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The head of a typical HDB flat household speaks (Part 3).

Thursday, January 1, 2015

In part 3 of our correspondence, we talked about investing in real estate for rental income:

Hi Ak

Another friend of mine (same age as me)is so concerned with unemployment before 50 yr old, that he keeps urging us to buy a condominium and then collect rental income on it. 

He already owns an apartment in KL, and claims that he is successfully collecting rent of it. But he always avoid my question when I ask about currency & political risk of owning foreign properties. 

Now he is aiming for his 2nd rental property in Singapore. He said that prices are coming down and good time to buy in 2015 or 16. But again he avoid my question when I ask him about maintenance costs affecting rental yield and the oversupply of condos/ foreign labour cut back in Singapore which makes it risky strategy.

When I suggest buying S REITS as an alternative, he said it's not worth doing it until he has a million dollar capital base.

He also say meeting minimum sum in CPF is no big deal for him..

I am highly suspicious of his recommendation.

Good if I can hear your objective view on owning a physical property vs buying REITS. 

Thank you


My reply:

Hi C,

Well, there will always be risks in investments. Risks cannot be avoided but they can be understood and even managed.

Your concerns with regards to buying a property overseas for rental income are valid. I hope that your friend is still doing OK with the RM's decline in value against the S$.

Anyway, is it better to buy properties than to invest in S-REITs? The topic is well discussed by many people before. Personally, I feel that both are good investments as long as the price is right. Quite simple, really.

I don't know what your friend has in mind but if it is something vague like buying properties in Singapore in 2015 or 2016 is a good idea because prices will come down, I think he needs to do a bit more research and analysis.

Personally, I feel that any property investment must be able to provide at least a gross yield of 5% to 6% to make it worthwhile. This is a primary consideration for me and I blogged about the Rule of 15 before. Then, there is a whole gamut of other considerations which I have blogged about in a piecemeal manner before too.

Ultimately, I would say to do what you feel comfortable with. There are so many paths to financial freedom. Choose a path you are not only comfortable with but one which you are sure will bring you to where you want to go. :)

Best wishes,

Related posts:
1. Rule of 15.
2. Journey to financial freedom is not a race.
3. Buying a property in Iskandar, Johor.
4. Don't think and grow rich. 3 points to note.
5. The head of a typical HDB flat household speaks (2).


The Sun said...

Hi Ak,

Putting yields and political risks aside, I believe investing in REITS gives an investor better cushion against currency risks if the REIT manager is able to successfully hedge against currency fluctuations and thereby provide investors with more stable income distributions. It will be much more challenging in my opinion for an individual property investor to do so to protect his rental yield against currency fluctuations.

Whowillbe said...

Hi C,

We (as a couple) had FAs who did retirement analysis for us being and after we invested in real estate.

Before: We had to set aside 5K to invest into instruments like endownments etc to meet our investment needs. (note this was before I became more savvy about stuff like reits).

After: We did not need to do anything nor set aside any more funds. The assumptions were that the properties will be paid up (using the rental income) and we will also be getting additional payout from CPF Life.

So in my opinion, if you can find a good buy and the gross rental yield is 6% and after the monthly mortgage payment and expenses, you are still cash free positive, then in my opinion, real estate will be an excellent retirement tool.

However if you need income right away, then direct investment in real estate might not be good cause most of the rental income will be used to build up the equity in the proeprty. The full benefit is only unleashed near your retirement when the property is fully paid up and most of the rental income directly goes to you.

In this case, investing in reits will give you quarter income.

Eg. Let's say you have 300k.

Scenario 1: Invest in a 1 million condo which gives 6% yield. After paying all the expenses and mortgage, you may have only 3-4K of free cash flow annually. But the principal amount owed dropped by 30K. So in actually fact, you have earned 33-34K but 30K is stuck as equity in your condo.

Scenario 2: Invest 300k in Reits that give 10% yield. You will get 30k annually.

So given the 2 scenarios, you got to ask which will suit your needs and then come up with a plan to achieve it. :)

Rebel said...

It is also important to teach your kids financial literacy and resilience.

Wei Xiong How said...

Hi Whowillbe,

Not sure if the calculations and assumptions in Scenario 1 and 2 are correct.

Scenario 1: A 6% yield on a 1mil condo would give gross rental of 60k. After deducting expenses and mortgage will quite likely give about 30k of free cash flow. This gives an estimated yield of 10%.

