The Magic of Property

The Magic of Property
Dolf de Roos

If Property is so good, why aren’t more people promoting it as an investment vehicle? or "Investing in Real Estate has special advantages, you should know about".

Although direct investment in property continues to be one of the best investment options available today, there are very few people openly raving about its merits.
Partially this is because there are not many people (other than property investors themselves) who benefit from property acquisitions. Indeed, in New Zealand, even real estate agents get their commissions not from the purchasers, as they do in many parts of the world, but from vendors.
The lack of enthusiasm for property is also partly the result of incomplete knowledge about how property works. This incomplete knowledge manifests itself when yields on properties are quoted and compared to the returns on fixed investments. Almost without exception, the yields quoted are income yields, and no account is taken of factors that can dramatically affect the net returns to investors, such as depreciation provisions on improvements and chattels. Similarly, most people not involved with property are very quick to point out the management "burden" of property, but fail to fully explore the tremendous benefits.
And benefits there are, both relative to property investment in other parts of the world, and to other investment vehicles. Of all the benefits, there is one in particular that sets property apart from most other investments....
Imagine going to a bank manager and saying: "I really think that gold and silver are going to go up in value, and I am quite bullish on diamonds as well, and furthermore my friends assure me that antiques and paintings are truly sound investments, so please Mr. Bank Manager will you lend me some money so that I may invest in these things?"
The response of the banker will be the same the world over.
On the other hand, all over the world banks and financial institutions are falling over themselves to lend you money so that you may buy property (be it for investment purposes or other reasons). That tells us two very pertinent things about property: firstly, it is still perceived to be an exceptionally secure investment, and secondly (and more importantly), you don’t even need to have the money required to buy a property.
Whenever I mention these points at a seminar there is always someone whose comfort zone does not yet encompass property who speaks up and says something like: "Now hang on a minute, one bank has just changed its lending rules from advancing 70% of the property’s valuation to only advancing 60%, which proves property is out of favour, so don’t tell me they are falling over themselves to lend us money". The answer is simply that even if one bank reduces its exposure from 70% to 60%, that is still 60% more than any bank will advance on almost any other asset in which you may care to invest. As to the "falling over themselves" part, I stand by the wording. Recently, one bank was offering mortgage applicants six chances to win $10,000 simply by arranging a mortgage with that bank. Another bank got on the band-wagon and offered a free trip to Sydney just for taking a mortgage out with them. Others replaced their standard 1% application fee with a $1 fee, or waved it altogether "for this month only".
At one seminar an attendee pointed out that banks don’t just lend against property: his bank had been more than willing to advance him 100% of the money he needed to buy unit trusts, so surely everything I had been saying was biased. When I asked him to share with us what the bank required him to put up as security for the loan, he admitted that he had offered his home as collateral. So even in this situation it is property that provided the security - not the unit trusts. Try asking a banker whether he would let you mortgage unit trusts to enable you to buy a property!
This willingness on the part of banks to finance your properties is a delightful situation: banks have the money needed to buy a property, but do not wish to own it, whereas you want to own the property but don’t have the money. It is, therefore, not surprising that a synergetic if not symbiotic relationship arises.
The net effect on the investor is that his investment is now "geared" or "levered". Consequently, the notion of yield is no longer as relevant as it is to an investment (property or anything else) that is not geared. To illustrate this, let us consider two investors, each with $100,000 in cash. Let’s assume that the first investor puts his $100,000 cash into an investment (again it matters not whether it is property or something else) without gearing. The yield on that investment then represents the return to the investor on his $100,000 cash. Let’s also assume that the second investor uses his $100,000 cash as a deposit on a property. For the sake of this exercise we do not need to know whether the purchase price is $200,000, $500,000 or whatever, for we are not interested in the yield on the purchase price, but in the return on his $100,000 cash.
Whatever the level of gearing, our property investor may deduct mortgage interest payments against rental income. If the investor is negatively geared (total outgoings exceed rental income), then he may claim the loss against other income, even if the loss largely comprised non-cash deductions such as depreciation (i.e. a paper loss). If the yield on purchase price exceeds the mortgage interest rate, then the greater the purchase price, the better off he will be. What ultimately interests the investor is the Internal Rate of Return or IRR, which takes into account his cash outlay, the cash flow transactions during the period of ownership, and the redemption value at the end of his period of ownership. The IRR then is a figure that tells you what your return has been, not on the purchase price, but on your series of cash flow transactions.
Although accountants have a complex text-book definition of the IRR, the concept is really quite simple. Calculating the IRR for a property is complex, but software easily takes care of that. And when the IRR of a property is compared to that of other investments, then suddenly it becomes apparent why property investors are such fervent practitioners of their trade.
Dolf’s brilliant books and software package "Real Estate Acquisition Program" or REAP are availalble on line.