Property is a must for any investment portfolio. Property historically has been the second-best-performing asset class, after shares.
You may not be aware of it, but if you are a member of an occupational retirement fund, as much as 20 percent of your retirement savings are likely to be in property investments.
You can invest in property in many ways, involving fairly low-risk to very high-risk investments – and the latter include scams.
The recent implosion of numerous property syndication schemes (of which Sharemax has been the most high profile), with the consequent loss of hundreds of millions of rands to investors, has shown just how risky some property investments can be. The collapse of the BlueZone property syndication revealed a plethora of improper behaviour, from inappropriate valuations to massive mis-selling, mainly to vulnerable pensioners.
Your home, a holiday home, and even timeshare and fractional ownership are not really investment choices. They are mainly lifestyle choices, because you are seeking to enhance your quality of life rather than financial enrichment. For this reason, they are excluded from our list of ways to invest in property.
Any capital growth on your own home is likely to be cancelled out by maintenance costs and, probably, interest payments. Many people do realise a cash return (not necessarily a profit) if they downgrade, say at retirement or when their children leave the nest, and purchase a smaller home.
To calculate whether or not you have made a real profit on your home, take the sale price and subtract the purchase price, as well as improvement and upkeep costs, interest and inflation; it is not just a matter of sale price less purchase price.
Although buying property, directly or indirectly, for leisure purposes is a lifestyle decision, this does not mean you cannot make a profit on a holiday home – you could profit if you rent it out when you are not using it. But holiday homes are typically seasonal affairs. On top of this, the holiday home market is normally one of the more volatile sectors of the property market, because it is likely to be the first sector to be affected by a downturn in the economy.
Even if you do make a capital gain on your holiday home, it is more than likely to be cancelled out by the costs of upkeep.
Timeshare cannot be considered an investment by any means – it is merely a way to book and pay for holidays in advance, with the very high risk that you will be ripped off, particularly if you buy into one of the points timeshare schemes. It is far better to buy into a physical timeshare development and then to join holiday exchange group RCI if you want to stay at other resorts.
Buy-to-let is a favourite way to invest in property, particularly when the market is booming and interest rates are low. But buying to let is also how many people get into trouble when investing in property, because they do not understand the risks. However, if the risks are accounted for and the investment is properly structured, buy-to-let is a sound investment choice.
Buy-to-let can include commercial, industrial and residential property.
Andrew Golding, the chief executive of the Pam Golding Property Group, says that when you buy to rent, particularly in a new development, it is important to undertake a due diligence investigation of the developer and/or the development. This includes checking the developer’s credentials and the documents that detail the nature of the development.
The location of the development is an important consideration, not only for resale purposes but also because of the lending policies that banks apply to different areas, Golding says.
You should also ensure that there is sufficient financing to complete the development, he says.
The main advantages of buy-to-let are:
* Someone else (your tenant) is paying off the property on your behalf;
* Losses, at least in the first three years, can be written off against tax; and
* You can make capital gains on, and receive rental income from, the property.
The main risks of buy-to-let are:
* Liquidity risk. If you need cash urgently, you may not be able to sell the property quickly or you will be forced to sell it for less than you want.
* Interest rate risk. People who purchase a property when interest rates are low often take little account of the fact that interest rates move in cycles and that a significant increase in interest rates could make it difficult to repay the loan.
* Rental risk. A tenant may not pay the rent and you could face legal costs in attempting to evict a non-paying tenant. Golding also warns that low interest rates can lead to an over-supply of rental property, making it difficult to rent out a property or achieve the rental you anticipated.
* Tax risk. Much of the capital gains on a property in nominal terms come from inflation. It is the nominal return that is taken into account when capital gains tax (CGT) is calculated. In other words, you are being taxed on inflation. And remember, you have to pay tax on any net rental income.
* Hassle factor. You are responsible for finding tenants, maintaining the property and ensuring that the tenant does not fall foul of the body corporate’s rules (in the case of sectional title). If you use a letting agent, you can expect to pay the agent 10 percent of the rental income.
2. PROPERTY DEVELOPMENT
Residential, commercial and industrial property is developed both for resale on completion and to earn rental.
Donald Trump is one of many people who have become exceedingly wealthy by developing property, but the development road is also littered with casualties, many of whom have lost their all.
