Real Estate Investor Magazine South Africa March 2014 | Page 30

FINANCE

BY KOOS DU TOIT

Buy-to-let: financial perspectives
To gear or not to gear?

I

n wea lth creation circles, gea ring or
leveraging is - somewhat tongue-in-thecheek - known as “using Other People’s
Money”, because that is exactly what it is:
borrowing the money required to invest in an
asset, using the asset being acquired itself as
security for the loan.

In real life
To illustrate how powerful gearing is in creating
wealth, let’s compare two investment scenarios.

Scenario 1
Let’s say an investor invests R500 000 directly
in an entry-level buy-to-let property, with
monthly expenses of R1 450 (rates and taxes,
levies, management fees and vacancy buffer)
and rents this property out for R5 000 per
month, for a total net monthly income of
R3 550 (R5 000 income less R1 450 expenses).
The annual net (after expenses) income from this
property would be R42 600 (R3 550 x 12 months)
which translates into an 8.52% return (R42 600
income / R500 000 invested * 100) over 12 months.
If the property also increased in value during the
year by 8%, this would produce a further R40 000
growth on the R500 000 investment, bringing the
total return to R82 600 (net income at R42 600
and capital growth at R40 000) for the year - a tidy
16.52% return in the first year. If inflation at 5% is
factored in, the ‘real’ return would be 11.52% in the
first year. And, as the rental increases each year and
as house price growth recovers, the returns become
more even impressive with each passing year.
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March 2014 SA Real Estate Investor

Scenario 2
But what if an investors does not invest
R500 000 in the property from his/her own
pocket, but rather “gears” the investment,
obtaining a R500 000 bond on a property?
Of course, the bond would have to be repaid
each month but, remember, the property is
generating a monthly income, which will cover
most of the bond repayment amount.
In our example, the bond repayment is R4 661
(based on a 9.5% interest rate over 20 years). As
in the scenario above, the net (after expenses)
monthly income is R3 550. This means that the
investor would have to invest R1 111 per month
from his/her own pocket to cover the shortfall
between the R3 550 net rental income and the
R4 661 bond repayment.
So, the investor is not receiving a rental
income from the property and is, in fact,
investing R1 111 a month from his/her own
pocket. But keep in mind that in this second
scenario the investor did not invest a R500 000
lump sum from his/her own pocket as was the
case in the first scenario. In fact, the total outof-pocket investment over the 12 months by
the investor in this scenario is just R13 328,
compared to the R500 000 total out-of-pocket
investment in the first scenario.
A lso remember that this shortfall will
decrease each year as the rental increases,
and at the end of the third year, this property
will breakeven (ie the income will cover all
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the expenses) and from the fourth year, the
property will start generating a monthly profit.

The impact of gearing on ROI
So what is the impact of gearing on the return
on investment?
Because the investor sacrifices the income
from this property during the first three years
to part-cover the bond repayments, the income
cannot be included in the return on investment
calculation until the fourth year. However,
during the first year the property increases in
value by 8%, and this will produce a R40 000
return on the R13 328 out o