Usually, investing in property is not very hard. This fact is further accentuated during times of economic prosperity. In such times, the property market is up in a positive way and it is not difficult to make some money riding the surf. However, like the economy, property markets have cycles. There are ups and downs. In addition to this, life events like losing a job or unforeseen medical expenses can seriously impact your ability to hold on to your property investment.
During such turbulence, the way you have approached your investment becomes critical. If you have not given much thought to liquidity or cash flow, you could lose your property and still be in debt with lenders. This is when the wisdom in your investment decisions become apparent. So how does one invest wisely in the property market? I will not delve into how you select a property to invest in. Insights into location and access to infrastructure are common and discussed routinely.
In this article, I will discuss the underlying thought process that should drive your property investment decisions. At LivingSpace, we have developed the Smart Investor Model and it comprises 5 broad principles:
1. Financial Sense
2. Occupancy Rate
3. Cash Flow
4. Opportunity Cost
The more you understand these 5 principles the more intelligent your investment decisions become. Let us look at these principles in details.
Financial sense is actually commonsense but as the saying goes; common sense is not so common after all. What is common sense in relation to investment? Very simple; an investment must generate returns for you. In order to predict whether an investment will generate returns for you, you need to understand the principles of profit and loss and return on investment.
It may come as a surprise to you but it is quite often that people misunderstand their operating income from a property. For example, if you collected rent of RM4,000 per month on an apartment, does it mean your rental income is RM48,000 per year? If you factor the real estate negotiator fee and vacancy period between tenants, your rental income could actually be 20% lower. This would make your real rental income RM38,400 per year (RM3,200 per month). If you had planned your financials based on RM48,000 per year,you could find yourself short by nearly RM10,000. As you can see, understanding how to crunch numbers is vital.
Occupancy rate is the number of months an apartment is tenanted in consecutive 12-month periods. When making a decision to buy a property, you will most likely be influenced by price. Simply put, between 2 identically sized condominiums in a complex, you would be naturally drawn towards the one that is priced lowest.
Let us say you are looking at two 1-bedroom apartments in a complex. Both are 560 sq ft except one. Apartment A, is on the 10th floor with a mediocre view while the other, Apartment B, is on the 29th floor with a beautiful view. Apartment A is priced at RM450,000 and Apartment B is priced at RM550,000. Apartment A can fetch a rental of RM2,200 while Apartment B can fetch a rental of RM2,300. At the outset, it would appear that Apartment A is a better buy. However, if Apartment B has a better occupancy rate because of its view, the potential returns change.
So let us say that Apartment A can get an occupancy rate of 80% while Apartment B has a slightly better occupancy rate of 90%. Now the gross rental income on A is RM21,120 per year while Apartment B commands RM24,840 per year. Apartment B, although significantly more expensive, is logically the better buy. This example demonstrates the importance of occupancy rates. Always look for occupancy rates when making your purchase decision. It is more important than plain yield. A potential gross yield of 8% is of no use if you cannot get the property occupied.
I always thought a business is doing well if it is in profit. In my first business endeavor, I found out that this is not always the case. The business I was involved in was running a healthy profit but we were nearly forced into shutting down simply because our cash flow was not healthy. We were in an industry where payment terms were 90 days at best. So we had to self-finance 3-months worth of work. The more we grew, the more this problem was exacerbated. I learned then, that “cash is king”.
So, how does this translate into property investment? For starters, it is not easy to buy a property with positive cash flow today. Let us look at an 890 sq ft 2-bedroom apartment in Kuala Lumpur. Assuming it is priced at RM780,000 and can fetch rental of RM3,200, the gross yield would be 5%. That is an above average yield (the average in Malaysia now being about 4.2%). But does it translate to positive cash flow? If the property is financed, the answer is most probably no. The example of the apartment above is a real life example and the yearly cash flow is –RM11,000. So every year, the owner of this apartment has to fork out RM11,000. If you have not planned for this or were not aware of this when you entered into the purchase, you could be facing tough conditions just holding on to the property. You do not always have to buy a property with positive cash flow because you can make money from capital gains. But you must be aware of the cash flow from a property so that you are prepared.
I always look at opportunity cost when doing making economic decisions. If there are two possible routes to a destination, one tolled and the other toll-free, I look at the time cost.
If it takes me 15 minutes longer to reach my destination using the toll-free road, it most probably is cheaper for me to use the tolled road and pay RM3 because I will burn less petrol and I could use that 15-minutes in productive work that will earn me more than RM3. This is opportunity cost. Opportunity cost is defined in Wikipedia as, the loss of potential gain from other alternatives when one alternative is chosen.
Every investment decision must factor in opportunity cost. This will ensure you make smarter investment decisions. For example, if you have RM500,000, should you buy one property worth RM500,000 in cash? The opportunity cost could be buying 4 of the same properties using financing. The potential capital gain would be a lot more. Tempered with prudence in planning cash flow, the latter option would be far better.
Here is another example that demonstrates an oftenoverlooked fact. Say you bought a property for RM780,000. The property averages an 8% appreciation every year.
Should you, after 5 years, liquidate this property and buy a bigger property for RM1,000,000? If the appreciation on the newer property is averaging 8% too, then you would have gained more after 10 years, if you maintained the first property. The opportunity cost of selling the 1st property was a loss in potential capital gain.
You should never move your money from one investment to another if the potential gain from the newer investment does not outperform the older investment. Never sell a property to buy a newer one because the newer property is more “appealing”. You must ensure that the newer investment has better performance.
Understanding the beast that is property investment will give you fabulous results. Notwithstanding the fact that property investment is one of the best investment vehicles, its biggest is liquidity. Unlike shares or forex for example, you cannot liquidate a property overnight. In Malaysia, even if you have an immediate buyer for your property, it would take about 3 months at best to cash out. If you understand this, you will understand that property investment cannot provide emergency relief in times of economic trouble. You need to plan your exit strategy.
Here is another point to note. Assuming you bought a property at RM1 million 5 years ago and it has now appreciated to RM2.5 million, are you richer by RM1.5 million today? Not really. This is a meaningless value until you can liquidate the property for RM2.5 million. Many people in dire circumstances have learned this the hard way, not realizing any if the appreciation gains because they could not liquidate in time and banks foreclosed on their properties. It is therefore important you understand that properties are not very liquid and make investment decisions with contingencies for this.
Knowledge is power. In this sense, understanding the mechanics of property investment is key to your continued success as a smart property investor. While there are many factors to consider, if you have a deep understanding of: 1. financial sense, 2. occupancy rate, 3. cash flow, 4. opportunity cost, and 5. liquidity You automatically elevate yourself to an elite class of investor. One who is resilient to the cycles in the property market. In fact, you could be making the most money in downturns.
This article was first published in the iProperty.com Malaysia June 2016 Magazine. Get your copy from selected news stands or view the magazine online for free at www.iproperty.com.my/magazine. Better yet, order a discounted subscription by putting in your details in the form below!