Property development requires a great deal of expertise in property markets and construction.
Golding says that developing a property enables you to control the design of the end product, which can make it easier to sell.
Whether you are planning to build a small block of apartments or develop a golf course, the risks are significant. They include:
* Increases in interest rates or the withdrawal of financing. The recent global recession was led by a property market collapse in which mainly American banks had given home-buyers very easy access to home loans. When the defaults started, the banks pulled back on all their lending. Property developers faced serious challenges and many went bankrupt.
Higher interest rates also normally result in a slowdown in sales, which means that you may have to hold onto a property for longer than you anticipated. So, although interest rates may have been low when you embarked on a property development, you could still be financing the project three or four years down the line.
* Increases in building costs. Remember the adage that when building you should plan on its costing twice as much and taking twice as long as you anticipated. Not planning for this may cause you to either borrow more from a bank (that will charge you more interest) or sell an unfinished project at a loss.
* A downturn in the property market, resulting in lower property values and/or higher holding costs until the property is sold. You need to understand what drives property markets so that you time your development to be completed when markets are booming. This means, for example, that you need to buy undeveloped land at a low point in the property price cycle.
* Disputes with building and other contractors. Conflict can result in the project falling behind schedule and in high legal costs and further delays in bringing your property to market. You need to know exactly with whom you are dealing and ensure you have proper contracts in place.
* Legal and regulatory issues. These can range from a change in the legislative environment that may affect the property cycle – such as the introduction of, or an increase in, CGT, to changes in town planning regulations. The increasing attention to “green” issues and the requirement that an environmental impact study be undertaken before a development will be approved have upset many a developer’s plans. If you do not have a sound understanding of property law, you must employ a lawyer who does.
And you should expect delays when it comes to obtaining approval for your plans. Property developers around the country are becoming increasingly frustrated by the lengthy delays in granting approval for plans.
* Unexpected structural defects can result in a substantial reduction in profit margins.
If, despite the above risks, you still expect to make a good return on a property development, you can proceed knowing that even in a worst-case scenario, where the bottom falls out of the market, you will not lose money.
3. COLLECTIVE INVESTMENT SCHEMES
The most hassle-free way to invest in property is through a pooled, or collective, investment. This means that you and numerous other people club together and buy a portfolio of properties, thereby reducing the risk should something go wrong with any one property.
The advantages of pooled investments include:
* Your risks are reduced, because you are investing in a number (a pool) of properties.
* You avoid the hassle of dealing with tenants and collecting the rental. Professional property management companies attend to all aspects of your investment, from maintenance to rent collection.
* Your investment is liquid in most cases; you can invest and disinvest at will.
* They enable people who do not have the significant amounts of money required for direct property ownership to invest in the property market.
A word of caution: a property syndication is also a pooled investment. This shows that collective investments come in many different forms with different levels of regulation and therefore risk.
The best-regulated property collective investments are those that fall within the ambit of the Collective Investment Schemes Control Act (Cisca).
Bert Chanetsa, the deputy executive in charge of investment institutions at the Financial Services Board (FSB), says that a property investment must be registered as a collective investment scheme with the FSB before it can be marketed as such.
Some sponsors of property syndications claim that their schemes operate in ways that are similar to collective investment schemes. But Chanetsa says he is concerned by such claims. “This is misleading and potentially harmful to investors.”
He says that property syndications are not collective investment schemes approved in terms of Cisca.
Chanetsa says that in terms of Cisca, a collective investment scheme, whether invested in property, shares or bonds, must meet certain requirements. These include:
* The investment must be held in trust by an independent custodian, which must be approved by the FSB.
* The investors own the underlying investments. When you invest, your money is held in your name by a custodian. The custodian oversees the activities of the portfolio manager, who must invest your money in accordance with the terms of the investment mandate set out in the trust deed.
* Investments may invest only in security port-folios, in accordance with the parameters set out in Notice 1503 issued in terms of Cisca. For example, portfolios are limited to how much they may own of an underlying investment. These restrictions ensure that the risk is spread.
* Portfolio valuations are determined by the markets. For example, a collective investment scheme that invests in property is required to have its participatory interests (underlying investments) listed on the JSE. This ensures daily market pricing and liquidity (you can buy and sell your units daily).
