Is rental property a good investment?

As a financial advisor, I often encounter clients curious about the viability of investing in rental property in South Africa as an alternative to traditional market investments. In this article, I aim to explore the merits and considerations of this investment choice through a brief case study, providing a clearer picture of what this avenue entails.

The appeal of real estate investment

The tangible nature of real estate investments holds a significant appeal; investors often appreciate the concrete reality of land and buildings over the abstract nature of digital or paper assets. Owning real property offers a unique sense of security and permanence, aspects that are less palpable in other investment forms. Real estate not only promises potential capital appreciation but also the possibility of generating steady rental income. Particularly in thriving regions like Stellenbosch and Cape Town, the South African real estate market has historically delivered robust returns, fuelled by consistent demand and economic growth.

However, it’s crucial to acknowledge that the location is the primary factor influencing property value, rental potential, and long-term investment viability. Additionally, each property is unique, with its value and potential income dependent on specific characteristics and local market conditions.

In the below, I’ve outlined a basic case study that compares the potential returns from investing in rental properties in Stellenbosch to those from investing in global equity markets, specifically using the MSCI All Country World Index (ACWI) as a benchmark for global equity returns. This comparison uses general property values and rental incomes from the Stellenbosch area to illustrate how these investments might perform under current market conditions.

Case study overview: Rental income vs global equity portfolio

In Stellenbosch, a notable increase in population and income levels has enhanced the area’s attractiveness to high-income demographics, reflecting its ongoing allure. The real estate market here has shown consistent growth, with property values appreciating annually by 3% to 7%, thanks to limited land availability and the region’s cultural and educational appeal.

Property appreciation: Over the last nine years, property values in Stellenbosch have increased on average from R1.85 million to R3.2 million (73%), translating to an annual growth rate of about 6.28%.

Source: Author supplied

The town experiences substantial demand in its student housing sector, showcasing an average annual increase in rental yields of 8.4%. Furthermore, the property values in this market have been rising steadily, with a notable average annual growth rate of 13%. This combination of factors highlights Stellenbosch’s ongoing appeal and stability as an investment locale.

Depending on the net projected rental income, high, medium, or low annual returns vary between 11.53% – 16.97%. Note that this figure does not account for taxes on rental income.

• High rental scenario: Assuming a net monthly rental of R20 000, the annualised return over nine years reaches 16.97%.
• Medium rental scenario: With a monthly rental of R15 000, the annualised return is approximately 14.22%.
• Low rental scenario: A monthly rental of R10 000 yields an 11.53% return annually.

Source: Parity Wealth Managers

Of course, the above is subjective, and generating illustrative rental income is influenced by many factors, such as the property’s location, current market conditions, and overall demand in the area.

Global equity markets:

On the other hand, global equity markets can offer a diversified investment profile through vehicles like the MSCI ACWI, allowing exposure across various countries and sectors. The MSCI ACWI, encompassing large and mid-cap stocks across 23 developed countries, spans approximately 1 600 stocks, offering broad exposure to international markets. 

Let’s first consider the ZAR/USD exchange rates over the past 21 years. 

Historical USD/ZAR approximate yearly starting value exchange rates (ZAR/USD):

Source: Parity Wealth Managers

Interestingly, the US dollar depreciated against the South African Rand in only six out of the past 21 years (28.50% of the time). 

When examining the long-term returns on currency investments, the outcomes are quite illustrative. For instance, if an investor had exchanged R5 million for US dollars at the beginning of 2005 and held these funds in a non-interest-bearing account by the beginning of 2009, this investment would have appreciated to R6.3 million when converted back to rand. Similarly, converting R5 million to US dollars at the start of 2011 would have yielded R11.74 million by the beginning of 2021 upon reconversion to rand. These examples highlight the potential for significant returns through strategic currency exchange, depending on market conditions and timing.

Historically, the MSCI ACWI has demonstrated strong performance in terms of South African Rand (ZAR), delivering average annual returns of 15.30% over the last five years, 13.39% over the last 10 years, 15.32% over 15 years, and 12.49% over 20 years.

