I'm a young adult at the age of 30. I have R250 000 cash and I currently have a bond on my house.... I have pre-qualified for an additional R1.5 million home loan.
My idea is to put down a R200 000 deposit on an R800 000 buy-to-let investment property, with R50 000 to go to transfer fees. Then later purchase a third place for R900 000 once I've saved up some money again.
My question is, should I put the deposit down on the house? Or apply for 100% bond and rather put the R200 000 in a unit trust? I feel in the current market situation, a property purchase would be good (property in Cape Town in a steady area with solid growth). But I also don't want to lose out on potential returns of the unit trust.
Lauren Davids, Senior Investment Consultant at 10X Investments, responds:
Please note that we cannot legally offer financial advice without first doing a full analysis of your financial needs; we can merely offer insight and information to help you make your decision.
Although you have asked just one question, there are two aspects to consider:
- Specifically, should you invest R200 000 in a buy-to-let bond or in a unit trust?
- On a related manner, should you be investing in (more) property?
1) We cannot provide a definitive answer to your stated question. It depends entirely on the specific numbers related to the property, in terms of how much debt you can afford to take on and still remain cashflow positive (which is the ideal for a buy-to-let investment).
Ideally, that number will be 100%, as this maximises both the tax deduction and your long-term return from any price appreciation (assuming this will be positive), while also permitting you to invest in a unit trust.
However, in doing this calculation, you need to allow for some margin of error, as the property may not have a tenant all the time. In this case, providing a margin of error would mean paying down some of the bond. Whatever money is left beyond that margin for error can then be invested in a unit trust.
An alternate way of looking at this – more relevant if the choice is to pay down your own mortgage or invest in a unit trust – is to compare your interest cost saving against your potential unit trust return.
We don't know what interest rate you qualify for, but the prime lending rate in South Africa is currently 7%. In other words, by putting down a R200 000 deposit, you save paying interest of R14 000 pa, at 7% pa (if that is what you qualify for). Depending on your marginal tax rate (we don't know, say 30%), you are effectively earning 10% on the R200 000 deposit, pre-tax. You can take that return that to the bank, at least until interest rates change.
They are unlikely to go lower from here, ie if anything your future hurdle rate (the rate of return you need to beat in your unit trust) is going to be higher.
Compare that to what you might earn in a unit trust investment. This depends on many factors: the amount of market risk you are willing to take, the performance of the market/underlying asset classes, the performance of your fund manager, the amount of fees you pay, future inflation and the length of time you hold the investment. Although future returns are always uncertain, and can be highly volatile in the short-term, real (or after-inflation) returns become more predictable or mean-reverting as the investment term lengthens, even if you assume a large degree of market risk.
Let’s assume you invest in a traditional balanced high equity fund. You use an indexing strategy that tracks the market return of each underlying asset class. Historically, such a portfolio has returned around 6% pa above inflation, but that number appears way too high in the context of where we are now. Realistically, 4% pa over the long-term appears a more reasonable and prudent assumption.
Let's further assume you pay low fees (say 1% pa, all in). Let's also assume that long-term inflation over your investment term averages 4.5%, which approximates current inflation expectations discounted in the bond market. In that scenario, your unit trust may earn you a long-term return of 4% real plus 4,5% inflation less 1% in fees, ie 7,5% pa net, considerably less than paying down your bond. Of course, in the short term it could also be much higher, or much lower than that.
If you choose active management instead of index tracking, you are likely to pay more in fees, possibly double, and your return could be higher, although it will likely be lower.
In this scenario, the prudent approach seems obvious.
2) The second (unspoken) question relates to diversification: Should you be investing exclusively in property, or should you diversify? The prudent approach, of course, is to never put all your eggs in one basket. Buy-to-let property investments come with many risks that you are no doubt aware of: your property standing empty for some months, pressure on rental yields in a weak economy, rising interest rates, rising holding costs related to levies, rates, etc, unexpected maintenance costs, advertising cost, transaction costs, illiquid markets etc.
Holding just one or two buy-to-let properties exacerbates your concentration risk even more. One bad tenant can ruin your investment.
So while it may be okay, to hold one or two property investments, representing maybe 10% of a portfolio that is broadly diversified across other asset classes, such as shares, bonds and foreign markets, investing 90% of your savings in one or two properties is a high-risk proposition that is unlikely to provide a commensurate reward.
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