* A scheme must pass on to investors all the dividends and interest it earns. The scheme may pay capital to investors only when they sell their units.
* Capital growth within a portfolio is determined by the value of the listed unit from the day you purchased the units and the price on the day you sell. The price is set by combining the values of the underlying investments, which in turn have been set by the market – not by any one or two individuals.
* Costs are limited, mainly due to competition. All costs must be disclosed. Funds must publish what are called their total expense ratios, which provide guidance on their total costs. The charges are calculated as a percentage of the value of the assets. Commissions paid to advisers are normally three percent upfront, or between zero and one percent initially and then between 0.5 and one percent annually.
* Investments are subject to both CGT and income tax. The conduit principle applies. This means that CGT is triggered when you sell your units. Income tax is paid annually on any interest and net rental income you may receive at your marginal rate of taxation, less any tax exemptions.
In the Cisca property sector there are:
* Unit trust funds that invest partly or almost entirely in property shares;
* Exchange traded funds (ETFs) and property unit trusts (PUTs), which are securities listed on the JSE that invest in property companies; and
* Mortgage participation bonds, which enable investors to lend their money to people who want to invest in property or who are involved in property developments.
The next point will discuss unit trust funds and ETFs; see point 10 for more information about participation mortgage bonds.
4. UNIT TRUSTS AND ETFs
As of December last year, 24 property unit trust funds, including one ETF, but excluding the PUTs listed as securities on the JSE, were registered as collective investment schemes.
For a unit trust to be classified in the domestic real estate sub-category, at least 50 percent of the fund must be invested in property shares.
Many unit trust funds that are classified in other sub-categories, particularly the domestic asset allocation sub-category (flexible and prudential funds), also invest in property, as do income funds, which are classified in the domestic fixed-interest varied specialist sub-category.
A fund manager selects the property shares in which the fund invests and the proportion of those shares that the fund will hold.
You can purchase units either directly through a management company or indirectly through a financial adviser.
Exchange traded funds
An ETF tracks an index that reflects a stock market or a sector of a stock market. The ETF buys shares in direct proportion to the shares that comprise that index. As such, ETFs are also called tracker funds or passively managed funds, because fund managers do not try to select the shares that they believe will perform well. As a result, the costs of an ETF are lower than those of an actively managed unit trust fund.
Mike Brown, the chief executive of specialist ETF linked-investment services provider company www.etfSA.co.za, says that ETFs, unlike unit trusts, do not have to hold five percent of their assets in cash to cover investor withdrawal demands, because all ETFs trade on the JSE, which provides instant secondary market liquidity.
Currently, there is only one property index-tracker: the Proptrax ETF. It tracks the FTSE/JSE Listed Property index, which consists of the top 16 listed property companies and property loan stock (PLS) companies on the JSE, weighted by their market capitalisation (the number of issued shares multiplied by the share price). The higher the value of its shares, the higher the proportion of the index allocated to a company.
Proptrax has a history of paying high distributions (an annual average of 9.5 percent over the past decade), Brown says.
If you reinvest the distributions, you can capitalise the income, which, added to the capital growth in the value of the companies in the Proptrax portfolio, makes Proptrax a very competitive investment, Brown says.
You can buy Proptrax ETFs through either a stockbroker or directly through www.etfSA.co.za
5. PROPERTY UNIT TRUSTS
A PUT, which issues what are called participatory interests, should not be confused with a unit trust fund that invests part or most of its assets in stock exchange-listed securities.
Leanne Parsons, the head of equity trading at the JSE, says a PUT is one of four types of property entities, excluding property ETFs, that may be listed on the JSE. The other three are property holding and development companies, PLS companies and real estate investment trusts (Reits). All four entities are listed in the real estate sector of the JSE.
All four options give you the opportunity to invest in a diverse portfolio of properties without your having to manage the properties, Parsons says.
Your investments are liquid, because, unlike with directly owned property, you can trade the four instruments on a daily basis.
Parsons says a PUT generates value for investors in two ways: through rental income earned by the properties in the portfolio and through the appreciation in the value of these properties over time.
Investors in PUTs therefore receive a share of the portfolio’s rental income in the short term, while the value of the units themselves increases in the longer term, mainly because of the rising value of the properties in the portfolio.
