Real Estate Investor Magazine South Africa September 2013

FINANCE BY KOOS DU TOIT Avoid Gearing Gaffes Don’t gear beyond your affordability Gearing beyond value While it is far less common since the credit crunch, a few years ago it was possible to gear a property investment 108% and even 118%. This meant that the investor could borrow 108% or 118% of the market value of the property asset, and often this was allowed to ensure the investor could not only pay the purchase price, but also pay the transfer duties and other costs associated with the property purchase. Many investors burnt their fingers when interest rates rose and property price growth stagnated, and these investors found that they could no longer afford the higher bond repayments and could not sell the property at a price that would cover the outstanding bond amount. Similarly, many investors took out second mortgages on a property – cashing in on the equity created as the value of the property increased (at as much as 25% per year at the height of the property boom) and their outstanding bond amounts remained static. However, as property prices corrected after the heady boom days and interest rates skyrocketed, many investors found themselves similarly unable to afford the bond repayments and unable to sell the property for an amount sufficient to cover the outstanding mortgage loan. interest rate (the long-term average) before buying a property. Negative gearing Negative gearing refers to the very common situation in which an investor acquire a buy-tolet property using gearing, ie a mortgage loan, but the income produced by the property (in the form of rental income) is less than the total monthly expenses (bond repayments, rates and taxes, management fees, etc) which means that the investor must fund the shortfall between the rental income and the total expenses from his/her own pocket each month. Negative gearing is, in the case of buy-to-let property, a temporary situation, because the rental income increases year after year, while the bond repayments will remain similar, barring interest rate fluctuations. As a result, the shortfall amount decreases year after year until the property investment reaches break-even point, at which time all the property expenses are covered by the rental income. Then, as the rental continues to increase year after year, the property asset begins to produce a growing monthly profit. Negative gearing becomes a major risk if the investor did not carefully analyse his/her cash flow situation to ensure that the shortfall amount can be carried comfortably, even in the event of interest rate increases, which could significantly increase the monthly shortfall amount. This risk is magnified when an investor has acquired multiple investment properties with negative gearing, and even a single interest rate hike renders the increased shortfall amounts on several properties unaffordable. Responsible gearing requires a thorough cash flow analysis and stringent cash flow management, and smart property investors build in a buffer by calculating their cash flow projections on a 12% M any investors, realising the power of gearing (borrowing money to invest in an asset) and the spectacular returns that it delivers, step into a common, but entirely avoidable, pitfall: gearing beyond their affordability or beyond the security offered by the asset. What is gearing? Gearing, or leveraging, is also referred to as using “Other People’s Money” (OPM) in wealth creation circles. Essentially, it simply means borrowing money to invest in an asset, such as using a mortgage loan to acquire a buy-to-let property. If you are acquiring a property for R500 000, and obtain a mortgage bond for R500 000, that is 100% gearing of the investment. Recently, it is far more likely that the mortgage lenders will require a deposit. If a 10% deposit is required, the result is a 90% gearing of the investment, while a 20% deposit requirement will result in 80% gearing. While gearing is a powerful force in creating wealth, exponentially increasing the returns on investment, responsible gearing is absolutely crucial to property investment success. Gearing beyond your affordability can result in serious cash flow problems, while gearing beyond the security offered by the value of the property can be a shortcut to disaster. September 2013 SA Real Estate Investor Smart gearing Gearing is a wealth creation strategy used by the world’s wealthiest individuals and institutional investors. It is without a doubt one of the most powerful strategies investors can use to acquire income-generating assets without access to significant capital and it exponentially increases the return on investment. However, gearing must be applied with care, including careful cash flow analysis – incorporating a generous buffer to absorb interest rate increases as well as unexpected expenses – and common sense to ensure the gearing does not exceed the security offered by the value of the asset acquired. RESOURCES P3 Investment Group 26 www.reimag.co.za

Real Estate Investor Magazine South Africa September 2013 | Page 28