THE PROS AND CONS YOU MUST CONSIDER
One of the things I love about property investment is that you get returns from two sources:
1. Capital growth or appreciation (the percentage with which the value of your property increases annually), and
2. Your Net Rental Yield (the return you generate from your annual net rental income).
Often, when analysts evaluate property as an asset class, they only focus on the capital appreciation or net rental yield. This is incorrect, as both returns should be combined to see the full returns that a property investment has generated.
There is, however, another significant advantage of property investment as an asset class… You can use leverage! In other words, you can buy property using the bank’s or other people’s money.
Leverage can drastically change the returns generated from the investment since it amplifies the returns (positive or negative) that are already there. Leverage is probably one of the biggest reasons why property investors invest in property. They can build wealth and generate returns without using too much of their own money.
And since what you really want to know is what returns you generated on the money you invested, you can start using formulas such as Leveraged Internal Rate of Return (IRR) to calculate your returns. This enables you to compare apples with apples:
The wealth created from your property portfolio vs The wealth you would have generated if you put that cash into another asset class or investment.
I have another way of looking at property investment:
1. Firstly, I look at my cost of capital or financing (in finance terms, this is called the Weighted Average Cost of Capital or WACC)
2. Secondly, I look at the return a property investment can generate (from the capital appreciation and net rental yield), and
3. Finally, I see if that return beats the cost of capital or financing.
As long as the return a property generates is more than the cost of financing, it makes sense for me to own as many such properties as possible. This is the leveraged approach to investing in property.
So, which way is better? To pay off your property portfolio or leverage or refinance it?
Your decision will depend on your ability to take on risk and your risk appetite! It is as good as asking which of these two you prefer: Paid off properties worth R10 million or Properties worth R100 million with R70 million debt? Of course, there is no right or wrong answer. Although there is more equity (net worth) in the R100 million portfolio, there is also more risk (more debt = more risk).
So, rather than asking whether you want a paid-off or a leveraged/financed portfolio, the question should be: What leverage or gearing ratio are you comfortable with? In other words, what percentage of your properties’ value can be debt?
Younger people just starting out might be comfortable with an 80%, 90% or even 100%-leveraged portfolio. In comparison, someone with a bigger property portfolio or nearing retirement would not want to exceed a 50% gearing ratio.
Read our article, To Restructure or Not to Restructure your Property Portfolio, to find out how you can leverage your property portfolio whilst restructuring.
One of the advantages of a paid-off property portfolio is that there is significantly less risk. However, your portfolio will be much smaller than when you gear, and you will also pay significantly more tax since your realised gains are much more. With a leveraged portfolio, your unrealised gains* are more.
*Capital growth on a bigger property portfolio that is not taxed while the properties are unsold, taxed at a lower tax rate if they are sold, and not taxed at all on any refinanced monies since debt is not taxed.
Keep in mind that cash is very important, not just equity. Equity will not help you much if you need cash, so rather convert your equity to cash by refinancing your properties. You can put the refinanced funds back into your access or flexi bond(s), so you won’t pay interest on those funds while you are not using them. The difference is that those funds are accessible should you need to access them.
The funds in your access bond(s) can be used as reserves, and if they are healthy, you can use them to:
- Subsidise shortfalls in your property portfolio (if you have shortfalls) or if an interest rate hike increases your shortfalls
- Expand your property portfolio and have funds available for deposits, transfers fees, bond registration costs, etc., to buy more investment properties
- Pay back some of the money you have pushed in over the years (loan repayment that should also not incur tax implications), and
- Distribute some funds to you if your loan accounts are settled.
You will sleep better at night knowing you have healthy cash reserves for your property portfolio in your access or flexi bond, roughly 15% of your properties’ value or more.
In our article, Start Using Your Access Bond Today, we elaborate on how you can use your access bond(s) for cash reserves.
In summary, here’s my take on whether you should pay off your properties. You can, but you don’t have to. There are advantages and disadvantages to paying off your properties. What is critical is ALWAYS to make sure you have healthy cash reserves in your property portfolio. As you age and your property portfolio grows, strive to increase those cash reserves. In this case, cash is still king!
Read the entire article in the November Edition of Real Estate Investor Magazine.