Question:
Hi, I’m John, a 35-year old real estate investor.
Presently, I own two residential properties and I am looking to invest in my third residential property, which is a 800 sq. ft. apartment in a nice neighbourhood. It is a well-maintained unit and its vendor is asking for RM 280,000 for his unit. As of now, this unit could be easily rented out for RM 1,000 a month and its service and sinking fee and other miscellaneous fees such as land and assessment taxes and Indah Water bills amount to RM 300 a month.
Thus, how to project my returns from investing in this apartment unit, if I intend to hold onto this property for at least 10 years?
Answer:
First, John is purchasing his third residential property in Malaysia and hence, he is required to place a 30% down payment for this apartment unit. This will work out to be RM 84,000 in down payment. In addition, John will incur five different types of transaction costs such as the legal fees and stamp duties to prepare for his sale & purchase agreement (SPA) and his loan facility agreement and as well as his property valuation report. Let’s put a cap to all these costs at about 5% of the property price and thus, work out to be RM 14,000 in transaction costs.
Next, we would need to make an assumption on the amount John will spend to touch up on his apartment unit. This will include repainting job, a change in this apartment’s furniture, and minor repairs, if any. For simplicity sake, let’s place a figure of RM 14,000 (5% of the property price) as his budgeted touch-up costs.
So, John’s initial capital outlay would be RM 112,000 to buy the apartment unit.
The Monthly Commitment
John will finance the remaining 70% of the property investment via a mortgage, which works out to be RM 196,000. In addition, John opts to buy a MRTA policy that costs around RM 10,000. This MRTA cost is added to this mortgage. Hence, John’s final mortgage is around RM 206,000.
John is eligible to obtain a 35-year mortgage for he is 35 years old. Let’s assume that the mortgage rate obtained is 3% a year. Thus, John’s mortgage installment is around RM 800 a month.
By including RM 300 a month in all property-related expenses stated above, the total amount of expenses John will incur is RM 1,100 a month on this property.
The Projected Rental Income
Let’s assume John is able to rent this unit out for RM 1,000 a month in Year 1-2. Subsequently, John could raise his rent by RM 100 a month every two years and hence, receive RM 1,100 in Year 3-4, RM 1,200 in Year 5-6, RM 1,300 in Year 7-8 and RM 1,400 in Year 9-10.
As such, John’s projected cash flow in that 10-year period would be:
The above is prepared assuming that John’s property is fully occupied in that 10 years. Here, let’s say, John would use the RM 12,000 during that 10-year period to make payments such as minor repairs and costs to replace tenants. Hence, in this case, let’s assume that John will be cash flow neutral in the 10-year period.
John’s Outstanding Mortgage @ Year 10
Based on the loan calculator, John’s outstanding mortgage upon 10 years works out to be RM 167,181.
Apartment Value @ Year 10
This will depend on the assumption John wishes to make to estimate the future valuation of this apartment unit.
Here is one of the many methods of calculation.
As stated above, John can rent out the apartment unit costing RM 280,000 for a monthly rent of RM 1,000. This works out to be 4.29% in gross rental yield.
Gross Rental Yield
= (12-Month Current Rental Income / Property Price) x 100%
= (RM 1,000 x 12 months / RM 280,000) x 100%
= 4.29% per annum
Let’s say that the gross rental yield of 4.29% per year remains constant, without change over the 10-year period. This means, if a new investor wants to invest in the apartment unit, he will expect to earn a gross rental yield of 4.29% per year from this investment.
However, at Year 10, John is collecting RM 1,400 a month in rental income from his apartment unit. As such, if a new investor wishes to earn a gross rental yield of 4.29% a year, the price he would have to pay John is RM 391,608. Its formula is as follows:
Market Price of Apartment Unit @ Year 10
= (12-Month Rental Income @ Year 10 / Gross Rental Yield) x 100%
= (RM 1,400 x 12 months / 4.29%) x 100%
= RM 391,608
Hence, at Year 10, John’s apartment is projected to be worth RM 391,608 and it has as much as RM 167,181 in outstanding mortgage. As such, John’s net worth (equity) on this property would be RM 224,427.
John’s Property Equity @ Year 10
= Projected Apartment Value @ Year 10 – Outstanding Mortgage @ Year 10
= RM 391,608 – RM 167,181
= RM 224,427
‘Simplified’ Compound Annual Growth Rate (CAGR)
This is by all means not super accurate, but I felt that it is simple enough to use.
We need three ingredients to calculate CAGR for John’s investment into his unit and they are as follow:
#1: Beginning Value
That would be RM 112,000, which is his initial capital outlay.
#2: Ending Value
This would be RM 224,427 and it is calculated as follows:
Ending Value
= John’s Property Equity @ Year 10 +/- John’s Projected Cash Flow in 10 Years
= RM 224,427 – RM 0
= RM 224,427
#3: Period
This would be 10 years.
Hence, with the CAGR calculator, John can simply estimate the CAGR of his unit and this works out to be 7.20% a year in the 10-year period. This means, John is projecting to have his net worth increased by a compounding 7.20% per annum from his investment into the apartment unit.
Of which, John may decide if the apartment unit is a worthwhile investment for him over the long-term.
Conclusion:
So, is the above projection demonstrated absolutely accurate?
The answer is no. We have to appreciate that this projection illustrated above is based on a number of assumptions and the actual returns will differ based on:
1. The transacted price of the apartment unit.
2. The exact transaction costs paid to purchase the apartment unit.
3. The actual refurbishment costs incurred to touch up the property unit.
4. Changes in mortgage rates in the future.
5. Changes in service fee, sinking fund, land & assessment taxes.
6. Changes in Indah Water bills
7. John’s ability in occupying his apartment unit with tenants.
8. John’s ability to raise rental income in subsequent years.
9. Repairs and maintenance costs incurred during the 10-year period.
10. The promptness of rental payment by John’s tenants.
So, that’s it for this week.
Let me know if you have questions by posting them to ian@kclau.com.
