Rental Gains not all they Seem
Rental property is sometimes an excellent investment. There, I've said it, for all those who reckon I'm anti-rentals!
Often, though, rentals are not quite as good as people think - and not just because the tax breaks are over-rated, as I said in my last column.
Following that column, a reader wrote: "there are other reasons which I believe are largely positive in running a rental property or two."
He gave the following example: "I purchased a two-unit rental house in 1980, borrowing the entire purchase price of $35,000, using my family home as collateral.
"Yes, during the first few years I did have to put in cash out of my salary to pay interest and running expenses, but the tenants paid most of the mortgage. And although I had to pay some tax, when I sold in 1999, the capital gain of $125,000 (selling price) made it worthwhile."
But how good was that? Over the 19 years, the gain was about 7 per cent a year.
That doesn't sound too bad, until we realise that for most of that period you could earn more on 6-month term deposits. Indeed, in the high-inflation early 1980s to early 90s, term deposits usually earned more than 10 per cent, and sometimes close to 18 per cent.
The growth in the property's value wasn't, in fact, much more than inflation, which made $35,000 in 1980 worth $113,600 in 1999.
What's more:
- The reader contributed cash to the investment, which lowers the return on the total amount invested.
- The tax he paid when he sold would have been a clawback of the depreciation he claimed over the years. That should be subtracted from the gain, making it lower still.
We don’t know enough to be sure, but it's quite possible the man would have been better off putting into shares all the cash that went into interest and rental expenses.
He doesn't like that idea, though. "Although I have had some good experience with the share market," he writes, "I personally find that form of investment much more challenging due to the experience and research required to invest in the right stock."
But that wouldn't be true if he made the type of share investment I like - into an index share fund. It requires no experience or research, and investors often do better than those who pick their own shares.
Index funds also involve much less hassle than rental properties. Our man acknowledges, "I've had the occasional tenant who has damaged and skipped or left owing rent."
Having said all this, the reader is clearly happy with his properties. He bought another rental house in 1990 that is now mortgage-free, "although the tenants didn't pay all the mortgage. And that now pays me a net $100 per week which supplements my pension very nicely."
And his properties have never been empty for more than a week, which suggests good luck, good management or both.
I don’t want to knock his achievements. He's done well, and I appreciate his letter.
All I'm aiming to do is to point out that, when people assess how well a rental investment has done, they often:
- Pay too little attention to all the extra money they put in over the years.
- Fail to realise that a big gain over many years doesn't amount to anything startling on a per-year basis.
- Also fail to realise that even term deposits paid high interest in the not-too-distant past.
- Overlook the clawback of depreciation.
Footnote: In my last column I said that this time I would write in depth about index funds. It will happen soon, I promise!
