What you should know about buy-to-let

11 September 2017

Being a landlord can earn you a good income, but it is not for everyone. Buy-to-let property investing has enthusiastic proponents, such as Rich Dad, Poor Dad author Robert Kiyosaki, but there are also many detractors, who argue that you're better off putting your money in the stock market.

If you are serious about investing in physical property (as against investing indirectly via listed property shares or unit trusts), you'll need to manage your property as if you were running a business and fully familiarise yourself with the risks - and costs - involved.

Last week, at the Allan Gray Investment Summit in Sandton, Michelle Dickens, the managing director of TPN Credit Bureau, which specialises in the rental property sector, provided delegates with an overview of the residential rental market, and had helpful advice for prospective landlords.

Dickens says it's essential to do your homework to find the right property in the right area, taking the following factors into account:

Property price;

Net yield, which is your rental income minus your expenses; and

Risks, which include how long your property may be vacant in-between lets, delinquent (late-paying or non-paying) tenants and the legalities of removing tenants.

When and where

When you buy a property, and how much you pay for it, is vital to the success or failure of your venture. Mis-timing the market may mean receiving a lower rental than you anticipate and a lower price if you have to sell.

Overall, the FNB House Price Index has shown little real (after-inflation) growth since the 2008/9 financial crisis, in stark contrast to 2004, the peak of the pre-crisis property boom, when South African residential property prices soared by almost 30%. Dickens says it was easy to make money in those years, but it is less easy now.

Where you buy is also important, not only because some areas experience higher price growth than others, but also because some areas (not necessarily the ones with high price growth) have a higher demand for rental properties than others, and their yields may be higher.

The Western Cape is far outstripping the national average for yearon-year house-price growth (about 5%). Properties on Cape Town's Atlantic seaboard are growing at 29.9%, those in the City Bowl at 21.1% and those in the southern suburbs at 14.7%, according to the FNB index.

TPN's market strength indicator for rental properties, which works on an average of 50% (when rental demand equals supply), shows that rental demand in Gauteng is 50%, in KwaZulu-Natal it is 53.98%, in the Eastern Cape it is 62.86%, and in the Western Cape it is 73.25%.

You need to consider whether higher-value properties are better rental propositions than lower-value properties in terms of both rental yield and quality of tenant.

Gross yields (rental yields before expenses) differ across rental brackets and areas.

Sectional-title units command higher gross yields than their standalone counterparts. Sectional-title properties are generally smaller and less expensive, so the yields you are likely to achieve are higher than on larger, full-title properties, Dickens says.

TPN divides the properties on its database into five rental brackets:

under R3 000 a month (22.5% of residential tenants),

R3 001 to R7 000 (the majority of tenants, at 53%),

R7 001 to R12 000 (17.1%),

R12 001 to R25 000 (5.6%),

and above R25 000 (1.6%).

Properties in the two middle brackets, representing rentals of between R3 000 and R12 000 a month, show the lowest vacancy rates (6.78% and 6.04%, with the national average 8.04%). They are also the brackets with the highest percentage of tenants in good standing - tenants who paid the rental on time, in the grace period, or paid late.

Price-wise, you should be looking at paying 10% to 15% less than the average property price in a particular area, she says, to earn a reasonable return on your investment after factoring in all the costs.

To work out the annual return on your investment, do the following calculation: subtract from your expected annual rental the ongoing expenses for which you will be liable, such as levies, insurance, rates and maintenance. Divide this figure by the total of the following: purchase price, plus transfer duty, plus conveyancing and bond costs, plus possible renovation costs. The result, multiplied by 100, is your net return expressed as a percentage before tax.

With regard to annual rental increases, Dickens says gone are the days in most parts of the country when you could increase the rental by 10% a year.

Only in the Western Cape do rental escalations currently approach that figure, at 9.88%. The national average is 4.37%, with the Eastern Cape at 5.9%, Gauteng at 3.87% and KwaZulu-Natal at 0.68%.

Which legal structure?

You can own rental property either in your personal capacity or in the name of a company, or in a trust. It's a personal decision, Michelle Dickens says, and it depends on how big you want to grow in owning and letting properties. You need to consider the following:

In each case, you are "making money off other people's money" by buying a property with a loan and getting the tenant to repay the loan on your behalf.

It's difficult to get a number of mortgage bonds with the banks if you are operating in your personal capacity, Dickens says.

If you are operating in your personal capacity, you will pay income tax at your marginal rate (up to 45%) on your rental income, whereas a company will pay tax on profits at a flat rate of 28%.

If you own several properties within a company structure, losses on one property can be offset against gains on others when reporting to the taxman, whereas they have to be reported separately if you are operating as an individual.

Regarding capital gains tax on selling a property, companies pay a flat 22.4%, whereas individuals pay an effective 18% on the highest 45% marginal rate (not allowing for exemptions).

If buying off-plan, either as an individual or a company, you have a taxable allowance under section 13 of the Income Tax Act that allows you to claim 55% of the purchase price over five years.

Trusts have largely become uneconomical vehicles in which to hold rental properties because of their high tax rates.

How to manage expenses

When buying a sectional-title property, Michelle Dickens says you need to make sure the scheme is financially sound, and you should ask about possible special levies.

You also need to look at the size of the complex, because the larger the complex, the more the risk of owners defaulting on their levy payments is spread across all owners.

Look at how well the other units in the sectional-title scheme or the houses in the area are maintained.

"It's no good having an oasis of well-maintained property in an area where the surrounding properties are badly maintained and there is a high rate of delinquency: you are unlikely to attract a good-quality tenant," Dickens says.

The more owner-occupied properties in a complex, the better, she says, because owner-residents tend to take better care of units and be actively involved in the management and maintenance of the complex.

Dickens says that nowadays landlords can recover expenses from sectional-title tenants that they were not able to in the past, including water, sewerage, electricity, refuse removal and parking. She emphasises that these expenses must be detailed in the lease agreement and cannot be suddenly foisted on a tenant.

You need to be disciplined in how you collect the rent (it's best, for example, to issue written monthly invoices) and how you deal with latepaying or non-paying tenants. The quicker you take action against nonpayment, the less money you lose, Dickens says. (On the legal process required to remove tenants, see "How to evict a tenant (lawfully)" on the Personal Finance website, www.persfin.co.za.)

Having good-quality, long-term tenants is the ideal, because you have a regular income and fewer periods when the property is vacant. To attract or keep such tenants, it is worth being slightly negotiable on the rental.

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