The only way an investment property makes sense is to back it up. Why am I saying this?
I want to make a controversial statement by saying that generally residential property is not a good investment.
The dynamics of South African residential property values and growth have changed significantly over the past 10-15 years. Those who were owners in the 1990s and early 2000s were blessed with exceptional growth. The growth experienced then was unfortunately projected onto the children of these people, creating an unrealizable expectation for the current growth of the property.
A common mistake is to take the sale value of a property and calculate the return by simply comparing it to the purchase price. All other costs are ignored. Once peripheral costs such as bond interest, maintenance, rates and taxes, levies, insurance, etc. are taken into account, residential real estate rarely outperforms inflation.
In fact, a bailed residential property is a loss leader if no rental income has been generated. The only positive point of an unlet residential property is the quality of life it offers to its occupants…
Let’s go back to your question about investing in rental property.
You basically have two options when buying a property:
- Buy cash, in which case your return on investment will be determined by market growth and net rental yield (rental income less tax); Where
- Bond the property, in which case you use bank money to finance the purchase and a tenant to service the bond or part of it (at least during the first two years of ownership in depending on interest rate movements). The bond’s ripple effect is what makes tied/pledged rental properties attractive. Let me explain with an example:
- Suppose you buy a property for R2 million in cash and the growth is 5% per year and the rental income is 7% increasing annually to 5% (inflation target), then your return after 10 years will be approximately R1,257,789 in capital (62% cumulative) and R1,232,631 (rental income of R1,760,901 less tax, assuming 30%), giving a total return of R2,490,420 on an investment of R2 million = 124.5% over the 10-year period. Not bad at first glance… Important to note: All property related costs such as maintenance, levies, tariffs and taxes are ignored in this calculation and will have a significant impact on performance.
- Now suppose you pay a deposit of R100,000 on the property and bond the rest. Over the 10 year period, rental income will be reduced by around R580,000 due to the ‘burn-up’ or shortfall between security deposit repayment and rental income. The following will then apply. Capital growth R1,257,789 and rental income of around R752,630 net of tax. This equates to a total return of R2,010,419 on an investment of R100,000 = 2,010%.
This comparison and example is oversimplified and ignores many factors such as interest rate movement, market demand and several other factors. It should simply be seen as a rough guide to explaining the advantage of gearing over a cash purchase when considering an investment property.
The opposite principle applies to your principal residence where a cash purchase is preferred due to the cost of financing over a long period. When bonded for 25 years, your refund triples the actual cost of ownership.
Investment income is fully taxable. This means that your total rental income will be considered taxable income. You mention that a rental income of R12,000 per month is possible on the property you are considering with a market value of R2 million. This equates to a yield of around 7%, which is in line with high demand rental properties. Rental properties under current economic conditions fetch around 5% to 7%.
Ironically, rental properties in “bad” areas can yield up to 12%+. These are usually low-cost apartments in the center of the suburbs that attract potentially financially risky tenants, hence the higher yield. These apartments also often lose value and are held purely for yield and not for capital appreciation.
The Sars will allow all expenses related to the rental property to be deducted from rental income. So it makes sense to keep spending as high as possible for as long as possible. Expenses may include, but are not limited to, insurance, levies, utilities, agent’s commission, maintenance, and most importantly, interest on bond repayments. Note that only the interest component can be claimed, not the full repayment of the bond.
It is important to note that Sars will only allow expenses to exceed income for a limited period of three to five years, depending on your motivation as to why expenses exceed income.
Sars wants his taxes and will not hesitate to close off your rental property and recoup previously authorized expenses if he feels the rental property will not earn taxable income.
I don’t know if you know all the pros and cons of owning rental property and the legal rights of tenants. I suggest you carefully consider all factors before embarking on this journey.
Tenants have far more rights than landlords.
This is for me one of the main detractors of owning a rental property, even though I own a few rental properties.
I covered similar factors I mentioned above in an article titled Investing in Real Estate: The Good, the Bad and the Ugly previously published on Moneyweb. Hopefully between the two articles you will find your answer.
I also want to address your comment that perhaps you should invest the R8000 monthly shortfall between bond redemption and rental income in a fixed bank deposit for 20 years.
To be frank, it will be the worst thing to do. After-tax cash will struggle to beat inflation. With a 20-year investment horizon, you should instead consider investing in an aggressive growth portfolio with a healthy portion of foreign exposure, not cash. That, however, is an entirely different discussion.