Buy-to-let is back - What new property investors should know

South Africans are returning to residential property investment in numbers not seen for years, encouraged by stronger rental markets and renewed confidence in property as an asset class.

According to recent ooba Home Loans data, buy-to-let buyers accounted for a record 14% of mortgage applications nationally in January, while more than 30% of applications in the Western Cape were for investment properties. Separate Standard Bank data has similarly put the Western Cape figure at 31%.

The enthusiasm is understandable. Rental growth has been running ahead of inflation, vacancies are relatively tight in many markets, and property remains one of the few asset classes ordinary investors can finance with substantial amounts of long-term debt.

But Renier Kriek, Managing Director of alternative housing financier Sentinel Homes, says a rising market can also attract inexperienced investors who confuse buying a property with making an investment.

“When investor demand runs strongly, the danger is that people begin asking what they should buy before asking what the investment has to achieve,” says Kriek. “A property can be perfectly good real estate and still be a poor investment at the price you are paying.”

If you’ve decided to become a property investor – that is, buy property not to live in, but to create wealth – you need to start in a considered, manageable and measured way. Then, work your way toward the risk efficiencies afforded by a portfolio of property investments.

“This way, you can develop the knowledge, capabilities, and savvy to achieve your financial goals, while learning to reduce the risk of overextending yourself,” says Kriek.

You can dream big, but it’s better to focus on your first investment property, not the fastest route to a high-yield portfolio, which could end in disaster.

First Steps
Your first property is a training ground for the skills and experience you must acquire. Of these, the most important are financing and strategy.

Leveraging (borrowing money) lets you buy more in property value than you could personally afford and enjoy a greater return on equity. However, excessive leverage puts even the best investment in danger. So, a knowledge of finance, including concepts such as return on equity, capitalisation rates, and cash-on-cash return, is indispensable.

Also, consider your strategy. Whether it is buy-to-let, rent-to-rent, Airbnb rental, student housing, a small factory, or a retail unit, each property type carries unique risks and rewards. Most investors settle on the trusted buy-to-let model, but your own strategy depends on your financial goals. 

Strategies like short-term rentals and student accommodation are rapidly evolving and have significant downside risks. As a result, they require additional research and, preferably, expert guidance. Don’t assume you’ll make money on an Airbnb unit in Sea Point just because it has been a winning strategy for the past decade.

Buying several properties too early multiplies the impact of over-indebtedness and a faulty strategy. “Patiently nurturing your first property towards profitability results in confidence to invest wisely and securely in the future,” says Kriek.

Self-Supporting Growth
Many beginner investors buy a property for what they can realize in future capital gains. Yet, they fail to assess how well a property can fund itself in the near future through rental income or another form of revenue.

“A property does not have to be cash-flow positive from day one to be a good investment. But, if you have to cover a R4,000 income shortfall per month, that contribution must be part of the investment thesis, not an unpleasant discovery after transfer,” says Kriek. “Ideally, you should be prepared to cover more than just the shortfall, because there will be maintenance, vacancy, or tenant non-payment at some point in the future.” 

You should research what rental income other houses in an area or apartments in a block are achieving, and consider what their expenses are, to arrive at your net operating income (NOI). If NOI is too low compared to the capital outlay, look elsewhere. Don’t be afraid to shop around—not for low-priced units, but for those that are profitable enough to sustain themselves within 1-4 years from purchase, or ideally from day one.

Know the Numbers
(Profit = rental income − bond instalment) is not a true equation. In fact, there are many numbers involved, and you need to factor them all in before investing. 

They include:

●      Bond repayment: Interest and potential interest rate fluctuations are inevitable.

●      Municipal rates and taxes: Local municipal charges increase every year.

●      Levies: Body corporate or homeowners association fees for sectional title units have been increasing faster than inflation almost without exception for more than a decade.

●      Maintenance reserve: Reserving 5-10% of rental income for ongoing repairs is good practice, as maintenance will always cost more than you expect, and these percentages provide a good buffer. 

●      Vacancy provision: Most people assume they will be the only property investor to never suffer a vacancy, but it’s prudent to conservatively allow for rental loss from vacancies lasting one month per year.

●      Gross rental income: Calculate realistic, market-related monthly rent for the area and property type.

●      Income tax: Net rental income forms part of your taxable income. Earning rental income may also make you a provisional taxpayer, subject to the applicable exemptions. Remember that the capital portion of a mortgage repayment is not deductible, so an investment can be cash-flow negative while still producing taxable rental income.

●      CGT: Capital gains tax can eat a big chunk of your expected profits on a sale.

●      Tax deductions and incentives: Expenses incurred in producing rental income, including qualifying repairs and maintenance, may generally be deductible from income tax. However, capital improvements are treated differently and cannot be deducted like running expenses (but may be accounted for in the treatment of capital gains tax, for instance). There are also specific incentives for qualifying property investments that are not available to other forms of investment. Section 13sex of the Income Tax Act, for example, provides an allowance for qualifying new or improved residential units.

“You have to manage a property investment like a business, considering not just income and expenses, but also cash flow disruptions that create unwanted pressure on your finances,” says Kriek. “And remember that risk management is central to running any business.” 

Put differently: even after building the most detailed forecast model, accept that things will go wrong, and your likely optimistic starting assumptions will not pan out in most cases. This is normal, and you must adjust your posture to allow for this fact.

Funding Your Portfolio
Your first property investment opens the door to your next. By managing costs on a property selected for high rental potential, you increase your rental profits.

These profits help you pay down your bond faster, freeing up equity you can use to secure financing for your next purchase.

“It’s a disciplined approach that helps you develop a sense of timing, which is essential to building a strong and sustainable property portfolio,” says Kriek.

In the long run, property investment is not about what you have in your portfolio, but the kind of investor you become. Your first property, managed correctly, will help you gain invaluable competence for the future.