The ins and outs of investing in property and the costs included.
Over the last few years, many people in South Africa have turned to property as an investment class and entered the property market as investors. Like any other investment, you need to understand how the investment works before you decide to invest your hard earned money. It would be foolish to rush into an investment without understanding that investment.
Bear in mind that you are interested in:
- Wealth creation; and
- Wealth protection.
In other words, what we are saying is that once you have created wealth, you need to also protect it and sustain it. In addition, you may have other people who depend upon you and you need to worry about their futures as well. There are so many products and financial services out there. We all need help to get through this minefield and hence the need for the services of a financial planner, those with experience in growing wealth.
It is important to remember that...
Your financial planning is as much your responsibility as it is your financial planner's that is assisting you. Do not wait for your advisor to call you; take the initiative and be pro-active. Your circumstances may change and as a result it may become necessary to modify your portfolio. Things that may happen include:
- Having a child
- Starting a new business
- Getting married
- Getting divorced
- Being involved in an accident
- Getting a new job
- Paying off your debt
We will briefly look at the following topics as investment options before taking a look at property as an investment:
What is an Endowment?
In simple terms, an endowment is a savings vehicle. Endowment policies usually require the investor to make monthly contributions. These contributions are then invested in particular asset classes in order to generate a return for the investor. People invest in endowments for a variety of reasons, such as:
- Saving for a child’s education;
- Saving for a future goal, like going overseas or renovating your house.
There are different types of endowments, but essentially they are all designed to build up a cash value, which will be paid out at the end of a particular period. Some endowments also have life cover (see the discussion of life cover below).
What is a Unit Trust?
A unit trust is a method of investing whereby the individual investor is able to pool their funds with other investors. In essence, your monthly contribution is added together with those of other investors. The purpose of doing this is for these investors to obtain the benefit of being able to invest with bulk purchasing power.
The unit trust is incorporated (created) with say one million units. You can view each unit almost like a share in the company. Let us also say that each unit is sold for R 1.00, i.e. the total sales of all the units will amount to R 1 000 000.00. As an investor, you would then receive 1 000 units for your R 1 000.00 invested.
The management company that administers the trust employs specialists who invest that R 1 000 000.00 into various financial assets. Hopefully, over time, the value of the shares that have been invested in will increase to a healthy sum of say R 2 000 000.00. Therefore, your 1 000 units are now worth R 2.00 each and your total investment is worth R 2 000.00.
What is a Retirement Annuity (RA)?
Retirement annuities (RA’s) are a form of savings vehicle subject to special rules. The advantage of RA’s is that the contributions are tax deductible and therefore provide the taxpayer with relief whilst he or she is contributing to the fund.
In essence, the idea behind RA’s is that you build up your own pension fund which can be utilised subject to certain rules. Upon retirement, you may draw a certain lump sum from the fund that you have accumulated and the balance is then used to purchase an annuity for you. The annuity is then taxable in the hands of the taxpayer at his or her marginal rate of tax and is subject to PAYE. An annuity received by a dependant of a deceased member of the RA fund is also taxable in the hands of the recipient.
If you become disabled it is seen as accelerated retirement and therefore the RA would be taxed the same as if retirement had taken place. You need to discuss with your financial advisor, what would happen when you die, as there are potentially estate duty implications for your RA.
What is Life Cover/Life Assurance?
Many people underestimate the importance of life assurance. If you have dependants, it is vital that you have adequate life cover in the event of your untimely death. Life assurance not only provides lump sums to the beneficiaries of the policy, but can also provide relatively good after tax returns.
The premiums that you pay into your policy are invested into various different asset classes. The life assurance companies employ specialists that are able to invest your money into a spread of assets that you would not ordinarily be able to do yourself. Many policies have certain guarantees attached to them that other investments, such as unit trusts or direct equity investments do not. You are able to increase your premiums on an annual basis, thus ensuring that your investment can keep pace with inflation. Many policies also have some flexibility should you not wish to have a premium increase in any particular year. Your policy will build up value over time and can be used as security should you require a loan or wish to purchase a business, for example.
Property as an Investment
The purchase of your home is probably the largest purchase that you will ever make. The same care that you take when buying a home should go into the property that you wish to purchase as an investment. Perhaps even more so, because of the financial implications of the property that is bought as an investment. It is important that you are not pressurised by estate agents, your spouse, yourself or anyone else. You need to take your time over your investment decision and consider all of your options. The principles of investing in property is a vast subject area. We aim to introduce you to some important concepts in this article and to point out certain issues to keep in mind with respect to the purchase of investment property.
