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Questions would-be buy-to-let investors must ask

Personal Finance

Property prices were down 2.5 percent in real (after-inflation) terms in September, compared with a year ago, according to the latest First National Bank House Price Index. And they’re down about 20 percent in real terms since the property boom peaked in 2007, Danie Venter, an advisory partner at Citadel Investment Services, says. Lower prices may present a buying opportunity for investors, because the less capital they have to outlay, the more likely their yields (rental income as a percentage of capital) will be high.

Buy-to-let property seems a fail-safe investment: you use the bank’s money to buy a tangible asset, your tenants pay off your loan, and the interest on the loan, as well as other costs, can be deducted from income tax (see “Expenses you can deduct from tax”, below).

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But, Venter says, every asset class has its risks, and you need to understand them thoroughly before you commit your money.

A property investment has high entry, or initial, costs, including transfer duty, conveyancing fees and mortgage bond registration fees, and it can take years to recover these costs. If you can’t afford the property and are forced to sell before you have recovered your input costs, you will lose money, Venter says. You will lose even more money if you have to sell when the property market is the doldrums.

Here are some of the questions you should ask before you buy an investment property:

 

Do you really know the market?

You need to find out how the buy-to-let market where you intend to buy is faring. National average indices and yields obscure vast differences among regions, metropolitan areas and suburbs. Some rental-payment bands have higher yields and fewer defaulting tenants than others. You need to investigate the yields, rental escalations and vacancy rates in the specific segment of the market in which you intend to operate.

 

Will you be able to cope financially until you reach the break-even point?

With most investment properties, there is a shortfall between the income generated and the expenses, including the mortgage bond repayments. The shortfall diminishes as the rent increases, and eventually you will reach the break-even point, where your income covers all the expenses. You need to calculate how long it will take before you reach the break-even point and ensure that you will have the finances to cope until during this period. Don’t forget to factor in possible interest rate increases and expenses.

 

Will you be able to cope financially if you don’t receive any rental income for a few months?

It is common for a property to be without tenants for at least a few months every now and again, because you cannot find a creditworthy tenant, or your tenants terminate the lease early, or you have to carry out extensive repairs or renovations.

 

Will you be granted affordable finance?

Shaun Rademeyer, the chief executive of BetterLife Home Loans, says that many homeowners who are planning to buy an investment property assume that, because they’re a ‘known quantity’ with a good track record of repaying their home loans, they will be able to secure a home loan for a second purchase on the same terms as the loan granted to buy their residence. However, even if the second property is in an area that the bank considers a good risk, they will usually be offered a higher interest rate, and often asked to put down a substantial deposit (20 or 25 percent of the purchase price), he says.

If the bank thinks the repayments on the home loan used to finance the investment property will be heavily dependent on rental income, the interest rate quoted might be even higher, he says. Consequently, if you want to negotiate a lower rate on a buy-to-let purchase, your should prove that you can comfortably afford the repayments on the new property in addition to your current commitments – and irrespective of whether or not you receive rental income, Rademeyer says.

 

Will you be able to keep up your mortgage bond repayments if interest rates increase?

Interest rates follow the inflation rate, and South African inflation is heavily influenced by movements in the rand: the weaker the currency, the higher our inflation rate, Venter says.

Venter says a friend took out a loan of R1.5 million on an investment property. When interest rates were 8.5 percent, her monthly payment was R13 000, but after interest rates rose to 10.5 percent in March this year, her monthly repayment increased by R1 950 a month.

Although investors can pass higher home loan costs onto their tenants, they usually cannot do this immediately, because most leases are renewed annually, he says.

Venter says we can expect a certain amount of imported inflation in the wake of recent rand weakness, because South Africa is a net importer of goods and services. The inflationary outlook is not promising, and Citadel expects inflation to remain at higher levels.

Another key risk is how a downgrade of the country’s debt to junk status will affect interest rates. Venter says this is a difficult question to answer. Some argue that the impact will be minimal, because 75 percent of South Africa’s sovereign debt is in rands, not United States dollars. But fundamental economics teaches that a downgrade results in bonds being perceived as more risky, which, in turn, results in higher interest rates.

However, higher interest rates may not be all bad news for property investors, because they deter aspirant homeowners from buying, so there is more demand for rental accommodation.

 

Will you be able to absorb higher rates, utilities and other expenses?

Venter says that, in recent years, municipal costs have significantly outstripped headline inflation. You also need to factor in levies, managing agent’s fees and maintenance and repairs. Again, these hikes cannot immediately be shifted to a tenant, and the owner has to be able to absorb the increase for a period of time.

Also bear in mind that, in a poor economic environment, your own income might fall, or not increase in line with inflation, which will compromise your ability to subsidise the rental property, if that becomes necessary. A weak economy also puts pressure on tenants, so landlords cannot impose high rental increases.

 

Do you have a cash reserve to cover unforeseen expenses?

In most cases, the lease obliges the landlord to carry out repairs. If damage prevents the tenant from having full use and enjoyment of the property, you will have to make good in order to honour your side of the agreement, Venter says. If your property is in a sectional title scheme, you may be called upon to pay special levies for repairs and maintenance on the common property.

 

Do you understand the regulatory environment?

Tenant-landlord relations are governed by a number of laws, such as the Rental Housing Act, the Consumer Protection Act and the Prevention of Illegal Eviction from and Unlawful Occupation of Land Act. These laws tend to favour tenants. If you buy a sectional title property, you, as the owner, will have to fulfil financial and other obligations in terms of the Sectional Titles Schemes Management Act and the Community Schemes Ombud Service Act.

 

Many people have successfully managed the risks associated with buy-to-let investing and earned a good return on their capital over the long term. You can too, provided you do your homework and ensure that your finances are sufficiently robust to withstand any potential shocks.

 

EXPENSES YOU CAN DEDUCT FROM TAX

Jan Davel, the managing director of RealNet estate agency group, says property investors can deduct the following expenses from their gross rental income to reduce their tax liability:

* Municipal rates and taxes;

* The interest on the home loan used to buy the property

* Sectional title levies if applicable;

* Any advertising costs paid to find new tenants;

* Any fees or commission paid to a managing or letting agent;

* The annual homeowner’s insurance premium;

* The cost of security and garden services; and

* The cost of repairs and maintenance needed to keep the property in good condition.

Davel says that expenditure of a capital nature, including the purchase price of the property and the cost of any additions or improvements, cannot be deducted from the rent. However, they could be added to the base cost of the property for capital gains tax purposes.

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