10. Pros and cons of an investment property
Question
I am thinking of buying some investment properties and using these to provide me with a pension when I get older. It looks good on paper but then there is a spreadsheet and there is the real world. What are the pros and cons of going this route.
Answer
Investment properties can be a great way of building up personal wealth and funding your retirement. I have seen people make a lot of money this way but have also seen people suffer financial hardship when property investments go wrong.
Gearing
One of the big advantages of investing in property is gearing. Here you put down an initial deposit and take out a loan to pay off the property. Any capital growth that you get will be on the full value of the property rather than the relatively small initial deposit. You are therefore gearing up the returns on your initial deposit.
You then rent out the property and use the rental income to pay off the bond. By the time you retire you will have a paid off property that will provide you with a pension.
On the surface this looks like a brilliant concept. An initial deposit has effectively secured you an asset that will pay you an income when you retire. However, as you mention, there is the spreadsheet and then there is the real world. Here are a couple of the downsides that you need to consider.
Active management
Property requires active management. You will have the hassle factor of dealing with broken geysers and automatic gates at inconvenient times. You also have the issue of dealing with tenants who may damage your property. If you want to invest in rental property, you need to be prepared to get actively involved or to hire someone, at a fee, to do this for you.
Your income streams are not guaranteed. There can be issues when it comes to collecting your rent. Many who are reliant on rental income were reminded of this during the lockdown when tenants were unable to pay all or part of their rent.
It is not that easy to evict a delinquent tenant so you need to have a war chest that will cover lawyer’s fees and a couple of month’s rent should you have an issue of nonpayment. You do not want to be in a situation where you default on your bond and rates.
Cycles
Property can be cyclical. I have lived through two “buy to let” booms where the demand for rental property was strong and the capital value of houses increased rapidly. Unfortunately, these booms were followed by crashes where the supply of property exceeded demand and people were stuck with empty townhouses for over a year. Be careful about overexposing yourself. Run a couple of cashflow models under different scenarios. You must be able to survive if you have no rental income for a period.
Pensioners, especially when they get older, can do without the stress of managing property. They also need the certainty of a guaranteed income. Following the lockdown, several pensioners have sold their investment properties and bought life annuities. Annuity rates are attractive at the moment so this is a good time for those pensioners, who want to decrease their reliance on property income, to make a change.
I recently had a case of a 70-year-old who sold his property worth R3m. He bought an annuity that pays him R24 000 a month with an annual increase of 5% each year. The money is guaranteed and will be paid for the rest of his life. He no longer has to deal with delinquent tenants and home maintenance issues.
On the other hand, if you choose to go the route of traditional retirement funding, you will get very generous tax breaks on your contributions. The investment growth will be tax free which is attractive. You won’t have concentration risk of having your investment exposed to just one asset type – property. Your investment will be in a portfolio consisting of equities, property and cash.
So, to summarise, if you want to use property to provide you with a pension, you must be prepared to actively manage the investment. Do not over-extend yourself and make sure have adequate cash reserves to deal handle the non-payment of rental, eviction of tenants and household maintenance. The advantages of gearing and capital growth are certainly attractive. When you get older and managing the property becomes an issue, consider switching out of property and take out a life annuity. Alternatively, you can fund your retirement the traditional way.
Kenny Meiring MBA CFP ® is an independent financial adviser. You can contact him on 082 856 0348 or at Financialwellnesscoach.co.za Please send your questions to kenny@financialwellnesscoach.co.za