Costs excluded from the purchase price:
It is important not to forget that there are significant costs that you will incur when buying or selling investment property. These costs have to be taken into account when buying a property as an investment, because they will affect the return on your investment. These costs are:
The purchase price.
Transfer duty - this is a tax that is paid to the government on the transfer of every property from one person to another as a result of the alienation of property, which is defined as a sale, donation or exchange of immovable property.
Bond registration costs - most people require the assistance of a bank to purchase their property. The bank will loan you money and in return you will have to provide the bank with some form of security, which is usually a bond registered over the property. The bond allows the bank to take the property away in the event of default. The bond registration will also be done by a conveyancer (not necessarily the same conveyancer doing the transfer) and the cost is also determined by a tariff.
Property transfer costs - this is different to the transfer duty that needs to be paid. In order to effect the transfer, you will need an attorney who is also a conveyancer. This is a specially qualified attorney who is allowed to attend to the transfer of property. The amount that you will pay is set out in a tariff guideline and varies with the value of the property.
Miscellaneous costs – people often forget to add up all the other costs, such as, levies, new carpets and curtains and various little maintenance jobs that may need to be completed before a tenant can move in.
Monthly costs of ownership – remember that you also have your monthly costs to pay, such as, rates and taxes, levies, water and electricity, home loan charges and administration fees, homeowners and loan protection insurance, household insurance, and so on.
Estate agents Commission – when you sell.
Capital gains tax - incurred when selling at a profit.
Financial aspects if investing in property
One of the most important aspects of purchasing property as an investment is the financial aspect of the transaction. Potential investors will often need to borrow money from a bank in order to finance the purchase of the property. The amount of debt that is required is also called the level of gearing. The higher the level of gearing, the greater the risk of financial distress should you lose your tenant or if interest rates go up. The advantage of gearing is that the interest that you are paying is tax deductible and therefore makes the investment more tax efficient.
You need to think about the following questions and issues before you purchase your investment property:
What is the return that I will be getting?
You need to determine what rental you will reasonably be able to charge and then you can calculate your gross yield from the property. The gross yield is calculated by taking the annual gross rental and dividing it by the price that you pay for the property. Compare the yield that you will earn with the interest rate that you will be able to get if your money was in the bank. Bear in mind that a holiday home will not generate a return if you do not want to let it out. Generally, holiday homes are not good investments as they stand empty for most of the year and are not able to generate any income.
What if I lose the tenant or interest rates increase?
Can you afford to pay the bond as well as all the other expenses, like rates and taxes or the levy, if your tenant moves out and you cannot find a new tenant for a month or two? Will you be able to afford the bond repayments if interest rates go up by 2 or 3 percent? This is very important for you to work out as it may severely impact upon your cash flow.
Will the property produce positive cash flow?
There are many people who advocate using as much debt as possible when buying investment property. Although this will increase the amount of interest that you are paying and therefore reduce your taxable income, it does increase the risk of the investment for the reasons explained above. Ultimately, you want the property to produce positive cash flow for you. This means that you eventually want the property to be providing you with income, especially as you get closer to retirement. A property should be purchased because it will make you money, not save you tax. It is also pointless getting into a lot of debt to buy a property because you hope that it will increase in value. The property's value may not increase the way you thought it would or at the same rate as might have expected.
Are you prepared to sell the property if you need to?
You must have an exit strategy if you need to get out of the investment. You cannot afford to be sentimental about the property and you must be prepared to sell it if the circumstances dictate that the time has come to move on.
How many properties can I afford to buy?
Based upon the manner in which you have financed the purchase of your first investment property, how many properties could you afford to purchase? It is easy to get caught up with the excitement of buying investment properties, but it must be affordable and you need to ensure that you do not get into financial difficulty.
Have you done all your research?
You must do your research correctly and check that all of your facts and figures are correct. You need to think carefully about your intended property investment. We are all aware that property prices have risen tremendously and this means that the returns that you will be able to achieve are not as good as they were, say five years ago. This means that the property will probably not produce positive cash flow initially and you may therefore have to be subsidising your investment from your own pocket.
Are you prepared to manage your investment?
Any investment needs to be properly managed and property is no exception. The question that you need to think about is whether or not you want to manage the property yourself or appoint a rental agent to look after the property for you. It can be a great burden to look after the property yourself and deal with your tenant directly. A rental agent can be very useful to use and it relieves you of a significant amount of stress.
As mentioned above, any investment needs to be correctly managed. We strongly advise you to obtain professional advice before committing your funds to any investment and you must be aware that you need to assess the performance of your investment on an annual basis. It is also important to educate yourself about the advantages and disadvantages of any investment before you spend any money.
This article originally appeared in Property Power 13th Edition Magazine. To order your copy at the discounted price of R120 click here.