Scenario 2: It would be difficult to find REITs that give 10% yield in the current market environment. A 6-7% yield is more reasonable.

In addition, it would be good to keep in mind the following points when comparing physical real estate investment and REITs.

1) Investing in physical real estate involve a higher degree of leverage. In your example given, the gearing ratio will be 70%. This is much higher as compared to typical REITs with gearing of about 30-35%.

2) Investing in physical real estate is much more illiquid than owning REITs. We should demand a discount (ie. higher yield) for the illiquidity.

3) Investing in physical real estate requires active management on our part. Again, we should demand a higher yield because of this.

Thanks for reading my 2 cents worth of opinion and feel free to correct me on any points.

Whowillbe said...

Hi Wei Xiong,

No issues. It really depends on the parameters like length of loan tenure, interest rates etc.

I should have been clearer in my explaination too. ๐Ÿ˜ƒ

My scenarios are based on my own experience in investing. I also forgot to mention that for scenario 1 (direct investing in property) is based on a normalized interest rate situation where rates are 2.5-3.5%. The current low interest rates are not the norm and the banks have been increasing their spreads. For me, I invested overseas, thus the letting fees and taxes are higher than Singapore one. So for local investment, the annual free cash flow be higher like 4-6k. Also I mentioned a gross rental yield of 6% as gross rental yield can be a good indication whether properties are overpriced or not. There was a post by AK71 on Rule of 15 to decode whether to buy or rent.

For Scenario 2, when it comes to investing for income, I assume 10% yield. It's really up to individuals, some are comfortable with 5%. But if I am to insist on 10% then I will naturally be waiting for a market downturn like the last GFC. It's really anyone's guess when will be the next big crisis. But in the meanwhile, I will continue to build up the warchest while waiting.

But to sum it up, what I was really trying to convey is the investing in Reits will give a greater Cashflow as compared to direct investment in properties where a lot of income is locked in as equity but there's also the power of leveraging which would be unwise to use in the case of investing in equities.

Hope this clears it up. ๐Ÿ˜ƒ

Whowillbe said...
This comment has been removed by the author.
bluelite said...

May I ask how is rental yield computed?

AK71 said...

Hi bluelite,

Gross rental yield is the annual rental divided by the cost of the property.

So, if you were to rent out a place for $3,000 a month, that gives you $36,000 a year. If that apartment cost you $360,000 to buy, then, the gross rental yield is 10%.

Then, there is net rental yield which is what you get after all the expenses (maintenance and taxes) are taken into consideration.

So, if the apartment has a monthly maintenance of $200 and the taxes to be paid is $3,000 a year, then, what is left of the annual rental is $30,600. The net rental yield is 8.5% in this case.

bluelite said...

Hi AK,

Thanks for your explanation.

Taking $360k cost of apartment, and ignoring any other expenses: $360k/$36k means after 10yrs your apartment will be fully repaid.

So after 10 years Dividend yield now is becomes 100%?

AK71 said...

Hi bluelite,

If we subscribe to the Rule of 15 which I have blogged about before, then, a property that gives a 10% gross yield is really very good, all else remaining equal.

Theoretically, the apartment would have paid for itself if there are no other costs or expenses to take into consideration in those 10 years.

To me, the yield will continue to be 10% on cost. It is just that you have recovered the cost in full.

Of course, if we think of the property as being free of cost after 10 years, than the yield is infinite even if rental should fall to just $1.00 a month. ;)

Whowillbe said...

Hi bluelite,

But definition, gross rental yield is annual rental income/purchase price.

So even if your apartment is fully paid up, your gross rental yield still stays the same until your annual rental income increases.

But the majority of your rental income will go into your pocket as free cash flow since your mortgage payment is completed.

Casey said...

Hi Ak,

I don't think we should restrict ourselve to any type of investment.

Property is a good instrument of capital gain in higher inflationary and low interest environment. Imagine you invested only 20% of the required but enjoying 100% of the capital gain on the inflation rate itself. If price goes up by 1%, your effective capital gain is actually close to 5%. However, in the deflationary environment, REIT could be the better option on the tax computation.

I love property investment due to its well established path and readiness to access to high levarege, that the stock investment could not be compared.

To invest in property, one must know why and when to start investing, if the environment of the market conditions turn against you, you should have a set of financial instrument to protect yourself.

