Hi, I’m Shirley. I run a small online business where I’m earning an annual income of RM 100,000. I intend to invest in a property but I am not sure whether or not if this is the right time to do so as I find that rental collection now is often lesser than the mortgage instalment of a property. What’s your take on this?’
For a start, it is wise to invest in real estate to earn positive cash flow where the rental income exceeds all property expenses. After all, a property that brings in positive cash flow is considered to be an asset while a property is considered to be a liability if its expenses exceed its rental income.
Presently, it is rightly observed that rental income received from most local real estate is less than their total expenses, especially those that are newly bought. Hence, does it mean that properties are ‘liabilities’ and we should refrain from investing into them altogether today?
Personally, I don’t think so. This is because I have come to realise that there are a few more benefits which many are not aware about in property investing that we need to consider beforehand. This includes an understanding of viewpoints from the taxman and your banker on your finances after you have invested into an investment property.
Along the way, you’ll discover why real estate, despite being negative cash flow, remains a key component to one’s investment portfolio. Here, I’ll illustrate with a simple case study as follows:
Where The Bigger Money is in Real Estate for Common Investors Today?
As I write, the local real estate market remains relatively depressed and this is a situation that would persist in the near future as long as local income does not rise to a level where people in general can afford to buy real estate locally.
Gone are the days where people can flip properties for a quick buck or to buy a piece of real estate in hope that it will appreciate greatly in prices after holding onto it for a period of 5 years.
Today, profiting big in local real estate is about investing into them at a discount to their market valuation. Typically, it is possible for investors today to obtain as much as 10%-15% discount for their properties from their market valuations.
For instance, it is common for an investor to buy a property, let’s say a 1,000 sq. ft. condominium worth RM 500,000 in market valuation, for RM 450,000 which is a 10% discount from its market valuation. Instantly, the investor makes a nice RM 50,000 in capital gains from investing in this property.
Let’s assume, Shirley is the investor mentioned and she is below 35 years old, is new to property investing and finances her property purchase with a mortgage where its interest rate is 4.25% per annum. The property purchased is tenanted to a family of four for RM 1,800 per month. Therefore, her property details are as follows:
Question: ‘What would be the financial impact to Shirley after she had invested into this property?’
#1: Net Worth
Shirley will need to fork out a 10% down payment and property-related transaction costs of RM 60,000 to buy her property. From it, she would successfully increase her net worth to RM 95,000, a 58.3% jump from RM 60,000 prior to acquiring her property.
#2: Monthly Cash Flows
In a glance, Shirley would incur a negative cash flow of RM 600 per month from this property. But, I believe this is not a complete picture. Why? This is because her mortgage instalment comprises of two parts: interest payments to the bank and repayments to reduce her loan principal.
Repayments to her loan principal is likened to be a ‘forced savings’ to Shirley as she would have gotten back this sum of money if she disposes off this property in the future. Typically, the proportion of interest payments to the bank against one’s total mortgage instalment is 75% for the first ten years.
Thus, the breakdown of Shirley’s mortgage instalments is as follows:
Hence, the true breakdown of Shirley’s cash flow statement after investing into her property is as follows:
Shirley would incur a net loss of RM 136 a month. She would be downed by RM 600 a month after including the repayments to reduce her loan principal.
Let’s assume the tenancy agreement for her property is stamped at a time after 1 January 2018.
Shirley is entitled for a 50% income tax exemption on her rental income in year 2020 for her condominium is a residential property and her rental collection is below RM 2,000 a month.
In addition, Shirley is able to deduct a couple of expenses from her gross rental income to compute her final chargeable rental income. These expenses include interest payments to the bank, maintenance fees, quit rent and assessment. As such, for Shirley, her final chargeable rental income is computed as follows:
Under Section 4(d) of the Income Tax Act (ITA) 1967, this loss would be treated as a permanent loss. In other words, the taxman views that Shirley incurs a loss from renting her condominium to her tenant and hence, would not be charged a single cent in income tax.
The banker views Shirley’s rental income as a legitimate source of income, thus, will raise her credit eligibility. Here is how it works.
First, we need to understand the concept of debt service ratio (DSR). Let’s say, a bank sets its credit policy where it limits the amount of any individual borrower up to a DSR of 60%. It means that if a borrower earns RM 10,000 per month, he can obtain a maximum loan amount where his debt instalment a month would be capped at RM 6,000, which is 60% of his monthly income.
Second, we need to understand the Rule of 200. It helps to estimate how much mortgage loan an individual borrower may qualify to obtain. From above, if the borrower has zero debt, he can obtain a maximum mortgage of RM 1.2 million, which is RM 6,000 in debt instalment quota multiplied with 200.
Thus, the maximum amount of mortgage an individual can qualify is as follows:
Let’s say, the bank views Shirley’s rental income as a valid source of income. As such, her rental income of RM 1,800 would raise her mortgage eligibility by RM 216,000, which she can use it to invest in her next investment property. This, I’ll like to call it, a type of phantom income.
In summary, if Shirley buys her condominium, she would incur RM 136 in loss a month or RM 600 in negative cash flow a month. Out of which, she would reap a net capital gain of RM 35,000, which is free from income tax for as long as she keeps her property, and an increase in mortgage loan eligibility of RM 216,000.
If you are Shirley today, would you invest in the condominium?
Think about it. For Shirley, it costs her RM 136 per month or RM 1,632 per year to earn herself an instant net capital gain of RM 35,000.
Meanwhile, if Shirley tries to earn an additional RM 35,000 in income from her business, she would be subjected to a personal income tax bracket of 24%. This works out to be RM 8,400 in income tax.
As such, if you are a business owner, it would be recommended for you to have real estate incorporated as a part of your game plan to build long-term wealth.