An idea to explore if you’re renting (Part II)

By Centauri78

If there’s part I, there must at least be a part II, right? Of course!! If you’ve been waiting for this sequel, sorry I’ve kept you waiting for so long. I hope I pack enough of a punch here to be worth your waiting time!

So anyway, some of you out there may be thinking that you’re nice and comfortable living in your rental place and moving’s such a hassle. However, property ownership still sounds like a good option to hedge against rising rentals. Well, certainly, you can do both! However, there are a few options, and correspondingly, there are a couple of questions you have to ask.

Question 1: Do you intend the property to be a back-up residence for you?

Consequences: If this property is a back-up, then you’ll need to consider those that suit your current or future needs. For example, if you have or intend to have a big family, say 3 or 4 children, then you’ll need to think about having at least 3 or 4 rooms. If you’re a consultant working from home, you’ll need to consider a workspace that is suitable for you. In conclusion, you’ll need to buy something that you can accept living in. You’ll have to be honest with yourself and think about all your requirements. taking into account all the financial constraints you may have.

Centauri78’s Thoughts: Generally speaking, this is not the best way to go. If you’re looking at a place that is suitable for living in, you might as well move in and enjoy it.

Question 2: How long can you hold the property? How long do you intend to hold the property?

Consequences: While property has never been the most liquid investment, buying property in Singapore nowadays is really quite tough. In order not to incur Seller’s Stamp Duty, you’ll need to hold the property for at least 4 years. You need to consider when you will need the money you are plonking down on the down-payment. If you intend to hold the property for a long time, then you may also need to consider the tenure of the property eg 99-year leasehold or freehold etc.

Centauri78’s Thoughts: From a financial planning point of view, you shouldn’t put short-term money into long-term investments. That is, if you need the money in the near future, you shouldn’t tie it up in an investment that may take some time to liquidate. When I buy property, while I may think about exit scenarios, I typically buy in for the long haul. Buying for en bloc potential is risky as it would already be priced in somewhat, which may limit your upside. Furthermore, the rental yield would be compressed and may not be able to service your mortgage.

In financial engineering (and business in general), there is a concept of arbitrage. This basically means that if there is a gap in valuation, there is usually a way to take advantage of it at reduced risk. For example, if you are somehow able to borrow, say, Australian dollars at 2% interest and put it in fixed deposit at 2.5% interest, then there is a 0.5% arbitrage profit. There is reduced foreign exchange risk to you as you will be able to repay your loan when the fixed deposit comes due. Of course, this doesn’t mean that there is absolutely no risk to you. Your main risks, in this case, are counter-party risk i.e. will you get your money back in the end?, and also opportunity cost risk i.e. will there be better opportunities?

For property, there is also a form of arbitrage that you may be able to take advantage of, and that is rental yield arbitrage. If you rented a place that is lower yield, and owned a place that is higher yield, then the excess cash generated from rental from the owned property can be used to “subsidize” the rental that you are paying. This approach is definitely more risky than the example given above, as there are a lot of additional risks that you are introducing as a property owner, but I think they are manageable risks. For example, as a property owner, you are exposed to fluctuations in property value, potential problems with tenants, risk of vacancy or delays in tenancy etc. However, these are risks that I think property owners should go into with their eyes open, and not complete surprises. Rationally, property owners should buy property only if they think prices are going to appreciate, or at least retain its value. It would be kind of silly to buy now if you think prices are going to fall, but that’s just my opinion.

Below are two tables that I have constructed to lay out the impacts on cashflow and cashflow going out to 3rd parties. The numbers should be relationally quite sound and should suffice as guidelines, but every case is different, so you should do your own calculations to suit your own circumstances.

  Rent Buy $2 mil
Home
Buy $2 mil
Investment
Buy $1 mil
Investment
Buy $1 mil
Investment
Cost of Property NA $2,000,000 $2,000,000 $1,000,000 $1,000,000
Loan-to-Value % NA 80% 80% 80% 57%
Loan Amount NA $1,600,000 $1,600,000 $800,000 $520,000
Stamp Duty NA $60,000 $60,000 $30,000 $30,000
Cash Outlay NA $460,000 $460,000 $230,000 $460,000
Monthly Rental Paid $6,000 $0 $6,000 $6,000 $6,000
Monthly Rental Received NA $0 $6,000 $3,500 $3,500
Mortgage Interest Rate NA 1.50% 1.50% 1.50% 1.50%
Loan Tenure (years) NA 30 30 30 30
Monthly Mortgage @ 1.50% pa NA $5,522 $5,522 $2,761 $1,967
Interest Component @ 1.50% pa NA $2,000 $2,000 $1,000 $713
Principal Component @ 1.50% pa NA $3,522 $3,522 $1,761 $1,255
Maintenance Fees NA $600 $600 $300 $300
Property Tax NA $200 $500 $250 $250
Tax on Rental Income NA $0 $450 $300 $350
Monthly cashflow @ 1.50% pa $6,000 $6,322 $7,072 $6,111 $5,367
Net monthly cashflow going to 3rd Party @ 1.50% pa $6,000 $2,800 $3,550 $4,350 $4,113

Table 1: Scenario analysis based on 1.50% pa interest rate

Rent Buy $2 mil
Home
Buy $2 mil
Investment
Buy $1 mil
Investment
Buy $1 mil
Investment
Cost of Property NA $2,000,000 $2,000,000 $1,000,000 $1,000,000
Loan-to-Value % NA 80% 80% 80% 57%
Loan Amount NA $1,600,000 $1,600,000 $800,000 $570,000
Stamp Duty NA $60,000 $60,000 $30,000 $30,000
Cash Outlay NA $460,000 $460,000 $230,000 $460,000
Monthly Rental Paid $6,000 $0 $6,000 $6,000 $6,000
Monthly Rental Received NA $0 $6,000 $3,500 $3,500
Mortgage Interest Rate NA 3.50% 3.50% 3.50% 3.50%
Loan Tenure (years) NA 30 30 30 30
Monthly Mortgage @ 3.50% pa NA $7,185 $7,185 $3,592 $2,560
Interest Component @ 3.50% pa NA $4,667 $4,667 $2,333 $1,663
Principal Component @ 3.50% pa NA $2,518 $2,518 $1,259 $897
Maintenance Fees NA $600 $600 $300 $300
Property Tax NA $200 $500 $250 $250
Tax on Rental Income NA $0 $220 $180 $200
Monthly Cashflow @ 3.50% pa $6,000 $7,985 $8,505 $6,822 $5,810
Net monthly Cashflow going to 3rd Party @ 3.50% pa $6,000 $5,467 $5,987 $5,563 $4,913

Table 2: Scenario analysis based on 3.50% pa interest rate

The figures speak for themselves, but, on a final note, I’d just like to point out a couple of things from the tables. The first is something obvious: The lower your loan quantum, the lower the impact of interest rates. The second, slightly less obvious, is that it makes a lot more sense buying a home when the interest rate remains low.

Disclaimer:
Centauri78 is not a licensed financial advisor. The information contained here is purely personal opinion, and whilst I make every attempt to ensure the accuracy and reliability of the information, this information should not be relied upon as a substitute for formal advice or as basis for investment.

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