The illusion that property is a good investment

There’s no doubt that South Africans love property.

In many cases, it represents a major portion of their assets. I agree that many investors have benefited from solid growth in residential property, particularly those who began making real estate investments in the 1980s.

This situation is also typical of my longstanding clients, who recently sold their house in a prominent Cape Town suburb. The house was purchased in 1986 for R800 000, including improvements, and was recently sold for R17.5 million. That is a fantastic return! Or is it?

Both spouses owned the property and have opposing views on how their share of the residue should be invested. After agent commission, capital gains tax (CGT), and purchasing a retirement home, they each have around R4 million to invest.

The husband wants to invest in growth assets through unit trusts, while his spouse wants to buy property to rent out. Who is right?

Before some property investors out there attempt to hang me from the highest tree for being anti-property, I should clarify that I love property and have had a fair amount of success with property investments in the past. However, there is a caveat. Property returns are very area and time-specific, and returns vary widely across suburbs.

Now, let’s examine the profitability of my clients’ property investment, which they have owned for almost 40 years.

At the outset, an investment of R800 000 growing to R17.5 million seems fantastic. But if we do the maths, the annualised return over the roughly 40 years that they owned the property is about 8% growth annually. That is ignoring purchase costs, interest paid on the bond, rates and taxes, maintenance and other expenses associated with property ownership. If all these costs are considered, the annual returns reduce to below 6% per year. It’s hardly a return that sets fireworks alight.

However, one must not lose sight of the benefit and enjoyment they experienced by living in this home and raising their family. It’s very difficult to put a value on this.

The scenario described above applies to purchasing a property for personal use. How then can one turn this situation around into a good investment?

By making use of gearing and getting someone else to pay your bond.

If we look at this property from a different perspective, one where it was purchased as an investment, the figures look much more attractive.

If we assume it was purchased with a 10% deposit, then the initial investment would amount to R80 000 plus the purchase costs etc. Let’s call it R90 000 as the initial capital outlay. If a tenant occupied the property and paid a market-related rental, then within approximately three to five years, the transaction would have changed from a cashflow negative to a cashflow positive situation and tax on the rental income would have become payable.

The long-term rental income would have added to the profitability of the investment, but without a detailed cashflow analysis of the income, expenses, interest rate movements, maintenance, rates and levies etc., determining the precise amount of profit won’t be easy. Using simple math and ignoring a lot of important factors, the return from R 90 000 to R17.5 million amounts to slightly more than 14% per year.

If we consider a rental yield of 3% after tax and other expenses (municipal costs, levies, agent commission, maintenance, etc.) per year, then we should be looking at a return of somewhere between 15% and 20% over the 40-year period in my opinion. That is not a bad return.

The challenge now is, how repeatable is the above scenario, and why am I trying to convince my 75+ year old clients to shy away from the residential property investment with a portion of their residue?

Firstly, unless someone is familiar with and comfortable handling the challenges of managing a rental property and tenants, I wouldn’t recommend that they start dealing with these issues during their retirement years. Having a property agent does not eliminate your responsibilities and liabilities as the property owner, and these can be burdensome.

Secondly, capital invested in a property is illiquid. During retirement, one should maintain a high level of liquidity, and this is not achievable with fixed property. Refinancing property while retired is also very difficult since banks in principle, do not provide bonds to individuals over 65. This means that even the option to bond a property and let a tenant pay for it becomes all but impossible once you are retired.

If you are in favour of property, a good alternative is a real estate investment trust (Reit). The benefit of Reits is that you have full liquidity and a large portion of the return can be paid out regularly in the form of rental income and the income should be stable. Remember that Reits’ returns are taxable and therefore less tax-efficient than equity unit trusts. Over the last 12 to 18 months, Reit returns have improved after dismal returns that were experienced since Covid.

Considering that a simple 60/60/40 split would have given you around 11% per year return over five, 10 and 15 years, is it worth the extra effort and risk especially if you are retired?

What will I recommend to my clients?

Mr Client requires little convincing. He is aware of the growth restrictions, challenges, and often unseen costs of property ownership. He prefers equities with an offshore tilt. This has been the structure of his portfolio for over 20 years and he wishes to maintain it, and I support his desire to keep it that way. Given his age, we will recommend that a slightly more conservative approach is adopted. The intention will be to structure his overall portfolio to somewhere close to 60/60/40 (offshore/equities/local). A more aggressive structure can be justified since Mr Client will be drawing less than 4% income against his portfolio and that he wishes his children, who live abroad, to inherit. We will not include any local Reits in his portfolio.

I will try to persuade Mrs. Client to invest in registered funds like unit trusts and allocate a portion to Reits, rather than investing directly in residential property. A well-diversified medium-equity portfolio should suit her well. The offshore exposure will ultimately depend on how much she decides to draw as income from her investments. Ultimately, she must invest in what she is comfortable with, and I wouldn’t be surprised if she chooses to invest in residential property anyway.

If inheritance was not a high priority for either party, I would have considered suggesting that a portion of the funds be invested in a voluntary life annuity, where tax efficiency would be achieved since part of the annuity payment is regarded as a repayment of capital.

The jury is out on how this will play out. However, everything should be clear within the next four to six weeks.

Stay safe and stay invested.