This is probably one of the most asked questions, and rightly so. For most people, their own home makes up the bulk of their investment assets, in South Africa at least. However buying a home to live in is a very different decision than buying another residential property for investment purposes. A home provides your family a place to make their own, to entertain your friends and to create memories. And you don’t pay rent, but rather pay your bond of. However buying a residential property as an investment is far more sobering. The alternative could have been to buy shares or bonds or Unit Trusts among other. So how does the return of a residential property investment stack up against the others?
Firstly, lets start with the basics. If we had no inflation at all, and knew that for the next 20 years, inflation simply doesn’t exist, then the average price of residential properties should at most increase by the growth in GDP/capita. One could argue that as the average population gets richer, they will be able to afford to spend more on property (even though by the classical definition, this would be property price inflation – but lets ignore that for demonstration purposes). The reason is that the cost for shelter (ie property price or rent) can’t continuously increase because then it would demand a continuously higher allocation of the household budget, and in many years would be 100% of the household income. Therefore, it only makes sense that over longer time periods, residential property prices can at most increase by GDP. That would not seem like a good investment at all.
The reality is somewhat different. Very few buy properties outright with cash, and most borrow money from the banks to fund their purchase. So now we are talking about a geared investment (and for the technical lot: it only gets marked to market a specific snapshot, when you are taking out the loan. After that, the banks very seldom care what the property price do, they would not suddenly ask you to repay large sums – very different than a geared investment in shares). The advantage of the geared investment can be demonstrated by a very simple calculation: lets say a capital return on an investment is 8%. If you only had R1 million to invest, your return per year would be R80 000. But if the bank lends you another R2 million to buy a property for R3 million, your capital return is R240 000. Obviously you have to pay back the loan, but the government is helping you by allowing you to deduct the Interest from the Income Tax due.
Any reasonable property investor would also try and get a decent tenant to live in the property. The rental due would help you pay back the bonds. A general rule of thumb is that if you borrow between 40% and 50% of the purchase price, the rental would cover the bond installments at an interest rate of 10%. So effectively you are buying a property at a 40% to 50% “discount”, and let the tenant pay off the rest. So does that make it a good investment?
The answer is still not very clear, because taking out loans, investing into immovable and tenants come with their own risks. However, there is one more factor: inflation. In SA, we have relatively high inflation at 6%. That is not only 4% more than in most of the developed world, but 3 times the rate. So in South Africa the primary investment risk should always be inflation. If the investment does not beat inflation, you get poorer every year. The same reason why residential property prices can’t beat real GDP growth over a long time make sure that it grows with inflation. The rental should increase by inflation, as do the costs, except the repayments of the bond. In short: if you live in a “high” inflationary area, ie anything north of 4%, it does make sense to invest into residential property. In a low inflationary environment, the benefits are not clear.
So who are the winners and losers: The winners are clearly the property owners and the banks, the losers are those bank clients who keep their cash in a current account (or most other bank accounts)