Keep a close eye on that rental property

Columnist·

15 Feb, 2002 06:39 AM11 mins to read

By MARY HOLM

I know you usually tend to discourage investment in residential property, and back it up with sound logic.

But I would appreciate your comment on this situation, as it appears to be meeting a long-term goal.

Six years ago I bought a two-bedroom unit for rental, contributing $40,000 equity

Brace yourself. I'm going to say something positive about rental property!

Through a combination of good luck and good management, you seem to be one of those who have done it well.

On the good management side:

You bought a unit. These tend to provide higher rent per dollar invested than houses.

The rent covers your mortgage and other costs. You're not under the same strain as landlords who keep dipping into their own pockets to keep the whole thing afloat.

You got a mortgage for about 62 per cent of the purchase price. That's lower than many investors. It lowers the riskiness of the investment.

The unit is probably a slightly different type of real estate from what you live in - assuming you own your own house. So you're somewhat more diversified than those who rent out a property similar to their home. Again, that lowers risk.

You've done some of your own maintenance, which keeps costs down.

What about luck? For a start, you've had a reasonable increase in property value in a period in which values have fallen in some areas.

You might put that down to smart buying rather than luck. People who do well with investments tend to do that.

But I reckon buying a single rental property, with a mortgage, is rather like buying a single share.

Everybody always thinks they're on to a winner. But only some turn out to be right. Many do okay, and some lose some or even all of their money.

It also sounds as if you've done well with tenants. You don't mention any long vacancies or tenant damage. There's got to be some degree of luck in that - which, by the way, may not last.

Now, as an absentee landlord, you need to decide whether to continue with the investment.

There's no obvious answer to that. I know, from long-ago experience, that it's more complicated being a distant landlord.

Nobody else cares about the place as much as you do. And you can't do your own maintenance.

On the other hand, as you say, you're getting to the point where less of your mortgage payments go to interest and more go into reducing your debt. That's always encouraging.

And you sound content with the investment. If you've got a reliable - and not too costly - person in Christchurch who can be Johnny On The Spot when necessary, perhaps you should stick with your unit for a while yet.

The key question is: What else would you do with your $60,000?

If you were to put it into another rental property in your new city, you might not be so clever and lucky next time.

And each time you sell one property and buy another, you have to pay agents' commissions, legal costs and so on.

But if you were to invest in my favourite long-term investment, an index fund that holds world shares ... I reckon you should do that. (Surprised?)

It would give you much broader diversification. Your average returns over the long run would probably be higher. And there'd be no worries about maintenance, tenants and so on.

Speaking of returns, your last sentence rather confused me.

The return on a property investment is made up of the excess of rental income over expenses, plus capital gain.

You say the excess rent is negligible. But you've made a gain of $20,000 on the $40,000 invested, over six years.

That's an annual return of about 7 per cent, and it's probably not taxable.

You're right. That's reasonable.

One plaudit, one comment and one question: Plaudit: I always look for and enjoy your column and point my finance students towards it - a nice mix of underlying basics, practical advice, opinion and humour. Thank you.

Comment on last item in last week's column on how long it takes to become a millionaire: obvious to you but possibly not to all readers - even if you wait 144 years for your dollar to become a million, you are going to need it all to buy your $1 cheeseburger.

Question: Do you have any views about exchange rates on diversification? I have heard a view that one should invest in NZ dollars if one requires the ultimate money (say, for retirement) in New Zealand. Would you recommend gradual repatriation as retirement age draws near?

Now to answer: 1. Thanks.

2. You're quite right. It's really important to take inflation into account, especially over periods of a century or more.

Another reader made a similar point. If your dollar will be $1 million within 144 years, you will not be a millionaire, he said.

Well, you will be. But the millions of other millionaires won't be particularly impressed.

Only Howard Hughes could have said in 1937, that "a million dollars is not what it used to be". But long before 2146 we'll all be saying it.

Still, I think you're both being a bit pessimistic.

In last week's example, the correspondent assumed a 10 per cent return. In your comment, then, you assume 10 per cent inflation.

You'd better not say that in front of Reserve Bank Governor Don Brash, who has been keeping our inflation basically under 3 per cent for some years now.