The features of PUTs include:
* A PUT may invest in immovable property (both local and foreign), the shares of property companies and other PUTs in foreign countries.
* Cisca stipulates that PUTs may borrow up to 30 percent of the value of the portfolio.
* PUTs are trust-based structures. They are highly regulated in terms of Cisca and the Securities Services Act. They are also subject to the oversight of the FSB.
* Unit holders have effective direct ownership of the fund and its underlying assets.
* The units are held in trust by custodians, but management companies are responsible for the day-to-day operation of the properties, lease management and the investment strategy of the trust.
* PUTs are purchased with lump sums, and you must buy a minimum of one share as is the case with shares in any other company listed on the JSE. You cannot purchase PUTs with a monthly debit order as you can with a property unit trust fund.
* Only the income retained by a PUT is taxed in the hands of the PUT. Like any collective investment scheme, a PUT is subject to the conduit principle. In other words, both CGT and income tax are paid by the investor. Any income, as it is generated mainly as rental income, is treated as interest and is taxed on an annual basis. CGT applies when you sell your units.
As of November last year, six listed trusts, with a total market capitalisation of over R24 billion, were listed on the JSE.
The prices of listed PUTs are quoted on the JSE and are published in the pages of most daily newspapers, under the “real estate” sector heading.
6. PROPERTY LOAN STOCK COMPANIES
PLS companies invest solely in property. They generate returns for investors from rental income, trading profits and, in some cases, the administration and brokerage fees that are generated by the PLS management companies. This form of listed property investment is the largest available to local retail investors. In November last year, 17 PLS companies, with a total market capitalisation of over R100 billion, were listed on the JSE.
Parsons says the main difference between PLS companies and other JSE-listed companies is the method whereby the owners fund the PLS company.
When you purchase a linked unit in a PLS company, it consists of part share and part debenture (or loan). The capital structure of a PLS company is comprised mostly of debentures. The structure is normally 99.9 percent debenture and 0.1 percent equity.
The debenture (loan) portion of the linked unit earns interest at a variable rate.
The interest comes from profits, which the loan stock company derives from the rental streams from the properties in which the company invests.
PLS companies have unlimited gearing. In other words, the company may borrow as much money as it wants to invest in immovable property.
The conditions and terms of the debentures, including the rate of interest payable and the repayment dates, are governed by the debenture trust deed.
Independent trustees are appointed to look after the interests of debenture holders.
You can invest in the listed linked units via a stockbroker.
Parsons says that PLS companies, and property holding and development companies are subject to the Companies Act and the JSE's listing requirements, as well as their own articles of association.
A PLS company may have a separate management company, but this is not compulsory.
PLS companies normally distribute all their profits, mainly through debenture interest, with the balance paid out as a dividend.
Distributions are paid as often as quarterly and, at the very least, twice during each fund's financial year.
PLS companies can distribute most of their profits pre-tax. This means that investors are liable to pay tax on any interest in excess of the exempt amount at their marginal tax rate.
PLS companies are subject to CGT on the disposal of immovable property, as well as on the disposal of any linked units in which they may be invested.
Parsons says PLS companies provide investors with the opportunity to invest in a diverse portfolio of properties without having to manage the properties themselves, while investors receive a steady cash stream that is tax-transparent.
She says PLS companies are suitable for investors with a long-term investment horizon who require income returns from their investment.
7. PROPERTY HOLDING AND DEVELOPMENT
Property holding and development companies make up most of the companies listed in the real estate sector of the JSE.
They are like any other listed share. The directors decide how much money the company should borrow, the properties in which the company will invest, and whether to build a portfolio of properties to earn rental income or to develop property for resale.
When you invest, you take all the risks that you would take with any other company listed on a stock exchange. You need to take account of things such as the level of debt, the price-to-earnings ratio, the composition of the portfolio and external influences, such as the state of the property market.
Profits are distributed as dividends, with the company paying income tax on net rental income. The dividends are currently tax-free, but, with the imminent implementation of dividends tax and the scrapping of secondary tax on companies, tax will be deducted from your dividends by the company.
Property holding and development companies are subject to the Companies Act and the JSE’s listing requirements, as well as their own articles of association.
