# Listed property vs Buy-to-let: Where should you invest?

With US President-elect Donald Trump on everybody’s lips, our office has been flooded with property investment questions again. Although it is true that Trump made his billions from real estate, our research has found that one is not likely to achieve these returns through the buy-to-let (BTL) property market, which South Africans are obsessed with.

I explain in this article why you would have been better off (with much less risk) investing your money in a portfolio of listed properties on the JSE or through a listed property unit trust investment.

A BTL property investment in this article is a residential property that an investor buys with a small deposit and mortgage from the bank. The investor then gets a tenant to rent it and receives monthly payments from the tenant.

A listed property investment, on the other hand, represents a basket of real estate investment companies listed on the JSE. Examples of listed property companies include Growthpoint and Redefine. Listed property can also be a unit trust investment managed by a property investment specialist.

Measurement used for comparing buy-to-let to listed property

In order to do a comparison between a BTL investment and a listed property investment, we had to build a model and decide on a metric. It was decided the best comparison measurement would be the annualised total return formula (XIRR formula in Excel), as it is a very popular metric in the investment industry.

In short, it calculates the geometric average amount of money earned by an investment each year over a given time period. It is calculated as a geometric average to show what an investor would earn over a period of time if the annual return was compounded. Another reason for this formula is that the cash flows don’t have to be periodic.

BTL parameters

For BTL investments the annualised return turned out to be a bit of a nightmare (as so many other factors associated with this type of investment). First, you have to build a model that takes into consideration many parameters. Below is a list of the most important parameters involved with this article’s BTL investment:

Initial investment value – A R1m investment property was used in the model. The property was mortgaged and a 10% deposit had to be paid. Since the investor did not have the luxury of financing the listed property investment, the listed property investment was started with the same amount as the deposit placed on the BTL property, in other words an initial investment of R100 000.

Interest rates – The average prime interest rate in SA over the last 20 years is just over 13%. The November 2016 FNB Mortgage Barometer predicted the Reserve Bank will leave interest rates unchanged for the time being, and that the repo rate is expected to move sideways through 2017 to 2019. In order to keep it simple, an average prime interest rate of 10% over 20 years was used in the BTL model.

Rental income – An initial rental income of 10% per year of the value of the property was used. According to the Tenant Profile Network, a credit bureau that specialises in vetting tenants for rental properties in Africa, the rent escalation average in SA for 2015 was just below 3%. The rent escalation from 2010 to 2016 however indicates an average of approximately 6.5%. It was decided to use 6% as the annual escalation rate, as it represents the higher end of the Reserve Bank’s inflation target rate.

Property value increase – The Absa House Price Index is based on the total purchase price of all houses (including all improvements) in respect of which loan applications were approved by Absa. The data goes back as far as 1966. According to this index the average size house price (as the one used in our research) has increased by approximately 10% per annum over the past 20 years.

Listed property parameters

Listed property investments are very easy to model as their annualised returns are freely available. The JSE has a total return SA Listed Property Index, which we decided to use as the benchmark for this comparison. In this graph, you can see the annualised total return for this index over the past 12 years (since inception).

BTL compared to listed property annualised returns

The model indicated that the BTL investment, using the parameters above, had an annualised return of almost 18%. The listed property investment had an annualised return of just over 21%.

Listed property therefore outperformed BTL by only three percentage points, which is probably not that drastic. However, the BTL numbers did not take into account and don’t reflect the massive risks associated with BTL investments.

The following risk factors were excluded from the buy-to-let investment model and comparison to listed property:

Non-paying tenants – According to the Tenant Profile Network’s (TPN) monitor for quarter 2 of 2016, nearly 68% of tenants were in the “paid-on-time” category, while 6% paid during the “grace period” and 11% paid late – adding up to a combined 85.08% in good standing. This means almost 15% of the owners of buy-to-let investments did not receive rent at all!

It is worth remembering that the law is on the tenant’s side. Evicting a non-paying tenant is extremely difficult in SA. These tenants can also break the “investment” down and steal all the fittings in the house. The risks are therefore not only a loss of rental income, but also possible damage to your property and the legal expenses you may need to incur in order to evict a tenant legally.

External factors – The risk of rising interest rates that can’t be passed on to the tenant can place the investor in a financial predicament. During 1998 the prime interest rate went as high as 25.5% and as recently as 2008 it rose to 15.5%.

Also, as property investors know, location is key to your investment. An area can become seedy overnight and unlike listed property, which you can sell and realise your return within four days, it can take months to find the right buyer at the right price. With listed property the price is very transparent with bid and offer prices regularly available on the stock exchange trading screens.

Diversification is the only free lunch in investing – Investors think that owning a few BTL investments in different areas provides diversification. In reality they’re all in the same industry and asset class. With listed property your portfolio could be diversified in residential or commercial property; developments or rental; local or offshore; high end or low end.

Rent escalations at an all-time low – The TPN monitor reveals that the national rent escalation average for 2015 was just over 4.5%. During 2016 this has drastically reduced to less than 3% for the first two quarters.

Technical benefits not included in the buy-to-let model

The following potential technical benefits were excluded from the BTL investment model and comparison to listed property:

Working in the industry
– Being involved (as a developer, real estate agent or renovator) in the property industry could lead to investors picking up BTL properties at bargain prices. It could also provide inside information about areas or properties that might surge in future due to certain developments. These advantages could make BTL a worthwhile investment.

Tax efficiency – Investors with a mortgage on their own home can borrow from their BTL property and pay off their own home loan. By doing this they’re shifting their interest expense deduction, which in turn reduces the rental income profit earned, thereby reducing their tax burden.

Undisciplined savers – The BTL investment forces undisciplined savers to save. It’s a fact that the bank will repossess your property if you do not pay every month. With this in mind, investors will make sure they pay their mortgages every month. A debit order on a listed property investment can however have the same effect.

Running the rental property as a business – This comparison did not take into account that investing in rental properties through a company legal structure could offer significant benefits from a tax and expense write-off point of view.

Conclusion

Even if the technical BTL benefits increased the annualised return of BTL to be on par with the listed property investment, it’s unfortunately not enough for me. The inherent risks associated with BTL are just too big. It is also a very illiquid and complex investment with many variables. Unlike listed property, with a rental property you need to be consistently involved, at the beck and call of the tenant. For me it’s a no-brainer – I will never invest in BTL property again.

This is a shortened version of an article that appeared in the 19 January edition of finweek. Buy and download the magazine here.

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