Some important factors that must be considered when investing in residential property, a decision which, for many, involves incurring large sums of debt and often implies significant cash flow risks.
TO FIX OR NOT TO FIX?
At present, with interest rates rising and jitters mounting, there is a focus
on fixed interest rates. Fixed rates should be seen as a service provided by
banks which enables the client to, for a certain period, shift the cash-flow
risk involved with fluctuating rates onto the bank. The bank assumes and manages
the interest rate risk, and the client obtains certainty over interest rate
payment cash flows. In return for this benefit, the customer can expect to pay
some price. Should average floating rates over the period in question never rise
to the level of the fixed interest rate for the period, then the client would
have been better off (with hindsight of course) leaving his interest rate to
float. Conversely, if the SARB shocks us with sharp interest rate hiking, and
the average floating rate over the period is significantly higher than the
average fixed rate, then the client will thank his lucky stars should he have
fixed his interest rate at the beginning of the period.
Our economics team only forecasts one further half-a-percentage point hike in
interest rates by the SARB in October, taking prime to 12%, and thereafter a
long sideways move until the resumption of some reduction possibly only in 2008.
However, we all know that the future is an uncertain place. For the more
risk-averse person, even should floating rates never rise to an average rate
equal to the average fixed rate for a specific period, the fact that this person
has cash flow certainty under a fixed rate arrangement for a defined period, be
it 1 year or 2 years or more, could allow him to sleep far more peacefully at
night and thus be worth its weight in gold for that individual.
Conversely for the more risk-taking individuals, given the general feeling
amongst economists that rate hikes will be moderate this time around, they may
feel that they are losing out on an opportunity by fixing rates. The decision is
always personal, but when considering whether to fix or not, think about the
following:
What is your appetite for risk? Does it cause you major stress? If so,
perhaps you lean naturally towards fixing.
How "close to the edge" are you financially? If your overall financial
situation gives you very little leeway to absorb any nasty shocks, you may
also lean towards fixing rates.
Finally, always remember that for one to "score" by fixing rates in
terms of paying less interest, the average floating rate on a bond for the
entire period of fixing must exceed the fixed rate for the period in
question.
Take the following example. Shortly after the first interest rate hike in
June, which took prime to 11%, a person contacted me asking advice. She was a
prime minus 2% (i.e. 9%) home loan client (not at FNB) and her bank had offered
her the option of fixing her rate at 11.8% for a year. This implies that for her
to benefit financially by fixing versus staying on a floating rate, prime would
have to average above 13.8% (given that she is a prime minus 2% client) for the
entire 12 month period, i.e. from mid-June 2006 to mid-June 2007.
Let's suppose that the SARB were to continue to hike interest rates at its
present pace until June next year. It has Monetary Policy Committee meetings
every 2 months, i.e. August (just past), October, December, February, April and
June - 6 in all. Half a percentage point per meeting until June next year would
raise prime rates to 13.5%, and the specific client's quoted floating would rise
to 11.5%. This is still below her offered fixed rate of 11.8%, and her average
effective floating rate for the whole period would be only 10.25%
Interest rates would therefore have to rise quite sharply over this period
for the fixed rate to be the option where that person actually pays less.
Now fixed rates differ, as do various clients' floating rates, and interest rate
forecasts can go awry. But when you get offered a fixed rate for a certain
period, do this calculation using some alternative scenarios before deciding.
ANOTHER WAY OF "FIXING" CASH FLOWS - SETTING MONTHLY PAYMENTS WELL-ABOVE REQUIRED PAYMENT
For those entering the residential property market as buyers now, a great way
to increase certainty regarding repayment of cash flows is by "living well
within one's means" by buying significantly cheaper than one's financial limits
allow. These days, many bonds have no penalties for early settlement. One would
then be able to set the monthly repayment significantly above the required
monthly payment, which would imply that up until a certain magnitude of rate
hikes one's monthly payments would not change, thereby improving cash flow
certainty.
TO RENT OR TO BUY?
The decision to either rent or buy can also have far-reaching implications on
household cash flows, as well as on wealth.
In recent years, huge capital gains were achieved by people owning
residential property, swinging the pendulum in favour of owning as opposed to
renting. It wasn't always this way though, and with the extreme interest rates
of the 1990s, rental may have seemed far more attractive to many. Now, with the
property market slowing and interest rates rising, rental may be becoming a more
attractive option for some once again. Before you decide, though, consider the
following:
The obvious benefit of property ownership is:
Capital gains accrue to the owner, and following a slowdown in overall
house price inflation until late-2007, my expectation is that house price
inflation will once again begin to rise on the back of a resumption of
interest rate cuts in 2008 and a strongly growing local economy.
