Is Rental Income a Sound Retirement Diversification Strategy?

by | Aug 2, 2020

Over the past few years, both the retail and residential property sectors in South Africa have been under immense pressure from the ever-weakening economy. When Covid-19 hit, the property sector was already straining to deliver the rental returns and property value growth that investors had enjoyed over the years

In a nutshell, various retailers and businesses in malls and office parks pay monthly rentals to larger corporates i.e.  Liberty and Growthpoint who own the malls and buildings. While the recent lockdown has been eased, allowing malls and businesses to reopen, many tenants have advised their landlords that they cannot meet their rental commitments.  In many cases, some of these tenants have had closed their businesses for good from a lack of demand and the devastating effects of the hard lockdown we went through.

It follows that in the residential space many property owners have been retrenched or had their incomes reduced and will not be in a position to meet their monthly bond payments in the future. Repossessions are going to follow.

Many investors with cash available will see this as an opportunity to purchase bargains with the intention to rent the properties to those residents that have had to sell their homes.

The big question is should property for rental income form part of your retirement income?

The below article by Richus Nel of PSG Wealth provides some interesting insights into this additional asset class and why PSG considers that this is not a sound retirement diversification strategy.

Rental income as part of your retirement income

Your retirement income and cash flow cannot rest on a 55% payment rate from tenants.

The Covid-19 financial market experience has unsettled even those most experienced in financial market investing. Records were set for all the wrong reasons; the S&P500 this time only took 16 days to fall into a bear market compared to 38 days in 1987 (including the infamous ‘Black Monday’) and 118 days for the Great Financial Crisis in 2008.

Various property syndications and physical investment property conversations re-emerged as all confidence has been shaken in the global and local financial markets. The marketing message driven home (excuse the pun) to potential investors, is that physical brick and mortar is somehow relatively immune to economic/financial market cycles. While investing in physical property perhaps provides a sense of comfort (or security) to investors, there are various aspects that are discussed less often than the “success stories” that are often bandied about.

The reality for physical investment property owners

Mortgaged investment property makes a lot of sense. You receive capital growth and income on assets you would not otherwise have owned. Landlords often don’t share their horrid investment property stories with their friends, but they surely open up towards their financial advisors. Gardens and swimming pools neglected by tenants, garage doors/geysers, kitchens/bathrooms maintenance (water supply/drainage), carpets and kitchen replacements. Leaking roofs/chimneys and sinking foundations are some of the stories I have heard. Anyone knowing their numbers can see that these unforeseen extras, quickly dilute any form of investment profitability. South African landlords are mostly unprotected against non-payment, legal disputes, verbal abuse and (in extreme cases) personal safety concerns.

Market prices or value

Residential: According to the FNB Commercial Property Finance Team’s Property Insights (May 2020) we should expect an economic shock worse/equal to that of the Great Financial Crisis (GFC) 2008-2009. The percentage of tenants paying on time dropped to an unbearable 54% by the end of 2008. According to the FNB report, it took 3.5 years to recover tenants in “good standing”/ paying on time to pre-GFC levels.

Commercial: Perhaps you think commercial property is different. The market prices of commercial property (selling prices/rental) generally do not initially adjust in line with the required “price equilibrium” (set by market supply and demand). However, the properties remain vacant for longer, and this too is obviously a devastating outcome for investment properties. “Forced selling” vacant commercial property during times of crisis, mostly requires owners to severely drop in price to find the real price equilibrium (willing buyers’ market).

“I have good tenants”

Many landlords argue that they “have been lucky with good tenants”. Everyone is (and feels) lucky until their luck runs out. It would be rational to acknowledge that good tenants can also get retrenched and run out of financial options.

Unfortunately, there seems to be a remarkably close correlation between economic cycles and the prices/rental prices for physical property. This means that the risks in receiving your rental income would peak at the same time when financial markets struggle to produce capital growth or receive dividend income. Diversifying financial market investment with physical property is therefore not a sound retirement diversification strategy.

Fundamentals of a sound investment strategy

Liquidity is one of the most underappreciated considerations in making investment decisions. Liquidity mostly only gets attention once it has dried up and assets cannot be sold. Physical property can experience profoundly serious liquidity challenges during times of crisis, both from a resale and rental income point of view.

Diversification during good times can be seen as diluting great returns from star performing assets. This feels true until the day most of your wealth is nested in a Steinhoff, EOH or Tongaat Hulett. Due to the value size of physical property, this asset class makes it quite difficult for the average investor to achieve effective diversification. Investment property is a business and with hundreds of examples of businesses that fail during crises, the following question needs serious consideration: “Does it really make sense that your retirement plan primarily/significantly rests on a handful of (at times) highly illiquid property assets or unpredictable income streams”?

Holding costs and taxes have, over recent years, dramatically increased for South Africans and global property-owners. Governments are capitalising on the dependable taxes levied on physical property, while labour fees have skyrocketed. I recently paid R800 for an electrician (call-out plus half an hour’s time, no stock used). Landowners constantly find themselves being squeezed between rising ownership costs and stagnant national inflation-adjusted rental increases. The reduction in interest rates was a welcome interim relief and they should be taking full advantage of it, as low-interest rates will not be with us forever.

Conclusion

It is extraordinary how quickly the pros can change into cons in the property arena during times of crisis. My advice is to diversify debt-free investment property timeously into a financial market investment, considering the appropriate asset classes (mostly a combination) that have the best chance to provide for your income drawings and return expectation/requirements, in line with your risk appetite and time horizon. Your retirement income and cash flow cannot rest on a 55% payment rate from tenants paying on time, during every economic crisis.