The 12 property holding and development companies on the JSE will soon be joined by another major player, Old Mutual, which has announced its intention to list a R12-billion property portfolio early this year. This will make it the third-largest listed property company after Growthpoint and Redefine.
Ben Kodisang, the managing director of Old Mutual Investment Group Property Investments, says the intention is to make the company the dominant player in the sector by 2015.
8. REAL ESTATE INVESTMENT TRUSTS
Reits are real estate ownership/investment structures that pay the income they generate to investors. The income is taxable in the hands of the investor.
Reits invest primarily in, or derive most of their income from, real estate. This is what both PUTs and PLS companies do, with the major differences between the two being:
* PLS companies have no limits on borrowing and are not subject to collective investment scheme legislation. CGT is paid by PLS companies on their property trades.
* A PUT, which is closest to an internationally recognised Reit structure, is subject to both borrowing restrictions and Cisca. Capital gains are taxed in the hands of investors, which means that investors pay CGT at their effective rate of CGT, less any exemptions.
The tax structure is to the advantage of taxpayers, because the rental income is not taxed in the hands of the Reits. The conduit system applies, with income tax payable in your hands at your marginal rate less the exemptions on interest earnings.
In many countries, Reits are the main vehicle for investing in property, combining the best aspects of listed property companies and collective investment schemes.
Currently, the JSE-listed Reit universe may consist only of foreign Reits that are dual-listed on the JSE, because South Africa does not have Reit legislation. There is one Reit listed on the JSE: Capital Shopping Centres Group plc, which is subject to Reit legislation in the United Kingdom.
Parsons says the JSE must be satisfied that a company or instrument satisfies the JSE’s listing requirements, as well as any other legal obligations, before it can be considered for listing.
She says the National Treasury and the FSB are working on drafting Reit legislation so that local property entities can either convert to Reits or establish themselves as Reits (or for whichever structure the legislation is created).
In a paper on the subject, the National Treasury said that all property investment vehicles have similar objectives, namely providing a “simple, quick and safe way to invest in property, enhancing liquidity for the investor, while providing a fairly predictable income stream to the investor with capital growth and the investment”.
The treasury says it is reviewing the Reit structure for application in South Africa for two reasons:
* The current fragmented property investment landscape is only partly regulated. The review also entails relaxing or redesigning some of the regulatory requirements that are “too restrictive and not internationally competitive”. The fragmentation creates investor uncertainty, particularly for foreign investors, who hold a mere one percent of the total shareholding in the sector. A Reit structure would encourage foreign investment.
* The inconsistent tax treatment of property investment vehicles.
Chanetsa says proposals for Reit reform are still a work-in-progress.
“Together with the National Treasury and in consultation with the South African Revenue Service, the FSB is looking into ways of breathing life into the corporate form of a collective investment scheme for purposes of Reits.”
He says that an open-ended investment company (OEIC) structure was introduced in 2003 at the urging of the collective investment schemes industry, but to date there have been no takers.
However, he says, it seems there is still an appetite for the corporate form of a collective investment scheme aimed at Reits.
“In this context I can confirm that we are currently investigating the efficacy of a close-ended investment company (CEIC). Key questions include permissible activities for CEICs, as well as tax considerations/dispensations,” Chanetsa says.
An OEIC, such as a collective investment scheme, allows for shares/units to be created and destroyed on demand, with the price established by the value of the underlying investments. A CEIC offers a predetermined number of shares/units, with the price of the shares determined by demand for the shares/units.
There is also a difference of opinion between the Association of Property Unit Trusts and the Property Loan Stock Association about whether a single Reit structure for both is required.
9. LIFE ASSURANCE INVESTMENT PRODUCTS
Life assurance investment (endowment) products offer a range of underlying property investments, from balanced portfolios that invest in the main asset classes, including property, to portfolios that specialise in property and even in sectors of the property market, such as Liberty Life's hotel portfolios.
Life assurance investment products are pooled investments, but they are not subject to Cisca.
The main differences between a collective investment scheme and a life assurance investment are:
* You own the assets of a collective investment scheme, whereas a life assurance company owns the assets it buys with your investment. The life company offers you a predetermined outcome, such as the returns on a property portfolio. To ensure that the company can deliver on its “promise”, it must hold what are called capital adequacy reserves.
