It is a commonly held belief that buying a property as an investment is the best way to create wealth as you are able to generate a return on your investment through rental income while at the same time enjoy capital growth on the value of your property, and that this way of investing is therefore preferable to investing in a unit trust portfolio. Before investing in property, it is important to understand the real return that your rental property is actually giving you so that you can make informed decisions about how to invest. The best way to achieve this is through a case study, which is set out below.
CASE STUDY: JOHN SMITH
John Smith lives in Cape Town and is fortunate enough to have saved up R4 million which is currently parked in this bank account. John knows that his money is better off being invested rather than sitting in cash, but he is unsure where or how to invest this capital. While he is aware that he can place his money with an asset manager in a unit trust portfolio, he has heard from his friends that owning a second property as an investment is a better investment proposition and that he should consider this over a collective investment. John is conflicted and decides to do some research into each option in order to fully understand the numbers behind each investment.
Unit Trust Portfolio
Investing in a discretionary unit trust portfolio seems relatively simple. John needs to have up-to-date FICA documents and then decide which fund/funds to invest his money into. He knows the plan is to invest for the relative long term, so he decides to invest in a balanced fund. After some research into the fund fact sheets of major service providers, John learns that his balanced fund’s asset class split will be 75% equity, 15% cash and bonds, and 10% property. He learns that his long-term expectations if invested in a balanced fund is approximately inflation plus 7% net of the asset manager’s fees. If he uses a local asset manager platform, he can expect to pay 0.6% including VAT as a fee for this service, resulting in a net expected return of inflation plus 6.4%.
Through his research, John has discovered that there are different taxes that may be applicable to his investment. Firstly, dividend withholding tax is a flat tax rate of 20% that is withheld on any dividends paid to an investor by the underlying shares he is invested in. The expected long-term return of inflation plus 7% as stated in the fund fact sheet does take this into consideration. Income tax on interest earned is something that John must take into consideration. The interest he earns on the cash and bonds in his investment could potentially result in tax being paid. John therefore assumes that the 15% cash and bonds portion of his balanced fund will generate a return of 7% (R42 000) which will get added to his taxable income. As an individual, John gets a R23 800 rebate on interest so only R18 200 would be added onto his taxable income.
For the purposes of this case study, we have assumed that John earns R30 000 per month (R360 000 per year), which means that in terms of the current tax tables the R18 200 would attract tax of R5 665 for the year. Please note that we will address the issue of Capital Gains Tax towards the end of this article.
Taking all of the above into consideration, including the extra tax that John would be liable for from the net return of his investment, it is apparent that John can expect a return of inflation plus 6.25% from his balanced fund over the longer term.
Equipped with sufficient information about a unit trust investment, John begins to do his research into what it means to own a rental property.
Transfer Duty and Conveyancing
John knows that when buying a house, he will be liable for transfer duty. Using the SARS tax tables, he calculates that he can only spend R3 700 000 on a property because the transfer duty on that amount works out to be R240 000 and conveyancing fees of about R60 000 should be budgeted for to bring his total cost of investment to R4 million. For the purposes of this case study, we have therefore assumed that John finds the perfect investment property for R3.7 million.
Return on capital investment
When working out what the growth of an investment property will be, as with most investments, no one knows what the future is going to hold and therefore it is very difficult to ascertain what a property’s actual growth value will be. According to John’s research, he found that the average annual house price growth in SA for 2019 was 3.6% and in 2018 it was 3.8%. South Africa’s inflation was 4.38% and 4.62% in those years respectively. John understands that the property market has been in bit of a slump over the last couple of years and decides to assume that the growth of his property over the long-term will be equal to inflation, bearing in mind that this is the global average assumption on property capital when taking a long-term investment view.
Yield on capital (or real return)
The yield of an investment property involves taking into account the rental income generated by that property. The rental income that a property is able to generate is dependent on factors such as the area in which the property is located, the condition of the property, and the current market environment in respect of rental property. For the purposes of this case study we have assumed that John purchases a three-bedroomed, residential property in Claremont, Cape town. Following his research, John believes he can rent out this property for between R15 000 and R25 000 per month. Giving himself the benefit of the doubt, John assumes he can get slightly above average rental returns and assumes a rental income of R22 500 per month (or R270 000 per year). He further assumes that he will be able to increase the rental income annually in line with inflation. This annual rental yield works out to be 6.75% of his capital value of R4 million.
Taking all of the above into account, John calculates that his investment property will give him a return of inflation plus 6.75% over the long-term. However, this is where many property investors get caught out as there are a number of other factors that affect the yield of rental property that should be considered when calculating the real returns. These include:
Rates, Taxes and Levies
As the homeowner, John is liable for the monthly rates and levies on the property. These can be calculated as follows:
R3 700 000 – R300 000 (rebate) = R3 400 000 x 0,0055 = R18 870 per year or R1 572.50 per month
John will need to take out homeowner insurance. The average cost per R1 million cover in Claremont is R120 per month, which means that John’s premium would be around R444 per month.
Naturally, John cannot predict what maintenance he will need to do to the house. However, it is safe to assume a long-term maintenance cost of 0.5% of the property value per year to keep the property in good shape. This would work to R1 541 per month for John’s property.
One of the biggest risks facing landlords is not having a tenant to cover the rent. While John is optimistic that he will have a permanent tenant in his property, he knows that it is safe to make a long-term assumption for tenant risk. It is common practice for landlords to assume a half-month per year of occupancy for tenant risk. This means that John can should budget to not have a tenant for an average of 1 month every two years. This translates into a reduction in monthly yield of 0.35%; or in other words, John assumed that for one month of each year he would only earn R11 250 in rent.
John also knows that he should budget for sundry expenses and potentially the costs of a property agent. For the purposes of this case study, we have assumed that John incurs no other expenses and chooses not to use a rental property agent. However, as John has elected to manage his own rentals, bear in mind that there is a value to the time that he will spend managing this property.
Income Tax is the most common omissions that investors make when calculating the yield on the rental property. Taking all the information above, John calculates his income tax as follows:
|Less: Rates & Taxes||R18 870|
|Less: Insurance||R5 328|
|Less: Maintenance||R18 492|
|Less: Tenant risk||R11 250|
|Total taxable income from property||R216 060|
This R216 060 will be added to John’s taxable income of R360 000 per year and will result in John paying additional tax of R75 228. So, how does this affect the yield from John’s rental property? Assuming that John incurs the above expenses and pays his taxes accordingly, the net annual return on his rental property would be as follows:
|Total Capital Investment||R4 000 000|
|Rental Return||R270 000|
|Monthly assumed costs||R53 850|
|Tax on yield||R75 228|
|Annual Return||R140 922|
|Return expressed as a % on capital||3.52%|
Having done his calculations, John realizes that the long-term expected return on his rental property is approximately inflation (capital growth on property) plus 3.52% per year assuming that he can increase his rental year-on-year in line with inflation.
Capital Gains Tax
When it comes to factoring in Capital Gains Tax it is important to bear in mind that CGT may be applicable to both a unit trust investment and a rental property. Assuming that John’s property experiences capital appreciation, on the sale of his rental property John would be liable for CGT on the full gain in value, subject to a R40 000 rebate, and thereafter 40% of the gain is included in his taxable income for the year.
In respect of John’s unit trust investment, he will be liable for CGT on the capital growth in the fund should he elect to do a full withdrawal at a later stage. The capital growth in the fund will be seen as a gain and taxed in the same way as the sale of a property. Should John elect to draw monthly from his unit trust portfolio, he could potentially pay CGT on a smaller amount and make use of his annual tax rebate of R40 000.