Given the long-term performance of property as an asset class, asset consultants generally recommend a weighting of 10 percent or more for property in a balanced investment portfolio. But should this investment in property be passive?
While the process of direct buy-to-let investment is almost identical to the methods employed by listed property companies, in which investors can invest passively, a direct investment in a property holds numerous benefits that investors should consider before making a decision.
With listed funds one can buy property like a shopping centre, a block of offices or a number of residential properties, which they can then rent out to tenants, thereby creating an ongoing passive income stream, while these properties generate capital growth.
The property acquisition is funded through property finance, while the management of the property and the placement and management of the tenants are outsourced to professional property managers. The finance repayments as well as other expenses, are covered by the rental income, which increases with inflation each year, generating growing monthly profits. Passive investors can acquire a share in such a fund and receive a portion of the monthly income.
Direct buy-to-let property investors replicate this system, albeit on a smaller scale, often in the residential property market, but also with smaller commercial properties. These buy-to-let investors acquire property using property finance, in this case a mortgage bond, and rent it out to a tenant. The mortgage repayments and other expenses such as the fees for professional tenant and property management are covered by the monthly rental income. As with the listed property funds, the monthly rental creates an ongoing, passive income, which is also inflation-linked, for as long as the property is held, while generating ongoing and compounding capital growth year after year.
While the process is virtually the same, both a passive or a direct property investment will yield ongoing passive income, there are a few differences that need to be considered before investors make a decision between a passive investment in a listed property fund or a direct investment in their own property.
Firstly, it should be noted that a passive investment in a listed property fund, for example, can provide diversification across different properties and different property sectors. However, this benefit comes at a rather hefty premium, as there are investment fees to be paid. The devastating effect of investment fees on returns have been highlighted by numerous experts.
A passive investment in a property fund is more liquid, i.e. it can be converted into cash quickly. However, given the long-term nature of property investment, whether passive or direct, the illiquid nature of direct property investment is actually a benefit, protecting investors from making emotional decisions based on short-term volatility, instead of sticking to their long-term investment plans.
Furthermore, a passive investor in a listed property fund has no control over the investment, and can do little more than hope that the fund managers will make the right decisions. The investment is also exposed to the volatility of the stock markets, and particularly vulnerable to changes in the bond market, to which property shares are closely correlated. In contrast, direct buy-to-let property investors have full control over their investments, and can sell, improve or upgrade their properties as they see fit to take advantage of new opportunities. Moreover, a direct investment in a buy-to-let property is shielded from market volatility, because regardless of what happens in the markets, tenants need a place to live.
Perhaps most importantly, direct buy-to-let property investment allows investors to use the power of gearing to leverage their investments. While investors will be hard pressed to find a bank that will finance a R500 000 investment on the stock market, they can most certainly gear a direct investment in a buy-to-let property through a mortgage bond. And as all savvy investors know, gearing has a massive positive impact on the return on investment. Furthermore, the investor benefits from the full capital growth on a direct property investment, as well as the full monthly income generated. And, thanks to the power of compound interest, the longer the property is held, the more impressive the returns on the investor’s out-of-pocket investment.
Direct property investors enjoy a number of advantages: the absence of crippling fees that decimate returns, an illiquid investment that protects the investor from emotional decision-making, full control of an investment that is also shielded from market volatility, the ability to gear the investment to generate impressive returns and the full benefit of the income and capital growth generated for as long as the property is held.
You do not need prior knowledge or qualifications, a lump sum investment or huge monthly contributions, nor do you need much time or effort to implement this system. All that is required is the willingness to investigate the alternative of a direct investment in an income-producing property