* A life assurance investment is contractual. The contract is based on your investing for a fixed term, with a minimum of five years. If you stop paying or reduce your premiums, or withdraw your money before the date of maturity or because of death, you can, as from January 1, 2009, be subject to a penalty of up to 15 percent of your investment. Before January 1, 2009, the penalty was up to 30 percent.
The penalties are applied even if you find yourself in financial difficulties through no fault of your own, such as being retrenched.
There are no contractual terms to a collective investment. You can increase or decrease your contributions, or withdraw your entire investment, at any stage without incurring a penalty.
* The life assurance company pays income tax on your behalf at a rate of 30 percent on all net rental income and interest earned by the portfolio, and at a rate of 7.5 percent on all capital gains. You receive the benefits tax-free at maturity. With a unit trust fund, you pay tax on the net rental income and interest in the year it accrues at your marginal rate of tax, less the interest exemptions. You pay CGT when you cash in your units, again less exemptions.
* A life assurance investment may offer a guarantee on your capital and/or your returns, but the guarantee will come at a cost. A collective investment scheme cannot offer a guarantee.
10. PARTICIPATION MORTGAGE BONDS
Participation mortgage bonds (also known as part bonds) have been a stable and, more often than not, low-risk investment option that provide a steady income stream. Not surprisingly, they are particularly appealing for pensioners and conservative investors.
Essentially, part bonds are a way for investors to lend money to people who want to invest in property through a third party, normally a financial institution or a specialist company.
Compared with other investments, part bonds provide you with a higher-than-average income and capital preservation.
John Field, the chief executive of part bond administrator Fedbond, says the third-party administrator provides the conduit for investors to lend money and for borrowers to buy property. The administrator manages loan applications from borrowers and administers the properties.
Field says the main features of part bonds are:
* Investments are governed by Cisca. Essentially, part bonds are a pooled investment, with numerous investors investing in anything from a single property to a large number of properties - mainly commercial, industrial and retail buildings.
* Part bonds provide a regular income stream. The income is based on the interest rates that borrowers are charged. As with mortgage bonds, the rates vary as prime and home loan rates rise and fall.
Field says the interest can be paid monthly or quarterly, in arrears or in advance, depending on the administrator. The manner in which interest is paid can affect the effective rate of interest you receive. For example, if you receive interest quarterly in arrears, you receive more income than if you receive interest monthly in advance, if the nominal interest rate is the same in both cases. The difference between what the investor receives in interest and what the borrower pays varies from 1.25 percent to 3.25 percent.
* You can invest in property without the huge outlay required to buy a single property yourself. The minimum investment amount is R5 000.
* In most cases, your exposure to risk is low. The larger the number of properties in the portfolio, the safer your investment, because the impact will be limited if one borrower defaults on a loan.
Other factors that lower your risk are:
* The part bond administrator can repossess the property in the event of a borrower defaulting, and if rentals are being paid on that property, the rental flow will go to cover the interest payments.
* The borrower can borrow up to only 75 percent of the value of the property.
* The administrator acts as a gatekeeper when deciding which applicants will receive loans. Loans are granted only after the administrator is assured that the borrower is financially viable.
* By law, properties must be properly valued by a qualified valuator.
* Your investment is held in trust and not by the part bond administrator, so your investment will be protected if the administrator goes bust. The property is registered in the name of a nominee company but is managed – not owned – by the part bond administrator/manager.
* Investments are for a minimum of five years, with only interest paid in the first five years. At the end of the five years, you are required to give three months’ notice if you want to withdraw your capital. You can withdraw your capital, either in full or in part, at any stage after the five year-period. You will continue to receive income on any outstanding capital you have invested.
During the first five-year period, part bonds can be used as collateral for a loan and can be traded.
If you die within the first five-year period, the full capital amount will be paid into your estate.
The part bond manager has the discretion to pay you out within the first five years if you can prove dire financial circumstances. However, the manager may charge you a penalty.
* In most cases, no costs are deducted from your investment. The profits and costs come out of the margin between what the part bond manager pays you, the investor, and the interest paid by the borrower.
If you invest in a part bond through a financial adviser, the adviser will be paid a commission (about one percent), but again, normally the money will come from the lending/borrowing margin and not from your investment amount.
This article was first published in the 1st quarter 2011 edition of Personal Finance magazine.