The only way that an investment property makes sense is to bond it. Why do I say 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 to 15 years. Those who owned property in the 1990s and early 2000s were fortunate to experience exceptional growth. The growth experienced then has unfortunately been projected onto those individuals’ children, creating an unachievable expectation as far as current property growth is concerned.
A mistake that’s often made is to take the sales value of a property and calculate the return by merely comparing that to the purchase price. All other costs are ignored. Once the peripheral costs like bond interest, maintenance, rates and taxes, levies, insurance and so on are taken into consideration, residential property rarely provides a return ahead of inflation.
In fact, a residential bonded property is a loss leader if no rental income was generated. The only positive of a residential property that is not rented out is the quality of life that it offers its occupants …
Back to your question regarding investing in rental property.
You basically have two options when buying property:
- Buy with cash in which case your investment return will be determined by market growth and the net rental yield (rental income less tax); or
- Bond the property in which case you use the bank’s money to fund the purchase and a tenant to service the bond or part thereof (at least in the first couple of years of ownership depending on interest rate movements). The gearing effect of the bond is what makes bonded/geared rental property attractive. Let me explain by way of an example:
- Let’s assume you buy a property for R2 million cash and the growth amounts to 5% per annum and rental income amounts to 7% escalating annually at 5% (inflation target), then your return after 10 years will be roughly R1 257 789 in capital (62% cumulative) and R1 232 631 (rental income of R 1 760 901 less tax, assuming 30%), making a total return of R2 490 420 on an investment of R2 million = 124.5% over the 10-year period. Not bad at face value … Important to note: all costs pertaining to the property such as maintenance, levies, rates and taxes are ignored in this calculation and will have a meaningful impact on the return.
- Now let’s assume you pay a R100 000 deposit on the property, and you bond the rest. Over the 10-year period, the rental income will be reduced by approximately R580 000 due to the ‘burning rate’ or shortfall between the bond repayment and the rental income. The following will then apply. Capital growth R1 257 789 and rental income of approximately 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 simplified and ignores many factors like movement in interest rates, market demand and several other factors. It should merely be considered as a rough guide to explain the advantage of gearing versus a cash purchase when considering an investment property.
The opposite principle applies to your primary residence where a cash purchase is preferred due to the cost of financing over an extended period. When bonded over a 25-year period your repayment increases your actual cost of the property threefold.
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 that you are considering with a market value of R2 million. That equates to around a 7% yield, which is in line with rental properties that are in high demand. Rental properties under current economic conditions yield around 5% to 7%.
Ironically, rental properties in ‘bad’ areas can yield as high as 12%+. These are typically cheap apartments in the centre of suburbs that attract potentially financially risky tenants, hence the higher yield. These apartments also often depreciate in value and are held purely for yield and not capital appreciation.
Sars will allow all expenses linked to the rental property as a deduction against the rental income. It therefore makes sense to keep the expenses as high as possible for as long as possible. Expenses may, among others, include insurance, levies, services, agent commission, maintenance and most importantly interest on bond repayments. Take note that only the interest component can be claimed, not the full bond repayment.
It is important to note that Sars will only allow expenses to exceed income for a limited period of between three and five years, depending on your motivation of why expenses exceed income.
Sars wants its taxes and will not hesitate to ringfence your rental property and reclaim previously allowed expenses should it feel that the rental property is not going to yield taxable income.
I am not sure if you are familiar with all the pros and cons of owning rental property and the legal rights of tenants. I suggest that you investigate all factors thoroughly before you embark on this journey.
Tenants have far more rights than property owners.
This to me is one of the main detractors of owning rental property even though I do own a few rental properties.
I dealt with similar factors that I mentioned above in an article titled Investing in property: The good, bad and the ugly previously published on Moneyweb. Hopefully, between the two articles, you will find your answer.
I also just want to touch on your comment that perhaps you should invest the R8 000 monthly shortfall between the bond repayment and the rental income into a bank fixed deposit for 20 years.
To be frank, that will be the worst thing to do. After-tax cash will struggle to beat inflation. With a 20-year investment horizon, you should rather consider investing in an aggressive growth portfolio with a healthy chunk of offshore exposure, not cash. That, however, is a totally different discussion.