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Thursday, 25 December 2008

Property investing - doing the math

MOST individual investors of real estate have a gut feel about whether they made, lost or broke even after holding their property for a certain period. In reality, few attempt to do the math to measure how well the investment truly performed and whether they were rewarded for the risks they took.

The only ones who are fairly confident of quantifying their profit or loss are the 'flippers' who speculate and deal in the sub-sale market without involving bank loans, rental income and outgoings.

This article takes the reader through two real-life case studies of investing in private residential properties in Singapore over two different time periods. The focus is on getting a sense of timing, time horizon, interest rates, rental yields and rate of returns. The outcome is to help an individual investor assess if real estate investing is worth the risks involved.

Case 1: 1982 to 1991

Not many of us will recall that there was a red-hot residential property market in Singapore in the early 1980s. Condominiums were making a splash and the Central Provident Fund was made available for investment in properties. It's hard to believe but mortgage rates were in the low teens in Singapore at that time. The particular property in this case was in the Pandan Valley area. It was a brand new 1,000 sq ft studio apartment that was launched at $300 per sq ft. The initial tenancy was at $2,500 a month. This translated to a gross rental yield of 10 per cent, bearing in mind that mortgage rates were around 13 per cent a year.

Everything was fine until the recession of 1984. The monthly rent dropped to $900. The value of the condo unit languished at the $200,000 level for the next two years. The gross rental yield fell to a more realistic 5.4 per cent (annual rental of $10,800 divided by prevailing market value of $200,000), almost in line with mortgage rates prevailing through the brief recession.

If the owner had sold the property after holding it for five years, the capital loss would have been massive. However, the property market recovered and by 1991, this studio apartment was sold for $400,000. The owner was not prepared to hold on because of the uncertainties connected with the first Gulf War.

More importantly, the investor decided to use the proceeds to upgrade his primary residence. Intuitively, he was satisfied that he had broken even in terms of cash flow. But he did not know (or care) that his actual internal rate of return (IRR) was only 6 per cent a year for the 10-year holding period.

Incidentally, an opportunistic investor who bought an identical unit in 1987 would have realised an IRR of 34 per cent a year in 1991. (see sidebar).

The question is: Was the investor who held the property from 1982 to 1991 - while suffering the throes of economic upheavals - fairly rewarded for the risks he took?

Case 2: 1996 to 2007

This period in time will be more familiar to most of us. The climax of the bull market of the 1990s came about unexpectedly when the government intervened in May 1996 with anti-speculation measures. Our second investor bought a brand-new condo in District 9, a few months prior to the drastic new housing rules. The 1,300 sq ft three-bedroom unit was acquired at $1,200 psf, or $1.56 million. The first tenant paid $4,500 a month for a gross rental yield of 3.6 percent. The interest rate was 5 per cent a year in the initial period, but steadily dropped to 1.5 per cent in 2001.

Till today, this condo is very marketable and the maximum period of vacancy between tenants was six weeks. The rent fell to $3,000 a month in 2000 for a gross yield of 4 per cent (annual rental of $36,000 divided by the market value of $900,000 in the downturn years).

Other property owners who did not have the holding power were forced to sell at a loss at around the turn of the millennium. Our investor took the lumps and hung on. By the end of 2006, with strong interest for second tier properties, the investment broke even compared to the original purchase price in 1996.

If this unit is sold today, the investor can pocket $1 million after settling with the bank (sales price of $1.8 million less outstanding mortgage of $800,000). The internal rate of return from the date of acquisition now stands at 3 percent a year over 11 long years.

The question is: Should the owner sell now or wait for a more respectable return? What is the appropriate benchmark to gauge if this investment has met the threshold for an acceptable return?

The two real-life cases were selected to demonstrate that timing in property investment is critical. Peak to peak time horizon within a property cycle may result in a lower than optimal rate of return. Investors cannot anticipate external forces that may derail the best laid plans. Speculators know this too well and they have no intention of holding property longer than necessary. It's simply capital gain they chase.

Exposure to real estate is part of a sound overall investment strategy. This exposure may not necessarily be in bricks and mortar (which has no liquidity) and should be beyond Singapore (for diversification). One alternative for liquidity and diversification is to invest in a portfolio of global property shares, funds and Reits. Due to higher risks, the expected rate of return from a well-timed property investment will be higher than a globally diversified portfolio of property securities.

If we assume an average inflation rate of 3 per cent a year in Singapore, then any investment should exceed this minimum return in the medium to long term. Then, there is the risk premium for property: an average net rental yield of 3 per cent and capital gain of 5 per cent add up to 8 per cent a year total return, or 5 per cent a year above inflation.

A useful proxy for the local landscape is the All Singapore Equities Property Index (left). The total return for the period August 1997 to August 2007 was 4 per cent a year. That's a dreadful performance indeed for the long-term investor in Singapore property stocks during this eventful decade. Maybe our Case 2 investor should not feel too badly after all.

In conclusion, investing in residential property provides pride of ownership and a hedge against inflation. Whether it delivers adequate income or capital gains to an investor depends on many factors. In a nutshell, the property investor should acquire a quality product, pay a reasonable price and have the ability to hold for a long enough time horizon to earn the appropriate return.

The property agent, conveyancing lawyer and banker play their part in the buying and selling of the asset. These roles are necessary to ensure a smooth transaction. An experienced financial adviser can offer advice on the required return on investment, asset allocation and risks connected with the property as part of an overall investment portfolio.

Roy Varghese is director, financial planning practice at ipac Singapore. The views expressed are his.
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