Let’s admit it. Like most Singaporeans, at some point in our lives we’ve all had the dream of owning at least two properties. So we can live in one, while renting the others out.
#passiveincome #financialfreedom #dreamretirementachieved
This may have been a popular retirement plan for Singaporeans in the 1990s and early 2000s, where many homeowners saw the value of their homes skyrocket, often by multiple folds. But with all the various cooling measures that have been put in place by the government over the years, it may no longer be so attractive in the present day and age.
A recent article published in The Business Times showed that property may no longer be that ‘pot of gold’ for everyone’s dream retirement. According to research from DBS, property prices in Singapore have risen by a rate of about 2.1% over the past 5 years, while income growth has only averaged between 1.2% (median income) to 1.7% (80th percentile). What this essentially means is that owning a property (not to mention multiple properties) is now becoming increasingly unaffordable for Singaporeans.
But still we’re seeing new condo units fly off the shelves days after launch, even in the midst of the COVID pandemic. What is it about investing in property that’s so attractive?
The story of Paul and Stanley
Paul and Stanley are always at loggerheads with each other and can never agree on anything. One day, they had an argument about investing. Paul believed strongly that he could make more money by investing in property, while Stanley believed that stocks were the more profitable investment.
So they set up a challenge: Stanley invested $250,000 in a portfolio of stocks. Paul, on the other hand, used the same amount of money to place the downpayment for a condo unit, took a mortgage of $750,000 and rented the unit out. The rent he collected paid for the mortgage, so he didn’t have to fork out any additional money.
A year later, the two men met for coffee. Stanley boasted that his stock portfolio had grown by 20%. Paul smirked and said that, while the value of his property only appreciated by 10%, he had made more money than Stanley. Why?
The power of leverage
Simply put, leverage is the use of borrowed money to increase the potential return on an investment. And one common example of leverage use is, well, in real estate investing. Let’s look back at Paul and Stanley’s story.
| Initial value of investment | Profit at the end of one year | |
| Stanley’s stock portfolio | $250,000 | $250,000 x 0.2 = $50,000 |
| Paul’s investment property | $1,000,000 ($250,000 downpayment, $750,000 mortgage) | $1,000,000 x 0.1 = $100,000 |
Both Paul and Stanley came up with the same initial capital of $250,000 each, but Paul made a higher profit than Stanley, even though his property investment appreciated less than Stanley’s stock portfolio. This was possible because of the mortgage he took, which allowed him to own a $1 million property with only $250,000. Leveraging on the mortgage, any returns on his property investment was multiplied.
As you can see, the use of leverage allows real estate investors to either purchase a property that’s worth more than the amount of cash they have available, or spread out their cash across multiple properties.
Technically speaking, the same would apply for rental income as well. Assuming the dividend yield and rental yield was 2% on Stanley’s and Paul’s investments respectively, Paul would also be able to draw a higher income from his property investment due to the use of leverage.
| Initial value of investment | Income from investment | |
| Stanley’s stock portfolio | $250,000 | $250,000 x 2% / 12 = $416/month |
| Paul’s investment property | $1,000,000 ($250,000 downpayment, $750,000 mortgage) | $1,000,000 x 2% / 12 = $1,666/month |
Of course, we’ve yet to take into consideration the various costs involved in maintaining an investment property, such as monthly mortgage repayments, property and rental tax, maintenance costs and utility bills. But even with all these different costs, what investors also get is a cold hard asset that they can see, smell, hear, touch and taste, giving one a more assuring sense of ownership. This is something that owning other intangible assets like stocks will never be able to give.
That’s what makes property investing so attractive.
Downsides of leverage
Some of you may then ask, if investing with leverage amplifies your gains, doesn’t that mean it also amplifies your losses? That is absolutely true.
Referring back to Paul and Stanley, if their investments both suffered a 20% loss after one year, here’s what would have transpired:
| Initial value of investment | Loss in dollar value after 1 year | |
| Stanley’s stock portfolio | $250,000 | $250,000 x 0.2 = $50,000 |
| Paul’s investment property | $1,000,000 ($250,000 downpayment, $750,000 mortgage) | $1,000,000 x 0.2 = $200,000 |
In such a situation, if for some reason Paul needed to sell his investment property then, he would have been forced to realise a loss of almost 80% of his initial capital after paying off the remaining mortgage.
Furthermore, with leverage also comes interest rate risk. Interest rates, also known as the cost of borrowing, fluctuate all the time depending on a country’s monetary policy during various economic climates. When central banks turn hawkish to curb inflation, a rise in interest rates would also mean an increase in one’s monthly mortgage repayment. In Paul’s case, since the rent he collects pays for the mortgage, a higher mortgage may mean he now has to fork out additional cash every month. For some, this can also add to their financial burden.
Essentially, if one’s return on investment is insufficient to cover the cost of borrowing, trouble ensues. This was the also the main reason for the entire Evergrande saga. It’s a super long story with many many details to go into, but the TLDR is, like many other real estate developers in China, Evergrande was in an over-leveraged position. In layman terms, they owed an unhealthy amount of debt. And due to various reasons, a loss in income resulted in them defaulting on loan repayments, bringing them close to collapse.
Conclusion
Truth is, while the risks involved with taking leverage are real, it is not all that scary if well-managed. Having a healthy amount of debt can sometimes be the sensible thing to do. And in fact, people use leverage in a variety of different ways every day — trading stocks, growing a business, and even in retirement planning.
If you’re planning to buy a second (or third) property as an investment, do work out your finances properly and make sure you’re not over-leveraged already. It also helps to know the different costs and taxes involved, as well as the pros and cons. Unintentionally selling koyok (translated: marketing myself) here, but working with a licensed financial planner like myself can help you consider and weigh between the various opportunities and options available. You can reach me through WhatsApp or call me at 9622 6231. Coffee on me, no obligations as usual.
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