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Saturday, November 21, 2009

Property investments – the leverage factor

Is property a good investment? Many Malaysians are likely to respond with a resounding “YES!”

In fact, if you were to ask anyone who had suffered equity losses, they would most certainly reply that they wished they had bought one more condominium unit in Mont Kiara or taken up the beautiful service-apartment in KLCC two years ago. For many Malaysians, property investing is not a new thing. There are people who would rather buy a property than put their money in other investments. And some wealthy individuals have even come together to develop small-scale property projects.

Properties seem to be keeping up in terms of value, especially if you have the holding power and the location is good. And more importantly, a property is tangible – you can look, touch and even smell them literally.

Why is property investing such an investor’s darling? Many die-hard property investors would say that they make money and receive rental income through their property. So investing in a property does indeed sound like a good buy.

However setting aside the benefits, there is one thing that many are generally unclear about: property investing comes with significant leverage benefit – that is, buying a property that is worth a lot more than what is paid at the onset. Most of the time, a property investor does not have to pay 100% of the property price because one would take a property loan from a bank. For example, if you take a loan with a margin of 80%, a RM1mil house would actually cost you RM200,000 upfront. The remaining 80% is paid off through regular mortgage payments.

On average, a property loan lasts for about seven to eight years, even though the legal tenor is 20 or 30 years. It is conceivable that a few things may happen within these seven to eight years, for example, the buyer of the property sells the property, or reduces his loan liability through pre-payment.

Using the previous example, let us assume that the price of the property has increased to RM1.2mil in three years. The total investment cost is the initial investment of RM200,000 plus other fixed costs. So the gross profit is RM200,000, or 100% based on the initial upfront payment. Of course, the net profit will be lower, depending on the fixed costs incurred for mortgage interest, legal costs, et cetera.

It is not uncommon for very serious property investors (and speculators) to pay only 10% upfront and take out a loan for the remaining amount. At 10%, the leverage is ten times! This means that if you make a 10% profit on the property value, the leverage would equate to ten multiply by 10% or a total of 100%, before deducting the cost of borrowing. The converse is true, if you have to sell your property at a 10% loss in value, you may not recover enough from the sales proceeds to pay off your outstanding loans. In such cases, you would have effectively lost your initial upfront investments plus all the associated costs.

One of the true dangers in using leverage is linked to the cashflow level of the investor. If you are financially strong, you can continue to hold on to the property even during the downturn. And if there is good rental income, you can further sustain the mortgage repayment. However, if you cannot repay the mortgage, the risk is possibly foreclosure. The United States is a good example where many mortgagees could not afford to service their loans as interest rates rose. Creditors had to foreclose and force-sell properties to recover the outstanding loans.

When dabbling in property investing, it is noteworthy to understand and take note of the leverage factor or loans taken up. The effects are not very different from margin investment. A quick reflection on past market turmoils like the 1997-1998 crisis will enable one to immediately understand that leverage cuts both ways – magnifying the profits and losses.

After all, property investing, like any form of investment, can be profitable and carry risks at the same time.

So before you jump into purchasing your next property, do bear in mind this leverage effect.

Tay is senior vice-president and senior head of UOB’s personal financial services division.

By The Star (by Tay Han Chong)

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