On one's primary residence, an additional benefit relative to some other
investments is that one is exempt from capital gains tax.
The less obvious benefits of ownership relate to human nature:
As opposed to renting, there exists a stronger incentive to invest in
one's residential asset and to add value to it through maintenance and
alterations. Many of us therefore end up with a far more valuable asset than
we started with, due, not only to market movements, but also to our
additional investment.
Ownership may encourage greater financial discipline than rental.
Because of the incentive to invest in one's asset in the case of ownership,
one may sacrifice a significant amount of consumption expenditure over the
years in order to finance this investment (either financing upgrades and
maintenance, or paying off the bond more quickly), thereby ending up better
off financially in the longer term compared to the rental option.
The non-financial but very important benefit of ownership is the power to
shape the asset the way one wants (within the regulations obviously),
according to individual tastes and lifestyles, in order to maximise the
"usage value" one derives from it.
Rental also has its benefits though:
Apart from the cash flow uncertainties surrounding bond repayments
(which can be fixed for some time of course), property ownership has the
added uncertainty of unforeseen costs, which are numerous. These could
include routine maintenance which, although we expect it, its costs are
tough to calculate accurately, or the unexpected maintenance which could
include a burst geyser, the removal of a tree struck by lightning, or a
termite problem. Insurance can solve much of this issue, but not everything.
By renting, one can pass many of these unexpected costs on to the landlord.
Obviously this requires that you choose your landlord well.
Rental can also be beneficial to people who risk re-location quite
frequently. Despite February's reductions in transfer duties, they can still
be quite significant the further up the price ladder one climbs, along with
commissions and other fees. Frequent buying and selling in a market that is
not currently inflating at the rapid rate of a few years ago could see
transfer costs wipe out capital gains. Property ownership, compared to
shares, requires less frequent buying and selling because of higher transfer
costs.
The greater flexibility in terms of re-locating that rental property can
provide is obviously subject to the length and terms of one's lease.
One also needs to consider the cash flow implications of monthly debt
repayments on an owned house versus those on a rental property. While rental can
be a better option in the short term with regard to cash flows (on many
properties, market rentals are less than monthly bond repayments at the start of
the loan term), ownership could possibly be the better longer term option.
Take a look at the following hypothetical example where a person has the
make-believe choice of either buying or renting the same house. Let's say that
the gross income yield on the property is 8%, in other words annual rental
income from the property would be 8% of the value of the house. A further
hypothetical assumption for the sake of the example is that operating costs of
the property would be 3% of value. Assume also that prime rates average 12% for
the 20-year bond period and that the client pays prime minus 1%, i.e. 11% on
average.
Now assume that capital value of the property rises by 7% per annum, as does
rental and operating costs. For the property owner, the bond repayment in this
hypothetical situation doesn't rise over time. While in real life short up and
down cycles in interest rates make this unrealistic, but in the very long term
interest rates need not necessarily go up and up such as is normally the case
with rentals and operating costs, which vaguely track the country's general
price inflation and generally keep rising.
With rentals not covering the monthly bond repayment early in the 20-year
period, one may be tempted to go for the rental option. Each to their own, but
remember that there is the chance that one may be paying more in the latter
stages of the 20-year period when renting, as the hypothetical situation
depicted in the graph above suggests. The owner only has to deal with annual
increases in operating costs. The tenant, on the other hand, has to deal with
rising rental costs each year, and under the above set of assumptions, he begins
to pay more than the owner's total bond and operating costs in year 13 in this
specific example, while he will also end the 20-year bond repayment period not
owning an asset.
IN SUMMARY
This article deliberately makes no recommendations as to whether one should
fix interest rates or not, or whether one should buy property as opposed to
renting. The reason is that everyone has a different financial situation, a
different risk appetite, and different priorities. Its goal was merely to
suggest certain factors that should be taken into consideration when deciding
between some important alternatives.
When considering fixing interest rates, be honest with yourself regarding
your appetite for risk, how much "shock treatment" your finances allow, and
calculate by how much and how fast your floating rate would have to rise for the
fixed rate to become the better option in terms of actual repayment value. If
you are a new entrant to the market, buying well-below your means limit can
enable you to set your monthly repayment well-above the required rate to
eliminate much of the cash flow uncertainty caused by rate movements. Finally,
if you are considering renting during these uncertain interest rate times, weigh
up the near term benefits in terms of greater cash flow certainty and smaller
monthly payments (compared to the full bond holder) when renting against the
benefits of ownership, which include the ultimate possibility of fully-owning an
asset of great value once you are debt free.
Also, there exists the possibility that a few years down the line your rental
payments may exceed bond and operating cost payments. In other words, it is
possible that renting can be more attractive in the short term, but with longer
term disadvantages relative to ownership.