By Warren Ingram, CFP®
Introduction:
Residential property investment is often promoted as a great way to accumulate wealth. The benefits, we are told, include passive income through rent as well as capital growth from rising house prices. In addition, there are the benefits of owning a tangible asset rather than an intangible asset like a share, unit trust or Exchange Traded Fund (ETF). However, the reality is a lot more complex; residential property has some real downsides that must be considered before purchasing. In this article, we consider the merits of residential property investment, dissecting its pros and cons to comprehensively understand its viability as an investment avenue.
Pros of Residential Property Investment:
1. Leverage through Borrowing: One of the primary advantages of investing in residential property is the ability to leverage borrowed money. With a mortgage (home loan), investors can use a small amount of their own money while borrowing a larger amount from the bank to buy an investment property. If the property grows in value, this will amplify the return on capital invested.
2. Rental Income: A well-chosen property with a reliable tenant can provide a steady rental income stream. In the ideal scenario, rental income can even cover mortgage payments in the long term, effectively allowing the tenant to pay off the investor’s mortgage.
3. Stability Against Market Fluctuations: Unlike investments in shares, residential property is less susceptible to short-term market fluctuations. The tangible nature of real estate often provides a sense of stability and security to investors, shielding them from the stock market’s volatility.
Cons of Residential Property Investment:
1. Illiquidity: Real estate investments are inherently illiquid. Unlike shares, ETFs, or unit trusts, which can be easily traded on the market, selling a property requires time and effort. In a property downturn, house prices can fall further and remain depressed for longer because it is so difficult to sell the assets. This lack of liquidity can also pose challenges when quick access to cash is needed.
2. High Transaction and Maintenance Costs: Investing in residential property entails significant transaction costs. From bond registration fees to estate agent commissions and transfer duties, the expenses can quickly add up, reducing the overall returns on investment. In addition, you need to cover ongoing maintenance, property taxes and levies if you own a sectional title. The total annual costs could be higher than 2% per year and must be factored into any growth calculation.
3. Property Management Challenges: Managing residential properties can be labour-intensive. Property management requires time, resources, and expertise, from dealing with tenant issues to overseeing maintenance tasks and unexpected repairs. Moreover, navigating tenant rights and legal complexities adds another layer of complexity, making it challenging to remove problematic tenants.
4. Risk Factors: Residential property investment has risks. Vacancy rates, property damage, legal liabilities, and market downturns are all factors that investors must contend with. Moreover, poor investment decisions or inadequate risk management strategies can exacerbate these risks, potentially leading to financial losses.
5. Moderate Returns: While residential property investment can sometimes yield attractive returns, historical growth rates have been modest compared to the stock market. In South Africa, capital growth on residential property has delivered approximately half the stock market’s growth over the long term. It is important to note that the impact of rental income is not included in capital growth. When considering the after-cost total growth of residential property vs the after-cost total return of the stock market, I estimate that residential property delivers half the growth of shares.
Conclusion:
In conclusion, investing in residential property offers a mixed bag of opportunities and challenges. While the passive income and long-term appreciation potential of residential property may seem enticing, investors must carefully weigh the pros and cons before diving into this asset class. From the illiquidity and high transaction costs to the complexities of property management and inherent risks, residential property investment demands a strategic approach and thorough due diligence.
Written by Warren Ingram
If you’re looking for a more nuanced conversation, check out Warren’s episode on Property investment. for more information.
CFP®, Wealth Manager, public speaker, and author. Host of the Honest Money podcast. FPI South Africa Financial Planner of the Year 2011.
