Wednesday, May 27, 2009

Housing Investment- how good is return rate?


Singaporeans are obsessed with housing as an investment. Considering the large number of people scrambling to buy a house even during such times are telling signs that you can know nothing about equities, forex, commodities and derivatives, but you can never miss out on properties.

“Land is scarce, so property is a sure win bet here” are one of the main reasons why the HDB auntie next door and the lawyer opposite are saving hard to fund their next property.

I rarely hear people asking how much they will be yielding on their housing investment if you buy and rent for 20 years.

Many are simply just interested in the absolute gain. The absolute monetary gain (if any), is likely to be large as housing like derivatives are leveraged products!

Before I comment further, let’s do some maths here to see if it is really worth our while to buy a 2nd property for investment.

Assumptions:

35 year old Mr. Tan just bought a new 99 year leasehold, 1000 square feet property beside Kovan MRT station, for $620,000 that will TOP in June 2011.

He intends to rent it out in 2011 and has started paying the monthly installment of his home yesterday (2009 May).

He intends to hold the property for 20 years (till 2029), before selling it away. Note that the property will have a remaining lease of 77 years when he sells it away in 20 years.

His has opted a 3% fixed interest rate for a 20 year loan, at 80% cost of the property which is $496,000.

He will need to pay $2,750.80 monthly to the bank for 240 months. Total amount paid is $660,193. Hence, the property actually costs Mr. Tan $124,000 (20% downpayment) + $660,193 (interest and principal payments) = $784,193.

He estimates that he will collect an annual rent of $30,000 per year (4.8% yield based on $620,000), after factoring all expenses, including property tax (10% of rent), repairs, fittings and furnishing, maintenance fees (estimated to be $300 monthly), and property agent fees of the apartment. (Take note that your tenant do not need to pay the monthly maintenance fees as they are part of the rent. You need to fork it out for them!)

Mr. Tan is making conservative estimate that for the first 10 years, net rental income will be $30,000 per year. The next 8 years (since rent only starts coming in on 2011), net rental income will be $40,000 (net of expenses) yearly. He is conservative because he is aware that there are times his property might not have tenants (like during sars and now) and if he needs to renovate the house, there will also be no rental income for 1-2 months. Besides, when his property is 15 years old, he might not be able to rent it out at a premium as there may be more and newer apartments around his neighbourhood for rent, depressing his rental. The rental will be used to pay for his monthly installment to the bank as Mr. Tan’s CPF is currently used to service his HDB flat. Total rental income from the Kovan apartment is estimated to be $620,000 for the 20 years of investment.
Effectively, Mr. Tan got his Kovan apartment for “free” after renting out for 18 years! Sounds good! His payback period for this investment is 20 years.

Mr. Tan feels that it is reasonable to assume that his $620,000 property will appreciate at 4% per year when he bought it this month. Hence at the end of 20 years, he will be able to sell it for $1,358,000.

What is the annual yield of Mr. Tan’s investment after 20 years?

Answer:

Total cost: $784,193

Total gain: $620,000 (rental income)+$1,358,000= $ 1,978,000

Net gain: $1,193,807

Annual yield (using financial calculator, N=20, PV= 620,000, FV= 1,978,000)= 3.33%

I know my assumptions are not perfect. The rent collected over the years could be higher, the property being sold at 2019 could be much lower. However given the information I have at hand, I do feel that my assumptions and projections are rather realistic.

Personally I feel that buying a property in Singapore for investment shouldn’t be a long term affair, and Mr. Tan should sell his property if there are offers of $720,000 in 2011. His yield will be roughly 7% per year if he can sell it at that price.

On top of that, Mr. Tan has to handle tenants complains, difficult tenants, chase them for rents, handle repairs and renovation, be at mercy of disappearing tenants, be saddled with a large mortgage loan and be afraid to change his job for fear of lower pay and possible underperformance which might lead to retrenchment. That’s stressful!

All that for 3.33%?

However, on the other hand, Mr. Tan can retire comfortably after selling his Kovan property in 2019. With a large sum at hand, he can invest $1m in large companies’ preference shares yielding 4.5% (rather ironic) per year with semi annual payments. He will earn $45,000 yearly and together with his CPF monthly payouts, retirement life should be a breeze for him.

Life will be easy for him after that.

Not that bad afterall!

Well, so if you really want to invest in that property, make sure you can get it at a bargain price, so that your yield on both rental and capital appreciation can be much higher, even if you have to hold it for the long term.

Most importantly, do your sums right!

Supposed Mr. Tan does not invest in an apartment. Instead, he invest his downpayment of $124,000 and 2 years worth housing installment of $66, 0192 into a diversified portfolio of stocks, with an investment horizon of 20 years. I am assuming here that he has prudently set aside about $190,000 before purchasing the apartment.

In the earlier example, Mr. Tan obtained a gain of $1,193,807 at the end of 20 years. Hence, to be equally wealthy at the end of 20 years, what is the return of his stocks portfolio he must achieve (compounded annually) before he can be indifferent in purchasing the property or investing in the portfolio of stocks?

Using a financial calculator, (PV= $190,000, N=20, FV= 1,383,807), the required return of the portfolio is 10.44%.

Hence, if Mr. Tan is not confident that his stock portfolio can give a return of 10.44% annually, he will be much better off if he invests in the property and earn 3.33% return annually.

In fact, even if Mr. Tan can only sell his property for $700,000 at the end of 20 years, his stock portfolio must return an annualized gain of 6.93% for him to be equally well off.

The above (and below) example shows why it is so much “easier” to earn a higher quantum of monetary gain in the property market, compared to buying securities. Property is also physical and hence emotionally more “logical” (adage of everyone needs a roof over their heads) investment for most people. It is less prone to nasty shocks like your property losing 50% of value in a month, compared to commodities. Worse case scenario, you can stay in it but you cannot live on stocks!

The 2 examples are not to determine a better investment asset but rather to show the difference of return between 2 different asset classes. Properties being leveraged product will return a lower return on percentage terms but higher returns on absolute monetary terms.

In this case, it pays to be in debt!

I do not include buying stocks on margin as the interest rates are exorbitant and people do not buy stocks on margin for 20 years.

If you are Mr. Tan with $190,000 on hand, which would you choose? Apartment or stocks?

For myself, I am on a lookout for a freehold property of about 800-1000 sq feet in the prime district near a MRT station selling for $650,000. I believe that the property market will have some more way to go down till 2011 as large waves of TOP apartments will flood the market then, bringing down the rental and price of private apartments.

Hopefully I can be as rich as Mr. Tan in 22 years time!

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