Why buy-to-let is not best

Why buy-to-let is not best

05-07-2005

If we weren't so emotional about our homes, the best financial decision for us to make at a time like now when real house prices are near or at the top of the property cycle, is to sell and rent, and to buy again when house prices are on the decline. In the meantime we would invest the profit from the sale and the difference between our monthly rental and the bond payments we used to make, and invest it in another asset with higher returns.

This would make the most financial sense, says property economist Erwin Rode, CEO of Rode & Associates. However, when it comes to residential property, emotions play a far bigger role in buying and selling decisions than probably any other investment decisions. "Somehow, I don't think Mrs Rode is going to be too happy to go along with this financially prudent plan and give up the home she has put so much into setting up", quips Rode.

When it comes to buy-to-let of residential units at the moment, the same logic should apply, advises Rode. As a generalisation, it is not a good idea to buy at the top of a cycle when an asset is fully priced or over-priced — which is where residential property is right now. Timing is crucial when it comes to investment decisions and one of the most common mistakes people make is to invest when an asset class is at the peak of a cycle rather than at the bottom.

Potential investors should treat investment advice about residential property based on unrealistic growth assumptions with a great deal of circumspection. The assumed inflation rate, assumed growth in rentals and assumed capital growth should be realistic and internally consistent. There are no grounds for assumptions that residential properties will be growing in value at 12% over the next 5 to 10 years. The point to keep in mind is that the rate of interest you will be paying on the money you borrow to buy a residential property right now will be higher than the rental you will be earning from that investment, and it is unrealistic to assume that this gap will be made up by capital growth any time soon. How long exactly it will take before the residential property cycle goes into its next upswing no one can say exactly, but it isn't likely to be sooner than 5 to 10 years. Because of the time value of money, it makes no sense to argue that you are prepared to suffer the losses over the first five to 10 years, because you'll make it up later.

"If the first half of a 20-year investment is bad, that investment will never become a good investment. "

The bottom line for at least the next 5 to 10 years in terms of residential property, says Rode, is to rent rather than buy, and to invest the difference between your rent and what your bond payments would have been, in unit trusts, bonds, listed properties, shares or other suitable assets.

PS: The same principles apply to the non-residential property market.