Invest for Cashflow or Net Worth
I recently came across two investors who made money in property investing, albeit in very different ways in the last two years i.e. from mid 2007 till December 2009 in the midst of the global financial crisis. I have taken the liberty to simplify and change some numbers as well as ignore all expenses so that we can compare apples with apples. Here are the details:
Investor A
Purchased a Semi-Detached house in a gated and guarded project in the Klang Valley
Land Area = 4,000 sq ft (40 ft x 100 ft),
Built-Up = 3,800 sq ft
Purchase Price = RM1.7 million
Loan = RM1,360,000 (80%)
Down-Payment = RM340,000
On completion in Dec 2009, he is receiving offers for RM2.5 million.
Gross Profit = RM2.5 m – RM1.7 m = RM800,000
RM800,000 - RM340,000
Cash-on-Cash Return = --------------------------------- x 100% = 135%
RM340,000
If he were to rent out, the expected rental = RM5,000 per month or Yield of 3.5% pa based on his purchase price of RM1.7 million.
At the current market price of RM2.5 million, the yield drops to a miserable 2.4% pa.
Investor B
Purchased a 400 sq ft retail shop lot in a shopping center in the Bukit Bintang area
Purchase Price = RM1.1 million
Rental = RM6,000 per month giving a yield of 6.5% pa
Loan = RM770,000 (70%)
Down-Payment = RM330,000
In Dec 2009, he is receiving offers for RM2 million as the expected rental upon renewal later in August 2010 is around RM9,000-10,000 per month.
Gross Profit = RM2.0 m – RM1.1 m = RM900,000
RM900,000 - RM330,000
Cash-on-Cash Return = --------------------------------- x 100% = 172%
RM330,000
Assuming the new rental is RM9,500 per month, the yield jumps to 10.3% pa. At the current market price of RM2 million, the yield is a still decent 5.7% pa.
Questions:
1. Who is the smarter or luckier investor in this case?
2. If you were presented with both investment options, which would you go for and why?
I emailed this real life case to all my book readers at my Yahoo! egroups and my past seminar participants. Here are some of the more interesting replies (lightly edited):
I prefer to be investor B
1. Choice of property investment: Rule of thumb or probability, commercial property has better chance of appreciation than residential property
2. The numbers: The returns are higher in B, in terms of returns of cash invested now, rental yield now, probably higher returns in future than A.
Investor B - as I can enjoy both rental return and appreciation. Futhermore, this investment is an established location with further upside in the future.
Next, as a commercial property, if the tenant is doing business well and making a good profit, I believe the rent review can be further to owners’ advantage. As the tenant, why move location when business is good? Pay a little extra on the rental is acceptable.
For residential, no way tenant is going to stay in the location if rental is high, move to another newer better location.
What’s more, I would not need to sell the property to realize the appreciation profit and still continue to reap the good rental return.
I think most of us would say the second investor is the smarter one. In investment, no one can accurately predict the future/outcome. Both investors have done well in the sense that both made profits.
Investor B. A few such investments and the investor is on his/her way to retirement.
- Retail lot – Steady + increasing cash flow
- The capital appreciation is nothing but an increase in equity / net worth.
- The capital appreciation in both are not realised until the property is sold. Investor A should be considering selling off the semi-D as the returns is worse off than most investments plus there’s negative cash flow.
- Investor B can continue investing and still enjoy cash flow as well as increase in equity through paying down the loan
I will go for Investor B's investment choice simply because:-
a) Lower down-payment (330K compare to 340K for Investor A case).
b) Better yield in term of gross return or rental return.
c) The shop lot in Bukit Bintang should be more in demand than the Semi-Detached in both selling and renting out
d) The chances of rental increment is better for B (commercial use) comparing to A (residential use) if both still tenanted.
What an illustration. But, let’s not forget, we have got the luxury of looking at the end result of which is very apparent. However, under real life scenario, nobody could foretell what the future is, it is not an easy question to answer though.
Risk-return wise, Option A appears to be more defensive as upscale residentials are in good locations are always in demand.
Without doubt, option B shall give one a much better return in terms of appreciation and yield when Malaysian economy prospers. On the flip side, it may kill when times are bad usually coupled with high interest rate era. Worse still, if we enter prolong recession (although unlikely).
My answer is... it depends on one’s risk appetite. It varies from case to case depending on individual credit standing. Have to look more into details of the deals and weigh on all pros and cons before answering. Have a good thought.
My answer is:
a) Investor B, if the strategy is to hold for rental as well as property value gain. This property will probably give him good rental over the years as it appreciates in value
b) Investor A if the strategy is to sell now. Reinvest the money again in similar way.
If I were given 10 such opportunities, I would invest 10 times in B type of investment scenario. Better rental yield, better capital appreciation, better long term potential.
For A, maybe for own use or as a gift for loved ones.
I would choose the shop lot in Bukit Bintang bearing in mind that there are many gated houses blooming around, but there are not much space in Bukit Bintang for new shopping malls.
Also, comparing competitors - more people invest in houses rather than shop lots. So better fight with less than more! And not forgetting recurring passive income is more attractive.
In my opinion, if both have met their original investment objective, then good for both of them.
If Investor A’s original strategy is to have capital appreciation, then he should be very happy with his cash on cash return after 3 years. He may want to flip to roll over his money for other opportunity.
If investor B’s original strategy to have rental return with positive cash flow (minus instalment payment and direct costs) then he should be very happy with is 5.7% return. In this case, he has capital appreciation too, so that’s additional bonus and creates an option for him to sell.
I think one need to know what is their original intention was. Risk appetite and investment strategy changes over time and differ among all of us.
Finally, my favorite email that came in is:
Help me get that B property type Milan!
My Personal Comments since I happen to be Investor B:
1. The mentality of the ‘grass is always greener on the other side’ comes into play. Hence most people preferred Investor B. At times, I actually wished I was in Investor A’s shoes.
2. Investor A has an easier no brainer task – SELL, pocket the profit and look for more deals like this. Cash in the bank is always better than increase in net worth.
3. Investor B – While it’s tempting to sell, he has to bear in mind that it might be difficult for him to reinvest in similar shop-lots. Also his returns are very good, hence there is no pressure to sell. If he decides to keep, he has to be contented with an increase in his net worth but no big increase in his bank account. However, he can do so by refinancing but the effect will not be as great.
If you have any comments on this article or questions, please email to me at achievers88@yahoo.com. I would highly recommend that you sign up at our moderated getrichbook egroups at:
http://finance.groups.yahoo.com/group/getrichbook/
It's free for all my book readers and readers of this article. Only relevant emails pertaining to finance, property and stock investments will be approved for broadcast.
Article Contributed by
Milan Doshi
Financial Trainer and Best Selling Author of
“How You Can Become a Multi-Millionaire Real Estate Investor!”
For more information, visit www.milandoshi.com
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