There are certainly advantages to paying cash for your investment property, however there is an intriguing alternative.
The advantages of an outright cash purchase are certainly appealing. You will not be paying interest on a loan and if you are disciplined, that money can be invested into a tax-free account, and you will own the property ‘outright’.
But, there are disadvantages if you plough all your capital into one asset, leaving little to invest for emergencies. And if the purchase price for the property drops, you have no gearing protection.
Buying two units instead of one
When investigating the best investment opportunity for cash buyers, I always advise them to consider the advantages of purchasing two units with 50% bonds instead of one with cash.
For example, if you find two properties where you pay R1m and realise a nett rental of R8,000 on each, you get a nett yield of 9.6%. With a 50% bond on both you are just R2,000 “worse off” than if you had purchased one unit with cash. But now you have two properties.
When bonding both properties at 50% (R500k), your combined monthly repayments will be approximately R10,000. The rental income of R16,000 delivers you a surplus of R6,000pm and a return of 7.2% on your initial R1m investment. Where it gets interesting is when you sell the property.
Say the properties grow at 8% per year over a five-year period. Each property is then worth R 1,469,328. This gives you equity of R2,938,656. Your outstanding bond will be R898,024. Removing this and your initial investment of R1,000,000, leaves you with R1,040,632. Had you bought one unit outright, it would also be worth R1,469,328, less your R1m investment, and you have R469,328. You can get double the return, and this after just five years.
Let’s look at the same hypothetical example over 10 years: One property will deliver capital growth of R1,158,924 if you bought it cash. If you bonded two properties with 50% home loans, your capital growth would be R3,587,605. Minus the initial R1m investment, and your capital gain is R2,587,605. You can more than double your investment using the bank’s money.
Optimistic, but not beyond reach
This illustration assumes a flat interest rate for five to 10 years, uninterrupted capital growth of 8% per annum, and gross rentals of R9,500 per R10,000 per month for, say, two 40m2units in a secondary area where demand is high. While optimistic, it is certainly not beyond the realms of possibility.
The basic premise behind this illustration is that whenever the total return (in this case, yield plus capital appreciation) exceeds the cost of financing, investors can use leverage to enhance their overall return. Of course, the tradeoff is increased exposure to property-related risk, such as potential downturns in property prices, defaulting tenants, rising interest rates etc.
Those looking to purchase investment property should discuss the ramifications and opportunities with an expert. It’s a personal decision – your risk appetite as well as your current and future financial landscape should be carefully scoped. Just remember, capital growth is your silent investment partner. If you are in a position to use bonds to double your growth, you need to think twice about spending all your cash on one unit, when two bonded units may offer a better return.