Wednesday, February 10, 2010

Property Investing – A Discussion on the Pros and Cons

It is with some trepidation and reluctance that I venture into the topic of property investing, for Singapore is a country whereby its residents fall in love with property, and where most of the rich folk make their money from properties. Personally, I also know a few relatives who are sitting on very good rental yields on property which was purchased a few decades ago. With the steady and relentless rise in property prices, for both HDB flats and private properties, I think now has come the time for me to voice out my views on this matter. Firstly, it is to highlight the salient aspects of property investing; secondly it is also a “diary” of sorts to remind myself of my thoughts at this point in time (when property is hitting new all-time highs).

The Essence of Property Investing

Property investing generally differs from equity investing in one important aspect – it makes use of leverage and collateral to “multiply” gains. This is what I had observed in the majority of cases as Singaporeans are generally not cash-rich enough to purchase the entire property outright, therefore most will pay a downpayment of say 20% and finance the remaining 80% through the use of a bank loan. Since those who can fully pay for their properties are just a small minority, I can conclude that most people make use of leverage for their property purchases, and when it comes to property investing, most may already own 1 property (in which they live in), and are contemplating a second property purely for investment purposes.

Even with equities, one can make use of leverage (commonly known as “margin”) in which shares are used as collateral to purchase even more shares. However, this blogger has always discouraged the use of leverage in equity purchases because during good times, your gains are magnified; but during bad times, your losses are exacerbated manifold. The same scenario also plays out in property investing as leveraged is usually heavily employed. Assuming a S$1 million piece of property, the down payment will then be S$200,000, with the remaining S$800,000 financed by a bank loan.

Assuming that property prices go up amid bullish sentiments, the property is then worth S$1.2 million, and you can sell it to pocket a S$200,000 gain. Considering you only put down S$200,000 worth of cash in the first place, this translates into a gain of 100% on your initial investment! On the flip side, assuming the market tumbles and sentiment turns bearish, the property may be worth just S$800,000. Assuming you sell, you then incur a loss of S$200,000 which will wipe out your entire capital. This simple scenario did NOT take the cost of debt into account, and I shall elaborate on that in a later section.

Risks and Rewards

The risks are as mentioned above with regards to property prices, and these are similar to stock prices in that they can rise and fall. However, property is far more illiquid and there may not be a ready market out there, which means it may be hard to sell or the bid-ask spread may be large and significant. Another risk is that of the bank asking for the topping up of the loan quantum as the collateral (which is the property you purchased) has fallen in valuation. This is a risk unique to leverage as there is no such risk of topping up if you had paid up fully in the first place. So the important thing about buying properties is the ability to stomach such dips by having sufficient cash buffer, and also being able to buy and hold if things go wrong.

The rewards (positive) side of holding a property is that it is a tangible asset, unlike shares which are essentially intangible (i.e. scripless). This means there will always be value in a property, unlike shares which can crash to zero if the company goes bankrupt and needs to wind up. The value, however, is based upon independent valuations as well as last transacted prices, and can be unique to the area (location) and the tenure (whether freehold or leasehold). Another positive about properties is the ability to rent it out to earn rental yield. This is unlike shares in which the dividend yield is determined by the company and the economy at large. Of course, one can argue that tenants may be in short supply during periods of economic turmoil; and in extreme cases, rental income may also not be able to cover the monthly instalment payments assuming you had purchased close to the peak of the market cycle.

Interest Rates

Interest rates are an aspect which property investors have to keep a close eye on, and much research needs to be done to ensure you get a good loan package; otherwise you may bleed more cash than is necessary just to service the loan. For HDB, they offer concessionary loan rates of 2.6% per annum, which has been “fixed” for the last couple of years. Most banks offer 2-year fixed rates (lock-in period) and thereafter start floating the rate, using SIBOR as a guide. The idea is to get a low interest rate on your mortgage and then re-finance once the lock-in period is over. It may be useful to look for a mortgage broker who can offer their services to hunt for the best home loan package to suit your needs, rather than to do the tedious homework yourself.

The often talked about threshold for affordability is that the debt servicing ratio must NOT exceed 35% of your total income. This is defined as the monthly payment amount divided by your total gross income (per couple). An example would be a couple earning S$10,000 a month – they should not service debt which is higher than S$3,500 a month, including car loans and other loans as well. Interest rates are currently at multi-year lows which makes many loans appear “cheap”, but take note that when rates rise in the near future due to inflation the impact on instalments may be quite significant. Do factor in potential rate increases to budget and buffer against such events and to ensure one is adequately covered and that the debt servicing ratio remains below 35%.

Conclusion: The Property Cycle

To conclude, one must be able to read the property cycle very well, as I had mentioned earlier that property involves leverage; and is also illiquid. Thus, one would really look to “buy low, sell high” rather than “buy high, sell higher”, as the risks are a lot higher for property compared to equities due to the two reasons mentioned.