Below is the USD and ZAR returns of the MSCI ACWI:

Source: Parity Wealth Managers

Notably, in year-over-year comparisons starting each January, the index has shown declines in only four of the past 21 years, marking an 81% rate of positive annual performance. 

Source: Parity Wealth Managers

Please note: This comparison solely contrasts the actual 10-year return of the MSCI ACWI in ZAR with the hypothetical returns of a property held for 9 years.

Comments:

The MSCI ACWI has provided investors an annualised ZAR return of 12.49% on average for over two decades, serving as a comparative for potential investments in rental properties. Investors should evaluate whether real estate ventures could potentially yield higher returns than this benchmark when deciding between the two options.

Although investing in rental properties has shown the potential for good returns, it is critical to consider the implications of taxes, which can considerably decrease the net profits. Moreover, while historical data can be enlightening, it is not a definitive predictor of future performance. Investors should be mindful that both real estate and global equities are exposed to the risks of market downturns and volatility.

Ultimately, even though property investment may appear advantageous on paper, investors should carefully weigh several critical factors before deciding such as:

1. Liquidity: Real estate is known for its liquidity constraints. The process of selling property can be lengthy and heavily dependent on current market conditions, which can fluctuate based on economic health, legislative changes, and other regional factors. Conversely, investments in stock indices like the MSCI World Index offer high liquidity, allowing investors to buy or sell shares swiftly on the stock market, often without substantial price reductions. The accessibility of funds from such investments may vary depending on the structure, such as unit trusts, endowments, or retirement accounts.
2. Taxes: In South Africa, rental income is taxable and must be reported on annual tax returns as part of the taxpayer’s total income, with taxes levied at the individual’s marginal rate. Property-related expenses, including maintenance, management fees, and mortgage interest, are typically deductible, which can lessen the taxable income. Additionally, capital gains from the sale of rental properties are taxed at a rate of 40%. The fiscal impact can differ based on how the property is held; for example, owning through a trust or company might provide tax benefits and deductions. In contrast, direct investments might incur capital gains tax and taxes on dividends and interest, though certain exemptions apply, particularly through retirement funding structures where different tax treatments, such as a flat 12% rate on capital gains within endowments, are applicable.
3. Maintenance: Managing a rental property involves continuous maintenance and addressing wear and tear. Ensuring tenants are up to date with payments can also be time-consuming. Property management services are available to help with these tasks, typically charging a fee ranging from 8% to 11.50% of the annual rental income. On the other hand, managing investments in financial markets requires periodic reviews to ensure alignment with your financial goals and risk profile.
4. Costs: Property ownership incurs various ongoing expenses such as maintenance, levies, insurance, and taxes, alongside transactional costs like transfer duties during purchase or sale. In contrast, accessing an investment account typically incurs platform fees ranging from 0.15% to 2%, depending on the investment structure and the chosen platform provider. Additional costs include advisory fees, which generally range from 0.50% to 1%. There may also be one-off costs associated with initial advisory services.
5. Diversification: While property investment can enhance the diversification of your financial portfolio, it does concentrate risk in a single asset class which could be vulnerable to local market downturns. Diversifying investments across global markets, which include equities, bonds, gold, and various currencies, spreads out risk and provides broader exposure to international economic dynamics, offering a protective buffer against localised economic downturns in South Africa.

Conclusion:

Choosing between investing in South Africa’s real estate or global equity markets depends significantly on an investor’s financial goals, risk tolerance, and investment horizon. Those leaning towards a more conservative approach or seeking to invest a market they are familiar with might find real estate more appealing. Meanwhile, those who prefer flexibility and faster access to their investments might opt for the global equity route. 

Regardless, each investment avenue comes with its own set of risks and benefits. As always, consulting with a financial advisor is advisable.

See the below of US trends:

Source: NYU Stern/Markets in a Minute

Source: Author supplied