Ben Crompton crunches the numbers to explain why buyers should never buy in cash
Why property is a good investment if you take out a mortgage
There are several asset classes investors can put their money into: stocks and shares, bonds, funds, art, cryptocurrencies, crowdfunding and more. The list can go on and on but property is nearly always near the top in terms of priorities.
High net worth individuals are told by financial advisers to invest a certain amount of their wealth into real estate, but why?
Over the past month I have discussed at length the benefits of buying property to invest in looking at how buying can cut your rent in half, how long you need to stay in the UAE for buying to make financial sense and why so many choose to own their car but not the home they live in. The benefits of buying your own home are numerous – but what about as an investment asset?
Andrew Carnegie is often quoted as saying: “Ninety per cent of all millionaires become so through owning real estate". And: “The wise young man or wage earner of today invests his money in real estate”. Mr Carnegie was one of the top 10 richest men ever to have lived, but even though he was writing over 100 years ago the fundamentals of his quotes are still true today.
Many people have made money investing in real estate, but the reason real estate is such a great investment is not for the reason you might think. Most people believe that real estate investing is about buying at the bottom of the market and selling at the top and making that 20 or 30 per cent appreciation on your property over the life of a seven-year property cycle.
To a certain extent this is how some have made money on real estate but even 30 per cent over seven years is only just over 4 per cent per year, and that is if you are able to pick the top and the bottom.
Even those whose property does not appreciate still made a great investment as they are effectively paying themselves rather than paying rent. But the investors who make the serious returns often do so without thinking about it, due to a principle called leverage. This principle is used by all private equity funds and leverage buyout funds throughout the world.
It is really quite simple. If you use debt at a lower interest rate than the return you are getting on your property, then you are making money from someone else’s money. Most people take out a mortgage because they cannot afford to buy cash, but I will explain why you never actually want to buy a property in cash.
Let’s use a nice easy example of a one-bedroom apartment for sale at Dh1 million, renting for about Dh60,000 per year net (after service charges), which looks on the face of it like a 6 per cent net return. Using leverage you will get a massive 12 per cent return on the cash invested. If you use leverage and your property increases in value, you will make a massive three times more money than if you use cash. Sounds crazy? Let me prove it:
Let us assume for ease that the value of the unit doubles to Dh2m and you sell it (unlikely I know, but it helps the sums). If you have used Dh250,000 cash deposit and Dh750,000 debt then after paying back the loan you are left with Dh1.25m; you have increased your original Dh250,000 by 400 per cent. If you used Dh1m cash, you now have Dh2m cash but that is only an appreciation of 100 per cent on your investment.
Now let’s see how leverage improves your rental returns. I will assume a buyer with a 25 per cent deposit which is Dh250,000, with the remaining Dh750,000 financed at 4 per cent over 25 years (First Abu Dhabi Bank was offering 3.99 per cent in May).
If you buy the property, your finance repayments would be Dh48,000 per year – you get to pay this monthly, so just like 12 cheques. In addition, in the first year about one third (or about Dh18,000 in our example) of your finance payment to the bank goes to paying off the principal of your loan. The other two thirds, or about Dh30,000, is interest payments). You can see an amortisation schedule on many sites online.
So to recap, you receive Dh60,000 in rent and you pay Dh48,000 in finance charges. You then get a credit of Dh18,000 by reducing your loan amount by that. So your notional income/profit is Dh30,000 per year.
You have used Dh250,000 cash to buy this property, so in earning Dh30,000 your return is a huge 12 per cent. Yes, 12 per cent on the cash you have put down (Dh30,000 over Dh250,000).
If you had bought it in cash you would be earning only 6 per cent on your Dh1m. What other investment scheme can compare to this? Don’t believe me? Do the sums yourself and do the research by looking up the principles of leveraged returns and cash-on-cash returns.
The moral to this story? If you have Dh1m in cash to invest, then buy three properties instead of one.
Ben Crompton is the managing director of Crompton Partners Estate Agents