By John Roberts
PROPERTY investment can be complicated, but a sound property strategy is a vital component of a well-rounded portfolio. One way for growing that portfolio is a process known as ‘gearing’ – specifically leveraging the first property to acquire a second investment property.
Anyone entering the property market for the first time takes into consideration several essential aspects. Principal among these is whether they are prepared for the investment and responsibility that accompanies home ownership, followed fairly swiftly by the research to establish available options, neighbourhoods and restrictions imposed by financial limitations.
There is the underlying realisation that home ownership is a major commitment not entered into lightly and that property acquisition affects financial well-being both immediately and for the foreseeable future.
The same considerations come into play for investment properties. An initial foray into second property purchasing means not making a rash decision, since the long-term nature of property can see buyers paying heavily for an ill-conceived purchase.
Taking the time to build a solid foundation of knowledge will pay those long-term dividends and enable investors to confidently acquire their first rental property … and their second, third and fourth.
Gearing is therefore the method used to acquire a second property by using the first one as a stepping stone. South African taxation allows investors to write off certain expenses incurred by the investment property against the income accrued from the rentals.
Those expenses include the interest on the bond repayments (note it is only the interest and not the percentage of the monthly repayments credited to the capital); municipal levies, rates and taxes, as well as legitimate maintenance, but not upgrading. Hence, the business model means having no or a limited bond on the primary residence, where there are no tax benefits to holding a bond, and maximising the bond on the investment property.
The codicil is that in using the residential property as the security against the investment property, investors stand the risk of losing both homes should the deal turn sour, specifically if you cannot meet those dual bond repayments.
It is therefore critical to have a strong contingency plan as a safety buffer that can potentially tide over the repayments and living costs for three to six months should that need arise.
The second property should then be geared to allow for the purchase of a third. This becomes effective when the capital repaid on the second property has been reduced to the extent that the rental income exceeds the tax deductable expenses and the property now accrues taxable income.
Before that point has been reached, investors need to realise that acquiring a second property even if through gearing, will have a significant impact on the monthly cash flow. This means taking into account having the financial stability to service both bonds and the associated costs of home ownership.
The next element for consideration is the rental income that can realistically be achieved from that property. When compared against the expenses incurred on the property – bond repayment, rates, levies and taxes – it reflects the deficit that has to be funded from the current monthly household income.
Ensuring that servicing the bond does not become an issue, investors must purchase properties that are well located and that can continue generating a constant income to become self-supporting. Translating that into commonsense means acquiring a property in an area where tenants are lined up waiting for accommodation and where there has been a strong history of growth.
Remember though that anyone approaching the bank for a loan to acquire that property will not be able to include the rental income into their assets and liabilities projections unless there is a signed lease agreement in place on that property. This would only be realistically possible should the property be an occupied rental unit at the time of purchase.
Yet, an element too often overlooked in property acquisitions is paradoxically one of the most important elements on this investment trail. It is the question on why you want to enter the rental property market and it is crucial because, in answering that question, the investor can stay motivated and focused on that goal when tougher times hit.
Owning and managing real estate is not easy. It requires time, effort and organisation to bear fruits, but it also requires objectivity, a characteristic rarely found in property purchasing. By its nature, property acquisition is a subjective issue and what is deemed ideal by one is considered unsuitable by another.
That objectivity comes into play when considering the goals for acquiring that property. If the goal is to achieve a certain return on investment over a specific time-frame (eg. five years), emotional attachment to that property cannot be a factor in the decision to sell when that time is reached.
John Roberts is CEO of Just Property Group