential property generates returns in two ways - rental income and capital growth. Some properties are stronger in one department over the other, although one can find a sweet spot between the two in a property we could lovingly call a GEM - generates easy money! According to Lightstone Property’s 2018 report, the properties growing the fastest are typically low and mid value. Coastal properties are growing slightly faster as well, with an emphasis on the Western Cape and Northern Cape.
One’s bond payments are set at inception, but the rental income typically increases with time. This means that in a place of high rental increases, eventually one will get to a point where their tenants are covering their bond.
The potential returns of property are massive for an investor who has no fear for risk and some toil, which many property investors soon find out they are not cut out for. The labour that goes into finding the correct property, sorting out the bond approval, finding tenants, retaining tenants, and maintaining the property for tenants (basically, get good tenants early on and keep them happy, your sanity and investment will thank you) is more tedious than a rookie may first predict. There are management companies that assist in taking care of all of the above for you, but of course not without a healthy fee.
Given the cost of property and the long term nature of it, one would usually own only one or two for investment purposes. This means that the portfolio is not geographically diverse and hence left vulnerable to fluctuations in area pricing and environmental events. These changes in prices may be seasonal or more permanent, whereas your bond payments are fixed.
There is inherent risk in renting out property since your rental income relies on one or two other people’s lives. This lack of diversification means that factors outside of your control can leave your property vacant without enough time to find a suitable replacement, leaving you with a tenant-shaped hole in your cash flow. One could resort to short-term leases or online lodging such as Airbnb to smoothen out this rough patch; although these come with their own set of risks and responsibilities.
There is more to the cost of property than paying off a bond; first time buyers are often ignorant to the impact of rates, taxes, levies, electricity and water. It is rare that rental income would cover all of the above costs, i.e. there is an out-of-pocket expense involved. There is also the need for upfront costs when purchasing a property (transfer and conveyancing fees). All of this is before potential maintenance and upgrades that would carry your property into in the modern world.
Property is an asset that lacks liquidity, meaning that you cannot access funds in a hurry. The FNB Estate Agent’s Survey for the first quarter of 2019 showed that the average time a house spent on the market was over 15 weeks. One also cannot access small portions as needed - you cannot sell your garden or kitchen off quickly for some cash flow.
We built a property case using real statistics and compared it to an investment equivalent
Mike purchases a 3 bedroom property in a Northern Johannesburg suburb for investment purposes. He charges the average rental for that area, and the cost of the property for a three bedroom was average too. He takes out a loan at 10.00%. After 20 years he has paid off the house, and its value has increased with inflation.
Mike’s twin sister, Sarah, begins a 20 year investment at the same time that Mike purchases his property. She invests only what Mike pays out of pocket every month (the difference between total cost and rental), so her monthly contribution actually diminishes over time as Mike’s rental income increases. Sarah’s annualised return after fees for her investment is 10%.
The graph below illustrates the value of Sarah’s investment after 20 years given various rental escalations that Mike may have had (i.e. Sarah would be contributing less as Mike spends less out-of-pocket). Here it is valuable to consider that Johannesburg’s rental escalations over recent years have been below inflation. The graph also considers different occupancy rates that Mike could have had (i.e. periods where Mike would have to unexpectedly pay more than usual out-of-pocket amounts).
· If rental escalations are at the recent average of 2.4%, even at 100% occupancy Sarah would still be in a better position than Mike.
· If rental escalations are at 5%, Sarah would be in a better off position if Mike is unable to get 80% or greater occupancy.
· If rental escalations are at 8%, Sarah would only be better off if Mike cannot get 60% or greater occupation.
This is merely a calculation and shows where one could expect to end up with a little bit of luck and where they may find themselves with some misfortune. However, it is up to the investor to decide how much of their time, cash flow, and liquidity they are willing to sacrifice in order to potentially get ahead. One may rather wish to pay a property manager a fee to relieve the headache, although that would quickly close the gap of their outperformance.
Although rental property is not what it was a decade or two ago, it still has a place in one’s investment portfolio – however, it shouldn’t be the bulk of it, nor should it be the entry point for an investor. Avoid going into a property investment without thorough research. Rather let property be a long-term building block in your diversified portfolio.
Victor Bucarizza CFP®
Victor is a certified financial advisor at GIB Financial Services
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