It surprises me how easily my friends will buy a new car but dread the purchase of property.
These days, at least where I live, a normal family sedan like a Mercedes C200 costs the same as a good investment property, only the one depreciates at a rapid rate while the other one slowly makes you rich!
When I’m using the term Investment Property, for the purpose of this article, I am referring to a residential property that will be let out to long-term tenants.
Let’s discuss some real life numbers
As the title states, salaries pay bills and property builds wealth, and I can truly attest to that. But what exactly does that mean?
Simply put, you need a salary or at least some sort of income to sustain your lifestyle, but one very important benefit an income gives you is the ability to finance property, normally with a very small down payment of about 10%.
Property trends differ all over the world, so you will need to do some research into your local property market to analyze its growth rate, but where I am, property generally grows in line with inflation or even a little bit above that, in the range of 7%-10% per year. Now, let’s say I am purchasing a property at a cost of R1m (about US$50,000). This will currently get me a 2-bed, 2-bath townhouse with a garage in a good neighborhood. I have to put 10% down, so that is R100,000 ($5,000) and I have once-off property transfer fees and taxes of another R50,000 ($2,500). That puts my initial investment at R150,000 ($7,500).
In addition to this, I now have a bond of R8,500 per month ($425) on a 20-year mortgage, as well as levies and rates at another R2,500 per month ($125), brining my total monthly expenses to R11,000 ($550). My rental income in year 1 will offset most of this as I can get R8,000 ($400) per month for my property, so I’m only R3,000 ($150) out of pocket, every month for year 1. At the end of year 1, my property’s value grows by 10%, so now it’s worth R1,1m ($55,000), that is R100,000 growth ($5,000) in year one on my initial investment of R186,000 (R100,000 deposit + R50,000 fees + (12 x R3,000)), a stellar 53% return!!
Come year 2 and my rental income has now gone up by 10% to R8,800 per month, leaving me with only a R2,200 monthly shortfall, while my property grows another 10% in value on it’s new starting value of R1,1m. This year, my investment is only R26,400 (R2,200 x 12 months), while my annual return is R110,000, over 400%! Year 3’s return goes up to 750% for the year, and after year 4 the property is entirely paying for itself, that is the bond, levies and rates, and now I have an asset that someone else is paying off.
If you now start to be a little bit clever here and increase your bond payments by the amount your annual rent is increased, you will bring your payment term down to 12-13 years, meaning the property is paid off in only 12-13 years during which time your property’s value has more than doubled.
Your total investment, made up of your initial investment and carry costs stands at R232,400 ($11,620), let’s round it up to R250,000 ($12,500) to account for any small variations, while your paid off property has a market value of anything between R2,5m – R3m ($125,000 – $150,000) after 12 years. At a R3m ($150,000) valuation, that property has literally given you back your initial investment of R250,000 ($12,500) 12 times, once a year for every year that you have owned it, an annual return of 100% for a total of 1,200%.
In conclusion
Buy property! But one very important theme to note here is that I did not go out and buy a property for all-cash of R250,000, but rather, I used my R250,000 to leverage my investment and buy a property of R1 million. Why is this important? Because 10% growth on R1m is more than 10% growth on R250,000, and when compounding starts to come into play, it completely changes the game. It’s as simple as that.
A quick example to round this off
If I had purchased a piece of vacant land for R250,000 all-cash (I have actually done this in the past), and it grew at the same 7% – 10% annual growth rate in value, after 12 years my R250,000 would be worth R600,000 – R800,000. Not bad, right? Read on..
The other caveat with vacant land is that I cannot really rent it out, there’s no value to it, meaning I am stuck paying the levies and rates out of my own pocket for the entire 12 years. Let’s assume a similar R2,500 per month (as vacant land is, for some reason, charged more than land with a building on it). That puts me at R30,000 per year carry cost or R360,000 over 12 years, meaning my total investment stands at R610,000 (R250,000 + R360,000), pretty much the same as what my property is worth on the lower end of the scale, placing my growth rate over 12 years at 0%.
Should my growth have been a consistent 10% per year, my total return is a mere 30% over 12 years for an average of 2.5% per year, less than my current inflation rate of 7%, which means in real terms, I am actually poorer off than when I started.
The name of the game – LEVERAGE that puppy!