Pros & Cons of Property Investment
Pros & Cons of Property Investment
Dear Financial Planner,
I refer to the article Working On Getting Rich & Famous published in the November 1999 Issue of Financial Planner.
In the feature, Mr Goh Yang Chye cited the example of a $1 million property growing at 7% a year, to double in value in 10 years' time. He added that if you borrow money at 5% interest, you would need to earn a much higher rate of return to achieve the net 7% return. 1 believe he meant that one has to achieve a minimum of 5% + 7% = 12% in order to cover both the ban interest and desired return of 7%. However, I beg to differ.
Using the above example and neglecting rental income, stamp duty and other costs, let us assume that you borrow 80% after paying the 20% downpayment of $200,000. At 5% interest on the $800,000 loan, the interest payable after one year would be $40,000.
Assuming a monthly mortgage instalment of $6,000, this would amount to 12 x $6,000 = $72,000 after one year. Therefore your equity will then increase by $72,000 - $40,000 = $32,000. Your total equity after one year would be $200,000 + $32,000 = $232,000.
At 7% growth, the property will appreciate by $70,000 after one year. The total return on equity is the capital appreciation minus the loan interest, i.e. $70,000 - $40,000 = $30,000. This will yield a substantial return of $30,000x100/200,000 = 15% after only one year.
In fact, even if the loan Interest and capital appreciation are the same at 5%, the yield will still be a respectable $(50,000 - 40,000) x 100/200,000 = 5%. Such is the power of leverage where you borrow money to make more money.
However, take heed. Leveraged investments such as derivatives, when taken to extremes, have resulted in infamous debacles such as the collapse of the Barings Bank. Investors who over-leveraged on properties during the recent crisis have also been led down the road to bankruptcy or worse.
Perhaps the biggest barrier to property investment is the large capital outlay required.
In this, the CPF ordinary account has been a boon for most people in accumulating capital for property purchases. Otherwise, we should start saving enough funds so that when the opportunity arises we will be ready to reap sizeable gains when we enter the market.
There is, of course, much more to learn in this complex subject, and for those with the patience and skill it could prove to be most rewarding.
Tenzin Quek Gim Soon, CLU, ChFC. By email
Dear Mr Quek,
We forwarded your letter to Mr Goh, and his reply (shortened, due to space constraints) is as follows
"Thank you for your comments and contributions on the above matter. In response, I would like to provide the basis for my contribution in the article mentioned above.
1. Interview Setting
Firstly, I would like to point out that the interview and interaction with actor Nicholas Lee was meant to be candid and light-hearted. The financial planning approach was by no means exhaustive and was intentionally simplistic so that we could engage the "layman" reader. Neither did I assume the calculation 5%+7%=12%
My comments on property investment in the article by no means questioned the value of property as an investment instrument, but highlighted that there are alternative instruments that can fetch reasonable returns of 7% p.a. on a greater-than-10-year timeframe. My purpose was to encourage investors to ask valid and important questions before committing their resources to any investment.
2. Debt Management
For the benefit of readers, I do not think it prudent to purchase a property based on an 80% loan and 20% downpayment under current economic circumstances. Instead, I would recommend a debt ratio of 30% downpayment and 70% loan (assuming the cashflow of the client can service the mortgage repayment comfortably without compromising on basic necessities).
In 1998, about 12 months back, it was not uncommon to see property valued at $600,00 to $700,000; at the peak in 1996-97, the same property would be valued at $1 million-plus.
3. Leveraging
The concept of borrowing money to make more money is tempting. However, leveraging can have a positive or negative effect. The results of leveraging are not dependent on the asset classes or types of investment instruments. Its effects are rather the consequences of a timing call. As most of us are not born with a good sense of timing, it would be wise to stay extremely cautious when embracing this kind of investment philosophy.
My mother's financial planning advice to me is: "Money has four legs and Man has two Legs. Hence, money will always run faster than me!" In short, debt is a burden. Unless it is managed wisely, it can wipe out the entire wealth of a person or nation, or set a person's investment plan back by many years.
I am sure we are aware of many Singaporeans who are in this unfortunate predicament even at current property valuations. As an example:
Property Investment 1995-96 $1 million ($800,000 loan)
1998 $600,000 (valuation)
If the owner is forced to sell his property at $600,000, he will incur a net loss of not $200,000 but $400,000; $200,000 from his initial investment and a debt of $200,000 he still owes the bank. The debt of $200,000 will continue to haunt him for years to come at an exponential rate.
To make property investing a positive experience, a person needs a good and clear understanding of his personal financial objectives, time horizon, debt ratio, timing, tax status and overall financial plan and allocation, as well as economic situation.
With regard to earning a return of 12% in order to achieve a desired net return of 7%. Mr Quek's calculation is perhaps somewhat simplistic. The actual return required is a function of the type of housing loan taken; its tenure and quantum; the prevailing interest rate environment, which impacts the opportunity cost of money; time of entry into and exit from the market; and so on.
To enjoy a positive outcome from your investment, you should therefore stick to the principles of proper financial planning and allocation. As stated in my article, the systematic and organised accumulation of wealth will help you manage your hard-earned money.
Any promise of a quick and fast return is invariably laden with peril and burden of risk. A decision on what is 'serious money' and what is 'fun money' should always be at the forefront of your financial decision-making.
By Goh Yong Chy