With housing prices hitting new all-time highs recently, for both HDB resale as well as private, to me at least, it does not seem like a good time to commit to an investment property, even if one has the cash.

I would like to hear readers’ views on the property market and property investing. Is this really the way to make “big money” in Singapore? Have there been any cases of “horror stories” that you had heard? I will be blogging more about property in the months to come, as I read more and digest the news bits.

25 comments:

AK71 said...

Hi MW,

This post is very well written and should be very useful to people who are considering real estate as an investment. I'd like to share a post in my blog here:

http://singaporeanstocksinvestor.blogspot.com/2009/12/real-estate-as-hedge-against-inflation.html

Createwealth8888 said...

Hi MW,

Share my view too. Tks

http://createwealth8888.blogspot.com/2009/07/investing-in-property-or-stocks-revisit.html

JW said...

Hi MusicWhiz,

just like how one invest in equities, investing in properties requires a strategy and mindset as well. Strategies can include buying a dilapidated property, sprucing it up, and letting go or renting it up at a higher price... i.e. adding value...


The most important advantage about property investing vs equity investing is that in property investing, you get to control, improve and enhance your assets yourself. It's just like you have your own business.

Leverage is indeed a double edged sword. Of course, risks can be reduced or minimised with sufficient homework done. Good that with your strength in analysis, coupled with your income and investments, you are starting to take a look at this topic of property investments. Looking forward to more of your research!

Musicwhiz said...

Hi AK71,

Thanks for the compliment. Your sharing is very helpful as well! Glad to know you invest in properties too.

Regards,
Musicwhiz

Musicwhiz said...

Hi Createwealth8888,

Thanks for your views and for visiting. I think we share the same views on leverage.

Regards,
Musicwhiz

Musicwhiz said...

Hi JW,

Yes you made a very good point - you can choose to enhance your asset to increase its sale value and revenue potential! Thanks for that.

Well, I am not sure if value investing in equities can be 100% applied to property investing as the nature is very different, but I will still try. I believe the principles should be the same though.

Cheers,
Musicwhiz

Hitori said...

Well written story about property!

Musicwhiz said...

Hi Hitori,

Thanks for visiting!

Cheers,
Musicwhiz

Berkshire said...

Hi Musicwhiz,

I like your article. Well written. Personally, I think it maybe hard to really put a pretty accurate valuation as to what a property can return over a period of time, mainly, for the reason that if based on rental yield, rental yield can be cyclical.

If I were to chose one aspect to value, it'd be based on affordability. If the average property price is $1m, and the per capital income is $300k, then the average house price represents 3.33 times of annual income per capital. If on the other hand, the per capital income is $100k, then the house is 10 times the average income per capital.

So when houses are priced at 3.33 times of per capital income, it is likely that an individual would have more disposable cash in hand, and he'd likely consume more, and drive up prices in things, which would include property prices.

Akatsuki said...

Well, do correct me if im wrong. Why not just use the money eg.200,000 and invest in REITs?
From what i know, the advantage REITs have over buying pure properties are as follows

1)Diversification

2)Experts,professional that manage your money

3)If property increases in value wouldnt per unit REIT also increase as much?

4)All rental income you don't have to bother.

Perhaps the capital apprecition in buying pure property is slightly more, more REITs are a safer choose in my humble opinon =]

JW said...

Hi Akatsuki,

let me share my humble opinion.

You enjoy the advantages of value creation, value addition, when you manage your own property.... all these on top of value appreciation :)

Less so for REITS.

Ricky said...

Happy New Year MW and all! :)

Musicwhiz said...

Hi Berkshire,

Yes, housing affordability is also measured in terms of how many times gross salary a property is. I've heard that 3-5X is generally considered "affordable". But there are stories in Shanghai and Beijing of this ratio jumping to 10X or even 20X, which probably implies a bubble is rapidly forming.

Even here in Singapore, imagine a couple earning a combined S$7K per month. That's about S$84K a year. If they buy a property exceeding S$840K, that's already 10X their annual gross salary. The fact is that housing prices seem to keep rising, but salaries are not moving in tandem (not keeping pace). To me this looks dangerous and unsustainable, but in the meantime everyone is happy and content....

Cheers,
Musicwhiz

Musicwhiz said...

Hi Akatsuki and JW,

Thanks for your comments on REITs. I can't say much cos I don't study REITS in great detail.

Regards,
Musicwhiz

Musicwhiz said...

Hi Ricky,

Happy New Year to you too!

Warm Wishes,
Musicwhiz

Berkshire said...

Hi Musicwhiz,

Totally I am in line with you. Properties, if it is growing above normal wage growth, and hit the tipping point, it can only go the other way. The question is when the tipping point is touched.

The worst kind of bubble is those that are supported by unrestrained lending facilities. Cos the bank will get hurt by having to write down nonperforming loans, having more foreclosure, and bringing housing prices back to where it rightfully belongs to. When banks get hit, their capital gets hit too, and it restrained its lending capacity, affecting all the rest up and down the chain.

