Conventional wisdom. A generally accepted belief. The kind of advice your grandmother would no doubt give you, while fattening you up with homemade cookies.
Often, conventional wisdom is simply a function of a generation and their experiences in history.
For example, older generations see gold as a store of value. Ask a 20-year-old whether cryptocurrency or gold is a more appealing investment, and I would feel safe betting that the answer isn’t the yellow metal.
So, conventional wisdom may not be so conventional after all. What worked in economic circumstances decades ago may not make sense now. Fashions do change.
And yet, there’s something that every generation seems to jump in and do…
Buying a flat and renting it out
In Joburg, it’s the classic Summercon or Balwin in Fourways. Identical to another 1,500 units within a radius of 500 metres, investors queue up to buy units in complexes in the hope of creating wealth.
Of course, the underlying principle is fantastic. It reflects a commitment to saving money and building assets, which is exactly the attitude that can unlock financial freedom one day.
Unfortunately, very few people understand the true economics behind these types of investments.
In Part 1 of this series, we will focus on the basic inputs for a calculation on whether property is a good investment. In Part 2, we will delve into other alternatives and the factors that can drive a successful property investment.
Get the calculator out
The conversation usually goes like this:
“I will buy a R1.2m unit and rent it out for R10,000 a month, which is R120,000 a year – someone else can pay my bond!”
In theory, maybe. In practice, probably not.
Before we carry on, you need to understand that the annual income from the property is known as the yield. This is an important term for you to remember. Gross yield is the rental income before any expenses, whereas net yield is the income after all property-related expenses i.e. the amount that will help you pay the bond.
So, what are the costs between gross yield and net yield? Here are a few examples:
- House insurance
- Monthly levies payable towards upkeep of the complex, security etc.
- Rates payable to the municipality
- Maintenance on the house (the responsibility of the landlord)
- Special levies that may be raised for projects like major maintenance items or complex improvement (such as the building of a park)
- Commissions paid to agents to place a tenant
Hmmm. So much for R10,000 per month. By the time insurance of R500, levies of R1,000, rates of R750 and monthly maintenance of R250 have been paid, there’s only R7,500 left.
The agent commission is usually one month’s rent. Not the rent after expenses, but the gross rent i.e. R10,000. So, we are sitting with a net yield of 12* R7,500 = R90,000, minus agent commission of R10,000 = R80,000.
So much for the theoretical R120,000 per year!
But wait folks, there’s more
The R80,000 assumes that everything goes to plan. We haven’t considered a special levy, for example. More importantly, we haven’t allowed for a month with no tenant or the nasty costs of trying to get a tenant out or fixing damages that can’t be recouped from the tenant.
A good safety net would be to assume another month of vacancy each year i.e. the loss of a further R10,000. This may sound like we are going overboard but consider the disaster of having a tenant who could take four months to remove for non-payment. In addition to the lost rental, there are legal fees to pay. Some companies offer insurance-type products for these situations but such products also come at a cost.
We therefore arrive at a net yield of R70,000. Compared to the purchase price of R1,200,000 that’s just 5.8% per annum.
We still haven’t talked about all the risks
Unfortunately, we live in a country with enormous wealth inequality. As a result, urban decay is a major risk for property investors and any properties near open land stand the risk of losing substantial value if that land becomes a target for informal settlements or any other project that is likely to cause a drop in value of the property.
We’ve all heard horror stories of people who bought into premium areas and paid a premium price, only to be stuck there later on or being forced to sell at a substantial loss. There’s no point in shying away from this risk in South Africa as it affects all property investors.
The technical term here is concentration risk – which in the case of fixed property, is enormous. You probably wouldn’t invest R1,200,000 in just one company on the JSE, yet that’s effectively what is happening through investing in a buy-to-let property.
On top of all of this, there is the stress of having a tenant.
Will your tenant pay on time this month? What if your tenant gets retrenched? Can you afford the bond repayment from your emergency fund? What if the tenants destroy the kitchen? Can you recoup body corporate fines from tenants for breaking the rules?
Clearly, this isn’t such a straightforward decision
Isn’t it amazing how a comment as simple as “someone else can pay my bond” can turn into a detailed analysis that suddenly isn’t as appealing as was initially believed?
Of course, there are reasons to consider property as a buy-to-let investment. The trick is to understand the benefits of this asset class and the economic conditions that can improve the return for investors.
In Part 2, we will explain when such an investment is attractive and when it should be avoided entirely.