December 2006

Buying property to rent it out

Let's assume you have bought your own house and still have a mortgage on it. Your thoughts turn to buying a second property, one that you can rent out while the tenant's rent effectively pays off your mortgage on this second property.

It's an appealing scenario, because once the second property is paid off, the rental becomes income for you, or, depending on where the second property is located, it can become a paid-up holiday home for your family in the future. Alternatively, you can sell the paid-off property, which will have increased in value over time, and invest the profits elsewhere.

In fact, some people have created entire property portfolios this way with great income-generating results. A post office employee in a small Karoo town acquired 17 additional properties during his working life. By the time he retired, all of them had been paid off, and from the continued income he enjoyed an extremely comfortable retirement!

However, there are several critical factors that must be taken into account before purchasing a second property, and not all of them revolve around cost. For example, do you have the time to manage a second property, attending to maintenance issues, screening prospective tenants and collecting rent? If you don't have the time, are you prepared to pay an agent's fees for doing these things on your behalf?

The issues that do revolve around cost have far-reaching implications. Let's take a real-life example: an actual two-bedroomed flat has come on the market in the suburb of Tokai, Cape Town, for a price of R750 000. If you were to purchase the flat, with a 100% home loan at an interest rate of 10,2%, your bond repayments per month would be R7 337 (over a 20-year period).

A spokesman from Seeff Properties, one of the agents marketing the property, says a two-bedroomed flat in this area can currently be rented out for approximately R3500 per month. The shortfall is immediately obvious. The difference is R3187 per month that you will need to pay to cover your bond repayments alone.

Just a few years ago the same scenario would have yielded different results, because property prices were much lower then and it was possible to almost match rental payments to monthly bond repayments. However, residential property prices have increased dramatically but residential rentals have not, which makes the buy-to-let market not as profitable as it used to be.

Renting out property can be risky, as unsatisfactory tenants might not look after it well, and might default on rent, leaving you to cover the full monthly bond repayment from your own pocket. (There is, however, a new affordable insurance product called the Landlord Protection Policy from Hollard Insurance Partners and Tenrisk Underwriting Managers, which gives landlords a financial safety net, enabling them to pay their mortgage bonds, levies and legal costs when tenants fail to pay the rent.)

Buy-to-let shouldn't be avoided completely forever though, as the market might yet change. The rental market is showing signs of improving, as more and more potential first-time homeowners are delaying purchasing a property, because of the threat of increasing interest rates and because it makes financial sense (see last month's article). So, more people are choosing to rent rather than buy, which affects the supply/demand ratio, which should therefore drive up rental prices.

There is also space in the buy-to-let market for the enthusiastic and experienced property investor who has sufficient income to finance a shortfall and is more focused on returns to be gained from the long-term capital appreciation of the property. Such investors usually have an excellent eye for a good buy, and you really need to have extensive experience in property to fit into this sector.

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