Nobody knows, of course, what will happen to inflation in the next 144 years. But we can hope it will stay closer to Doctor Don's rate than to 10 per cent.

If it does, you should be able to get at least a feast of cheeseburgers for a million bucks in the mid-22nd century.

3. In many cases, I don't think people do need to bring their investments back to New Zealand before retirement.

But before we get into that, I think it's a great idea to put more than half your retirement investments overseas - probably through a New Zealand-based managed fund.

Although in the last couple of years the New Zealand sharemarket has performed better than world markets, that is often not the case. And the New Zealand market tends to be more volatile.

What's more, if you stick to local shares you miss out on investing in many industries not represented here.

It's true that, when you invest overseas, you take on exchange rate risk. If the kiwi dollar rises against most other currencies, that will hurt the value of your foreign investments; if the kiwi falls, it will boost the value.

But experts say this added risk is cancelled out by the risk reduction you gain from broader diversification.

Still, many people might feel happier reducing their foreign exchange rate risk as retirement approaches. Does that make sense?

It depends on how you will spend your money in retirement.

If you expect to spend most of it on New Zealand-produced food and local services, you probably should bring your money back home.

But better-off retired people often spend lots on overseas travel and imported goods such as cars, books, clothing, and so on.

It's better for them to keep a portion of their savings overseas. It gives them a hedge.

If the kiwi dollar falls, the prices of travel and imports will rise. But so will the value of their overseas investments, to help cover those rises.

If the kiwi rises, travel and imports will be cheaper.

The value of their overseas investments will fall, but with their cost of living falling, they won't mind too much.

The "72 Rule" has generated some interesting correspondence over the last few weeks. But where does the "magic number" 72 come from?

As one of your correspondents on this topic pointed out, the number reduces slightly from 72 to 69 for low interest rates.

Calculation shows that this is just 100 times the natural logarithm (ln) of 2.

The 100 comes from the fact that interest rates are expressed as a percentage; the natural logarithm derives from the exponential growth that occurs with compound interest; and the number 2 arises because the rule gives the time to double the investment.

This can readily be generalised. Admittedly, the name "100 ln x Rule" does not have quite the same ring to it, but with modern calculators it is easy to use.

For the example in last week's correspondence (building a $1 investment to $1 million) the factor x is 1 million, and 100 ln x is about 1400.

That means that the time taken to achieve this for an interest rate of 10 per cent is about 140 years.

(The method works accurately for low interest rates, but only a slight upward correction is required for normal rates.)

A $1000 investment at 10 per cent would take 70 years to grow to $1 million - still an unreasonably long time!

With a saving/investment of $1000 per year the period reduces to about 50 years.

I don't know of any simple rule like the one above to calculate this quickly, but it does show that saving/investment is the only realistic way for the average person to achieve such a result.

Of the several letters I've received explaining the 72 Rule, yours is the clearest.

Perhaps that's because you're a university professor - although there are those who would say that it's despite your being a professor!

(For Rip van Winkles who haven't seen this column lately, the 72 Rule says that if you divide a percentage return into 72, you'll get roughly the number of years it will take for your investment to double. For example, an 8 per cent investment will double in about 9 years.)

The mathematicians among us can now use your "100 ln x Rule".

But I'm still happy to stick with 72. For returns between about 3 and 15 per cent, it's pretty accurate. And you can do the sums in your head.

The point you made about accumulating $1 million by saving $1000 each year for 50 years, at 10 per cent, might encourage young would-be millionaires. But, at the risk of being a wet blanket, I feel obliged to say:

Ten per cent is too high a rate to assume. At a more realistic 5 per cent, $1000 a year will grow to a bit more than $200,000 in 50 years. That's not quite as exciting, but still not to be sneezed at.

Keep in mind the point made above about inflation.

One final note: Thanks to all of those who sent me many lines of maths about the 72 Rule.

Whoever said New Zealanders were mathematically illiterate?

* Send questions for Mary to Money Matters, Business Herald, PO Box 32, Auckland; or e-mail: maryh@pl.net.

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Mary cannot answer all questions, correspond directly with readers, or give financial advice outside the column.