November 2006

What you need to know about fixed property investment

Property (residential, industrial and commercial) is a hot topic right now. On average, house prices in South Africa have doubled over the past four years, but this rapid increase in prices is tailing off now, partly due to the recent interest rate hikes.

How does this affect the approach that you should adopt towards investment in property? For the average salary-earner, the questions around residential property are numerous. They include:

• Should I rent or buy?
• What should I look for when buying a house?
• Should I apply for a variable rate or fixed rate mortgage bond?
• Should I buy a house in my personal capacity or via a separate business entity?
• Are there any "hidden costs" incurred in buying a house?
• What are the implications of e.g. sectional title ownership?
• Should I buy a second property to rent out?
• What are the potential income tax and capital gains tax implications of property ownership?
• Are there other ways of investing in property besides buying bricks-and-mortar houses?

Property can make you a lot of money, lose you a lot of money, or make little difference to your financial status. If you want property to make a positive difference on your path towards financial freedom, you need to be knowledgeable about how it works.

Our aim in the next few issues of Money Matters is to give you some guidelines that will help make investment in property work for you. Bear in mind though that our series is no replacement for doing your own homework thoroughly. No property transaction should ever be rushed into.

Firstly – should you rent or buy? This might seem like an odd question, because to make money from property you need to own property – and renting means you aren't getting your foot in the property market. However, renting can sometimes be an essential first step to investing in property. For example, if you have recently moved to a new city, renting for a short time will give you time to assess house prices, various suburbs and other factors before you buy.

Renting is also an option if you are transient, i.e. you are only working in a certain town temporarily and are likely to move within the next 12 to 24 months. And for someone who does want to buy a property, you can rent while saving up for a deposit on your first house.

But the main factor driving your decision should be: can you afford to buy a property? Here's what you absolutely must consider when answering this question:

• Your home-loan repayments should not exceed 35% of your after-tax salary.
• You need to be able to afford household insurance, rates and taxes, maintenance, and levies (in a sectional title property) in addition to your bond repayments.
• You need to consider the possibility of an extreme increase in the interest rate. In 1998 interest rates soared to 25% and many people lost their homes because they could not afford the escalated repayments on their home loans. If the interest rate increases, have you got the finances to tide you over until it comes down again?

You have to be 100% honest with yourself about your financial situation before buying. Overextending your finances by buying a house can be disastrous. We've created some calculations, based on certain assumptions, that give a hypothetical illustration of how renting can actually save you money (in the current market, that is).

Let's take a house with a market value of R1 million, and assume the following factors:

1. The bond interest rate is 12% per annum.
2. House prices escalate at only 5% p.a. – which seems to be the case at the moment and for the foreseeable future, unless the repo rate rises further.
3. Property rates and taxes are say R450 per month.
4. Homeowner's insurance is say R220 p.m.
5. Maintenance costs are about R200 p.m.
6. All costs increase by 5% p.a.
7. Rental is 6% of the market value of a house with 5% escalation.

Buying the house: Projecting 5 years into the future

Initial bond instalment on 20-year bond: R11 011 per month.

Total initial monthly outlay: R11011 + R450 + R220 + R200 = R11881

Market value of house: R1 276 280

Future value of total monthly outlay at a discounting rate of 8% p.a.: R956 720

Outstanding bond: R917 440

Net equity is thus: R1 276 280 – R917 440 = R358 840

Renting the house: Projecting 5 years into the future

Total initial monthly outlay: R5 000 (i.e. 6% of R1 million)

Future value of rent at a discounting rate of 8% p.a.: R402 620

Comparing the two options at the end of 5 years:

The difference in future values of costs over 5 years is as follows:
R956 720 – R402 620 = R554 100

From this example, it would be unwise to buy the house. Rather rent and invest the savings on monthly outlay. At the end of 5 years you would have an amount of R554 100 to put down as a deposit on the same house that would then cost R1 276 280. That means you would have a bond of R1 276 280 – R554 100 = R722 180, compared to an outstanding bond of R917 440 if you had opted to purchase the property instead. You would, in fact, be better off to the tune of R195 260.

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