Read this before you buy-to-let: Part 2

At some point, practically everyone considers a buy-to-let opportunity. Most of us grew up being told that property is a fantastic investment and that everyone should get onto the property ladder as soon as possible.

Whilst the decision to buy a property to live in is a function of stage of life among many other factors, the decision to invest in a buy-to-let opportunity comes down to the numbers.

In Part 1 of this series, we looked at the key inputs in the calculation and why the rental paid by the tenant is firmly a gross return, with many expenses that must be deducted to arrive at a net return or net yield.

In Part 2, we will look at the reasons why investors still go ahead with buy-to-let opportunities and what the driving factors of a successful investment could be.

High-yield investments

We showed in Part 1 how a gross yield of 10% per year can be reduced to under 6% per year once all property-related expenses are considered.

How does this compare to other asset classes?

Dividend-paying shares on the JSE typically trade on a yield of 1.5% – 3.0%. Even after tax, property investments pay a higher yield than this. So, investors seeking yield usually look beyond shares towards other asset classes like property. An alternative to this is government bonds.

South African Retail Savings Bonds, a product by the South African government aimed at those seeking income investments, currently pay 6.25% for a 2-year fixed rate up to 8.5% for a 5-year fixed rate. Considering the much lower risk of government bonds vs. a specific property investment, this is significantly better than the <6% net yield on the property in our calculation in Part 1.

A closer comparison of risk would be the STANLIB income fund, which invests in bonds of major corporate entities in addition to government bonds. This has returned 7.5% over 3 years and the money is not locked up for a minimum time as with Retail Savings Bonds.

In this case, the yields of buy-to-let fall well short.

The power of property isn’t in the yield

This is a lot to take in. The key point to understand is that the income-generating quality of property isn’t as great as conventional wisdom might suggest. This means that the attractiveness of property investing is based on capital growth and the accumulation of wealth.

This is where property is unique: the capital growth can be achieved using money borrowed from the bank.

The capital growth on a property is based on the full purchase price which allows investors to earn a return on an amount that they wouldn’t be able to invest without help from a bank. No bank will lend an investor R1,200,000 to invest in shares or government bonds but all banks will do it for property.

If the property grows by 10% in a year, that’s a R120,000 capital return (before expenses). Before getting too excited about this, we need to look at the expenses linked to buying and selling a property, just like we considered the operating expenses against the yield.

If you don’t sell, you don’t get to enjoy the capital increase in value.

Crunching the numbers

The FNB House Price Index is a reliable source for house price growth in South Africa. The February 2021 report suggests 4.2% house price growth over the past year across the market.

Importantly, one must delve down into the typical buy-to-let bucket (under R1,900,000) and look at the 2021 forecast, based on current economic conditions. Within that bucket, the latest FNB forecast is just 0.1% growth.

Clearly, with these capital growth numbers, buy-to-let is anything but an attractive investment. Investors seeking yield should look elsewhere.

To illustrate the point though, let’s assume 5% annual growth and consider whether that is enough to create an attractive investment. Bear in mind, this is far in excess of the current economic forecasts.

After four years, the R1,200,000 property is worth over R1,450,000. Sounds great right? Let’s look further.

When you bought the property, you would’ve paid around R50,000 in bond costs, conveyancing fees and a little slice of transfer duty (since the first R1,000,000 doesn’t attract transfer duty). Your true in-price is R1,250,000 and the bank won’t lend you the money for those costs, so R50,000 had to come out your pocket.

Then, when you sell for say R1,450,000, you need to pay an estate agent at least 5% for the pleasure of selling your house, taking your net proceeds down to R1,380,000.

Profit? R130,000 and that’s before SARS gets its share of your capital gain because this isn’t your primary residence.

We still aren’t done.

We showed in Part 1 that the annual yield was R70,000 on the R1,200,000 property, or 5.8% per year. The interest rate on the bond is unlikely to be any better than 7.5% at current rates, an annual interest bill of R90,000.

In round numbers and with some simplifying assumptions, you are paying the bank R20,000 per year in interest over and above the yield on the property. Over four years, that’s R80,000.

The capital profit of R130,000 minus the R80,000 additional payments takes us to R50,000 profit over four years. Again, this is a pre-tax number.

As a final point, what if there is no capital growth?

This is where it gets seriously ugly.

If there is no growth at all, the in-price of R1,250,000 plus the R80,000 additional payments to the bank means you need to get R1,330,000 back from the property just to break-even.

Unfortunately, in four years it could still be worth R1,200,000 and you need to pay 5% in fees to sell it, taking the net proceeds down to R1,140,000.

That is a spectacular loss and a terrible investment.

Conclusion: let’s talk about it before you do it

If property appeals to you as an investment, it’s critical to run the numbers and go in with eyes wide open.

If the goal is to generate a stable income, there may be better ways to achieve that. If the goal is to create wealth over time, then we should talk about what the property market is doing and how different growth rates may impact your returns.

I would welcome the opportunity to discuss these economic scenarios with you and the various alternatives