To enjoy these sets of instrument, one would need a strong cash backup, and that is what I call the entry financial qualification, it is not the academic qualification, it is a financial qualification.

The cash backup will be the source of cash flow to generate enough cash for the loan commitment, cash could be switched from one instrument (reits, bond, gold, loan, stock, etc) to another easily as long as it work hard enough to generate the highest cash flow for you. On the other hand, your property work hard on the consistent capita gain.

Property itself is a cash flow instrument as long as it is rentable, but it is not necessary a net cash flow instrument due to the housing loan amortization nature. One should not invest in property if there is less chance of capital gain, as this instrument is used to hedge inflation and not the other way in this part of the world. When it has less chance of capital gain? Simple, when the price is too high, the property ownership mindset changed, or when the population is decreasing or increasing too slowly.

If the interest rate increase drastically, what should I do? A loan that is linked to the loan serving account and calculated based on the net balance of both would be a good instrument to counter the change of interest rate. This is why you need to be financially qualified to invest in property safety.

On foreign property investment currency depreciation risk, one should look into getting the highest leverage possible using local currency loan. Getting Singapore dollar loan for regional property investment is the stupidest strategy I ever heard due to the long term SGD strength on its powerful Sovereign investments especially against the MYR and the IDR. Certain reits use this moronic hedge. Unless the REIT price is 50% below the NAV, I would avoid it at all cost.

It is all about how cash should flow to generate highest investment return. Property is a new 'gold' that is most effectively protect us from inflation in this part of the world, we cannot write it off. But unfortunately, one needs certain level of financial qualification to make it an investment, and not a gamble.

It is just my personal view.


AK71 said...

Hi Casey,

That is a very good comment. In fact, it is more like a thesis. I like it so much that I feel like cutting it and putting it up as a guest blog instead. Is this OK with you? More people will get to read it as many don't read the comments section. Of course, it could attract many questions and you might be kept busy replying to these if we have it up as a guest blog. ;)

Personally, I have received a leg up from real estate investments. As long as the price is right, real estate can be a good investment. However, overpay and we might have to face the music.

To me, rentability is an important part of real estate investment. At the same time, having the resources to ride out rough patches is necessary. One who depends solely on rent generated by the property to service the loan could be walking on thin ice.

I like how you put it that we have to be "financially qualified to invest in property safely". Indeed, if we know how it works but do not have the financial qualifications, it should be avoided.

However, I have an inkling that many local property investors (I will not say most) are not financially qualified and it is better to err on the side of caution for them. Better not to make money than to lose money.

For them, it is better to keep things really simple, I feel.

Buy when Mr. Market is feeling depressed and willing to offer meaningfully lower prices. This will give the buyers some margin of safety.

Stay on home turf or familiar grounds where it is easier to grow a circle of competence.

Ensure that rental yield and rentability are both reasonable. This is especially important if they are not eminently financially qualified. :)

Casey said...

Hi Ak,

Thanks for the offer, but I think it is still best to leave it as a comment, it wasn't well written too.
In a blog post, unless it is very well and clearly written, it often prone to misinterpretation. My comment is meant to share my opinion on investment property in the inflationary environment and how various leverage (debt) could be used as instrument to take advantage on the inflationary environment. When the intrinsic value of the debt is diminishing and the asset value is growing, also the backup plan when the trend reverse.
It is too complex to be discussed in the blog post. To those who are interested, it is best to study and learn themselves, teach less so that one can learn more and avoid misinterpretation.

Besides, I fully agree with you, if one is not an experienced or qualified investor, stay on home turf to grow a circle of competence. Read more books to gain your financial intelligence.


AK71 said...

Hi Casey,

Yes, I have had my fair share of being misunderstood in my blog posts. LOL. I understand.

Well, I understood your point of view on real estate investment in the current environment totally. I also appreciate the contingency plans that you have shared. Thank you. :)

AK71 said...

S$1.00 = RM 2.7234

Ringgit at its lowest in 34 years.

Those who borrowed in S$ to invest in rental properties in Malaysia should worry if this trend is intact, especially with the expected oversupply of properties in Iskandar in the next few years.

AK71 said...

From FB:

Benjamin Lee Yongkai:
I guess it is true to some extent as long it is fully paid by then?

If his friend can buy a condo in Singapore as an investment property and pay fully within 10 years (from age 39 to 49), I don't think he needs to worry about retirement income. Instead, his friend should worry about being unemployed while still servicing the loans for these investment properties.

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