Almost counter-intuitively, South Africa saw record unit trust net inflows – R88bn – during the second quarter of 2020, the height of the lockdown. Half that money came from retail investors.
While there may have been some contrarians among them, looking to profit from the negative sentiment, most were simply looking for a better interest rate than the banks are now offering on savings and fixed term accounts. R48bn went into money market funds.
It appears that South Africans have joined the international search for yield. Locally, only government bonds still look attractive on the basis, and only if we ignore the ‘junk’ rating and our country’s dire financial position. In this context, it is then perhaps then not surprising that (anecdotally at least) there is renewed interest in ‘buy-to-let’ investments.
On paper, this looks like a no-brainer: borrow to buy property, get tenants to pay back the loan, and 20 years on you have an appreciated, unencumbered asset that you can either sell or let, to help fund your retirement.
In Excel, the investment case has become even more compelling: the prime lending rate has dropped by a third, but due to our economic malaise, property prices have not risen as a result, as one would normally expect. All else equal – and in contrast to other asset classes – buy-to-let returns are looking up.
A question that typically arises in this situation is whether any spare cash should go towards reducing the bond or be invested elsewhere. But the more important issue is often ignored: does buy-to-let fit into a sensible retirement plan?
As to the former, the basic premise is that such an investment should be self-funding. If you have to pay in every month, because the rent does not cover all costs, you will soon be demoralised. Ideally, you can make it work with a 100% bond, to maximise your return on equity, but you may have to settle for less, for the scheme to be cashflow positive. This depends on your specific property costs, and the terms of the lease.
If you do have spare cash, you need to consider the opportunity cost of not investing it elsewhere, in the context of your time horizon. If you intend to realise the property in a few years, your benchmark should be the money market return. If you are hanging on to retirement and beyond, it’s what you might earn from the stock market over the long-term.
As a general rule, the higher the opportunity cost relative to your lending rate, the less sense it makes to pay down the bond. The theoretical cross-over point depends on your lending and marginal tax rate. If you are borrowing at, say, 8%, and qualify for a tax deduction at your marginal tax of 30%, then that point is around 5.6%. But it can change numerous times over a 20 year period. You also want to earn a decent risk premium above that point, to compensate for the guaranteed interest cost you could be saving.
If your current alternatives are between money in the bank or paying down your bond, you’d rather pay down the bond. But if you are a long-hauler, you may do better in the stock market, provided you follow a sensible investment strategy that avoids active management, high fees, and market timing.
It’s not just about you and your model though. Lenders will impose their own terms. While you may qualify for a 100% bond, in a buy-to-let scenario the bank will typically want to see some equity, probably 25% or more of the purchase price. That is their margin of error, should you default.
You also need to consider your own margin of safety. There is your spreadsheet and there is the real world, in which your property may stand empty for a few months, or you tenant falls in arrears, you incur unexpected maintenance or eviction costs, interest rates rise, special levies happen, rentals come under pressure, or property rates go up unreasonably.
A smaller bond obligation gives you a better chance of surviving these phases, and not being turned into a desperate seller.
But even if you can make the numbers work, with an adequate margin of safety, ‘buy-to-let’ still does not stack up conceptually as a suitable retirement-funding asset.
The main problem is the lack of diversification. In a typical investment portfolio (pre or post retirement), you would look to diversify across different asset classes and markets. And your exposure to any specific security would be modest, to ensure that one bad apple does not ruin your retirement.
Relying on one, or even a few ‘buy-to-let’ properties won’t do that for you. It won’t protect you against a broad down-turn in the rental market, or the economy. And one rotten tenant can play havoc with your finances.
With property, you also cannot diversify across time. Unlike a financial investment, you cannot enter or exit the property market gradually (as one does when adding to or drawing from a retirement fund). This increases timing risk: you may unwittingly be buying your single asset when prices are high and forced to sell when prices are low.
As described, ‘buy-to-let’ properties come with considerable operating risks; but unlike a financial portfolio, you cannot de-risk your property portfolio in retirement, to secure your income. Even if you are debt-free by then, you are still at the mercy of your tenants for your monthly income. You would need to own a good few such properties to mitigate against this.
Two other features that would commend your retirement plan are low costs and simplicity. With property, the holding and transactions costs are high. Plus, there is the hidden cost of an inefficient market: it is illiquid, transactions take months to settle, bid-offer spreads are wide, and inevitable legal processes to assert your rights are slow and expensive, and often ineffective.
Last but not least, you want to keep your retirement finances low touch. Managing ‘buy-to-let’ properties is anything but, and often requires a considerable investment of your time, nerves, and energy. You may have the nerve and energy when you start out, and you may have the time when you retire, but you are unlikely to ever have all three at the same time, unless you make this your business.
In phases, there is good money to made in property, as when inflation runs high, boosting rentals and quickly deflating your home loan, or when a structural decline in interest rates pushes up property prices, as happened during the early years of the new millennium. But there are also long periods when residential property prices go nowhere. According to the FNB House Price Index, average house prices have appreciated by just 5,2% pa over the past 15 years, not even keeping pace with inflation.
So, ‘buy-to-let’ is not the no-brainer that Excel suggests. Many are drawn to it because it enables them to invest with minimal capital and leverage their return with debt. A few may do really well, but the majority will probably walk away with little more than a lesson about concentration risk.
In summary, this is a high risk proposition, more so if investors intend to fund their retirement this way; they are simply not adequately diversified. While it is tolerable to have such holdings represent maybe 10% of their retirement portfolio and income, with the balance broadly diversified across other asset classes, relying exclusively on rental income from a small number of properties presents an unacceptable level of concentration risk. It is unlikely to be rewarded with a commensurate return, or provide a financially secure retirement.