The Case Of Over-Gearing In Properties And Increased Liabilities

The Case Of Over-Gearing In Properties And Increased Liabilities

The case of over -gearing in properties and increased liabilities - 12 May 2012

ONE of the most prominent businessmen in the 20th century was a man called Joseph P. Kennedy (President John F. Kennedy’s father). In the 1920s, Joe Kennedy invested in stocks and later claimed that he knew it was time to get out of the stock market when he received stock tips from a shoe-shine boy. The rampant stock speculation of the time eventually led to the 1929 stock market crash and, subsequently, the Great Depression.

I am reminded of this story when I see that, today, people seem to be investing their savings in many properties at once. Those without savings opt to take out bank loans to finance such investments. Just yesterday, the tea-lady told me about a “hot new property” to invest in. While this alarms me, I’m not saying that as a serious investor you shouldn’t invest in properties. To the contrary; it is still possible to invest in properties and not harm your financial portfolio.

Just over 10 years ago, people who invested in properties tended to be more cautious. They were people who had saved up money and needed to invest that money somewhere “safe”. Many of them bought properties expecting to generate a healthy stream of rental income and were unlikely to sell it immediately. This was probably because there was no real financial incentive to do so. For one, with the real property gains tax (RPGT), whatever properties purchased and sold were subject to a high tax of 30%.

Over time, though, this rate of 30% has been reduced. Under Budget 2012, the Government proposed that the RPGT will be revised where properties held and disposed of within two years are subject to RPGT of 10%. Properties held and disposed of between two and five years are subject to RPGT of 5%, while those which were held and disposed of after five years are not subject to RPGT at all. As a result, many people today buy properties with little intention of using them to yield a rental income. In fact, rental yield has generally decreased from 7% just over 10 years ago to approximately 4% now.

People tend to be more interested in “capital appreciation” of a property. This means that buyers tend to look for properties that are in the process of being developed or near completion. They take out loans to buy these properties and, the moment the development is complete, the property is sold at a profit. They hold a strong belief that one can never go wrong investing in property and live by the maxim, “the only way to go when investing in properties is up.”

The dangers of undertaking such an investment venture were highlighted by the actions of a successful business owner I once knew. In his early 60s, with his spare cash, he invested in over 15 properties in the short space of two years. He spent very little money doing this as he had, on average, taken out loans of 85% per property. 12 of them were concentrated in some of the most exclusive enclaves of the city. Of these, some properties were still being developed and others were rented out to expatriates.

When I came to know of what he was doing, it rang warning bells for me as over investing in properties can lead to financial ruin. I advised him to diversify his portfolio into other assets like equity, bonds and cash. I also advised him to keep some of his wealth in liquid investments to limit the risk he was under. He slowed down buying properties and invested in bond funds. However, he remained adamant that what he was doing was right and believed that he would make a healthy profit when the developments were complete.

Unfortunately, he passed away suddenly and the family was left to deal with the deceased’s debts. When the tenancy agreements ended, the expatriate tenants didn’t renew their agreements. Instead, they opted to rent other newer properties with better facilities. With no rental income, coupled with the market slowing down, the deceased’s family was forced to sell these properties at a price that was much lower than what the deceased initially paid. In addition, the deceased’s family could not service the loans for the properties that were not yet completed. Naturally, the banks foreclosed on these properties. Although the family did, eventually, settle all the deceased’s debts, it was not before considerable money was spent.

All said and done, this doesn’t mean that you shouldn’t invest in properties. In fact, more than ever now, investing in properties is a viable option if you are a serious investor. However, it is imperative that you do so cautiously. For one, never “over-invest” in properties. Always make sure your investment portfolio consists of various investment assets.

Even if you choose to invest mainly in properties, never choose properties located in one geographical area. You could end up concentrating your risk in an area that might go “out of favour” or become less popular (as the case seems to be in certain parts of the Klang Valley). Sometimes, there is an over-supply of properties in one particular area. If these happen, you might find that you’ve gone from being in a “seller’s market” to a “buyer’s market” or a “tenant’s market”. In other words, instead of enjoying the benefits of getting a healthy rental for your property, you will end up accepting whatever rental your tenant might pay you. Therefore, to minimise your risk, always pick properties in different areas.

Although banks have begun to tighten up the lending criteria, bear in mind that over gearing (taking out a maximum loan from the banks for property investment) is not advisable. Therefore, minimise your interest payments and reduce your exposure to liabilities by taking out a reasonable amount of loan.

Ultimately, there is no doubt that you must invest in properties. However, do so in a prudent manner to ensure that it is a financially rewarding exercise for you with minimum risk and damage to your long-term investment goals.