Musicwhiz said...

Hi Berkshire,

Yeah you're right. What you described sounds uncannily like the USA sub-prime crisis. A lot of NPL for banks, no doubt, as housing prices fell and homes were foreclosed. The sad reality is that it can happen anywhere, and is not just confined to the USA.

Cheers,
Musicwhiz

shopwithme said...

Hi,

I am a mortgage broker, do drop me a mail if you have any question regarding the bank interest rate.

For Refinancing
Fixed Package:
1.88% fixed 2 years
thereafter 3mth sibor +1.25%

Floating
3/12month sibor +0.50% (1st yr)
3/12month sibor +0.50% (2nd yr)
thereafter 3/12month sibor +1.25%


There are Pro's and Con's in taking SOR package now.
Pro's - currently its at one of the lowest point ( usu higher than Sibor but currently lower than Sibor as the economy is down)

Con's - SOR flucuate up and down very fast ( Volatile), if tie down to 1 - 2 years , your heartbeat might not take it when the economic turn better.

Do drop me a mail at ngweiwei@gmail.com if you need any advice on the best rate in the market right now.

{~}For Risk taking, different people have different tolerance level, i can give you the best rate but in the end it's you who is going to make the decision. {~}

Berkshire said...

Hi MW,

But there's a big difference between mortgage loans in USA and many other parts of the world, including SG. During the precrisis US, banks are even willing to finance up to 100% of home value. There's no skin in the game for homeowners. But what is worst is homeowners can chose to walk away and banks have little or no recourse in pursuing the owners' other assets or future income. Banks would take the hit directly. This is unlike in SG, UK or many other countries where if you chose to walk away, you still carry the burden.

8percentpa said...

Hihi,

Would just like to add my 2 cents. Historically, rental yield calcuations based on current rental income over market price have indicated that property gives about 3-5%. ie a PE of 20-30x. Of course there are times that the yield hits like 7%, which is a screaming buy. Or 1%, like Shanghai, Monaco, Tokyo during the bubble.

I think Singapore's yield today is probably one of the lowest in its history at 3% or so. For some developments, it may even be 2%. So a value investor would not buy at such prices. I would think that a true value investor would look for yield of 5% or so.

Having said that, property prices are very inelastic on the downside but not so on the upside, it takes time for the yield to increase to from 3 to 5 or the juicy 7%. Maybe like 5 years or more. So those poor newly weds are in for a hard time.

The other concern is that property prices in global cities are increasing getting bidded up by international wealth, and coupled with low interest rate, it is likely to see rental yield fall even further. It is not unimaginable that all global cities have rental yield of only 1-2% like Monaco. Global cities includes New York, London, Shanghai, Hong Kong, Tokyo, Mosco, Mumbai, and of course, needless to say Singapore.

Then the 5C dream will be broken and most Singaporeans should seriously think about renting for life bcos it will work out to be cheaper.

Musicwhiz said...

Hi shopwithme,

Thanks for the offer, I will consider it if I need a mortgage broker.

Regards,
Musicwhiz

Musicwhiz said...

Hi Berkshire,

Thanks for pointing out the difference. I guess here in Singapore, banks protect their backsides very well; and the individuals who speculate too aggressively in property cannot just turn tail and walk away. They must bear the burdens of their reckless behaviour. In a way, I think it's good too as it teaches people that excessive risk-taking can only end in disaster. Still, we continue to hear of people flipping properties....haha

Cheers,
Musicwhiz

Musicwhiz said...

Hi 8percentpa,

Wow that's very enlightening but also very scary at the same time. If property prices keep soaring and rental yields keep moving down, this means that eventually people would rather rent because they will be priced out of the market!

Your observations are indeed accurate for major developed cities around the world in terms of rental yield because that's what I read in the news as well. The "hot" money is moving fast into properties and pushing them to new all-time highs, and the low interest rates are not helping.

But if we take a 3-4 year view and the USA starts to pull the plug on the stiumulus, then eventually rates will begin to rise. It's inevitable though the timing cannot be exactly known. What then will happen to those who had leveraged up to flip or speculate? Or even the young executive couple who takes up 30-35 year bank loans to service their spanking new condominium? That, I suspect, will be a worrying thought for the future.

In view of all this, how can a couple rationally have children? The cost of living is becoming increasingly more and more expensive!

Regards,
Musicwhiz

Royston said...

Hey there,

I think property is a good form of investment. But like all other investments, alot depends on the price. At the current market highs, i don't think its wise to go into property now.

Also, i think property is better as a long term investment and rented out for rental yield. As compared to flipping by speculators. The transaction costs are high, and so are the risks.

As a long term investment, i think property is hard to beat, cos of the leverage that you can use.

Cheers.

Musicwhiz said...

Hi Royston,

Yep I agree with your points. Problem now is that I don't have enough $$ to put as downpayment to invest in a property! Still building up cash.....

Cheers,
Musicwhiz