Timing is so vital to making successful investments. For most property investors, the fact that the investment is made with a long-term view in mind, short term (1-3 years) fluctuations in market value do not overly impact on the return of their investment. However, for the speculators out there, and for those that bought into the highly leveraged models espoused by the readers of the ‘Rich Dad Poor Dad’ books, a dip in market value, and in particular rental income can have a much more serious impact on investment returns.
This discussion is particularly relevant in the Cape Town property market over the past five years. In 2016/2017 property prices in the Atlantic Seaboard and the City Bowl had been growing at more than 8% a year for a few years and it seemed at the time that they would continue on this trajectory, due to various factors being espoused at the time, everything from ‘semigration’ to the limited amount of liveable space close to the city because of the city’s location between the mountain and the sea.
Unfortunately, as history has shown us, real estate, like the broader economy, normally works in a cyclical manner, and the real estate market had definitely peaked by 2018 and values began to fall steadily in 2019. This in itself would not have been a problem for most investors, that is until, we walked into COVID in 2020.
David Rebe, CEO of Sandak-Lewin Property Trust explains the effects that COVID had on the real estate industry, “The fact that COVID exacerbated the downward cycle of the property values is one thing, but where it really hit property investors is on their rental returns. For the most part, the value of a property is only an estimated number, only to be fully revealed in the willing-buyer-willing-seller marketplace, so while a healthy value may look nice on a balance sheet, that value is nothing more than a book entry until it is time to sell.”
He continues by comparing the COVID-impacted market with the market from a few years before:
“While the rental market, although sluggish in 2018 and 2019, was still ticking over, the hard lockdown in 2020 really hit the rentals hard. This is where tenants refused, or were unable to afford rent, moved back with their parents, absconded or generally gave notice, which resulted in an increase of the supply of rental units and inadvertently caused a massive downward correction in the rental returns from investment properties.”
“Now the speculators have a very real issue on their hands, the rent that they were receiving to (often) cover the finance of making the purchase in the first place has decreased or stopped completely, but the cost of finance did not. OK, it may have been on hold for 3 months... but speculators were then forced to decide whether to try hang on to the property (and increase their investment through monthly payments to cover the difference between their rent and their bond) until such time as they can sell it for a profit, or whether to sell now, accept the loss and move on.”
This decision described by David Rebe is only applicable to the investor who is able to afford the increased differential between what they owe the bank and what rental they are receiving. Many unfortunately were not that lucky and will be forced to sell. Through an example, David Rebe illustrates the assumptions that an investor will have to make to come to a decision as to whether to hold or sell.
“Assuming in 2018, a two-bedroom property was purchased in Vredehoek for R2.5mil and the buyer assumed R2.1mil debt.
They signed a tenant at R14k per month and their costs would have been… Receive R14k, pay R1,5k rates, R1.5k levies and R17,5k on their bond – they would be left paying in R6,5k per month. That is on top of making an initial layout of about R400k. We can safely say that at the time the property was worth R2.5m.
In 2021 the situation now looks a bit different: The rent has now dropped to R11,5k, the rates and levies are slightly higher, say R1,75k each, and the bond has decreased due to lower interest rates to R16,5k. The investor is now putting in R8,5k per month.
From the outset the speculator may have projected – 8% return over 3 years. Excluding for costs that remain no matter what state the market is in (i.e., sales commission and transfer duty). This would have seen him invest R400k initially, plus R6k per month for 36 months, or R72k per year, for a total investment of R400k + R216k = R616,000. Assuming that the market did indeed grow at 8% per annum, he would have been able to sell his property at R3.15m. Settling his bond of approximately R2m, he would have realized R1.15m off his investment of R616k, approximately a 100% return over a three-year investment period.
However, with the market depreciating since the initial purchase, if he sells it now, he will only receive approximately R2.3m, from which he will need to settle his bond of R2mil leaving him with R300k. His initial investment of R400k plus the R72k put in in year 1, R72k per year and R102k in year 3 gives him a total invested amount of R646, less what he received on the sale of R300k gives him a net loss of R346k.
The decision he now faces is whether he believes that the rental market will recover in the next year or two to lessen the extra investment he is making into the property per year, or at the very least that the property price will appreciate at least as much as what he is currently putting into the property (i.e., R102k per year). So, if he believes that the property market will recover by more than R102k per year on a (currently valued R2.3m property) i.e., about 4.4% then he should try and hang on.
Each year of growth at a minimum of 4.4% growth, and assuming that the rental market has also bottomed out and possibly may increase over the next few years, will see his investment returns increase.”
The example above makes it clear, if the investor does not believe that the house prices will increase by 4.4% over the next few years, then he/she should sell, not hold, and dispose of the property and not exacerbate their losses.