How conventional accounting methods prevent people from investing in property

By Neil Vorster | 1 The power of property investment

investing in property growthHave you ever wondered,  “If investing in property is so good, why isn’t everybody in it?”

 

A primary reason, being the miscalculation of Investment Returns, hides the power of property investment.

 I will give you an example of what I mean.

What is ROI

The main definition to understand is “Return on Investment.” – Also known as ROI. This is generally used to measure how good an investment is, and is expressed as a percentage per annum.

It is best explained by an example;

If you invest R 500 000 in a bank account and the bank pays you R 30 000 interest over twelve months.

The ROI is therefore R30 000 / R500 000 = 0.06  which  expressed as a percentage is 6% (You earned 6% interest. )

When this is applied to a townhouse investment “they” calculate the ROI as follows;

Purchase Price R 500 000, rental income in the first year is  R 4500 per month, less Levies of R 1 200 per month = R 3 300 net per month, which multiplied by 12 months returns R 39 600 in annual income.

The townhouse ROI calculation is therefore: R 39 600 / R 500 000 =  7.92%

Conventional wisdom will then compare the two investments, and say that their  ROI’s are quite similar. The property investment option is therefore discarded due to it’s inherent risks and the bank becomes the preferred option.

Property Investors work out their true ROI this way

When working out the ROI for the townhouse, one fundamental assumption has been made and one source of wealth has been excluded.

Firstly, the above example assumes you paid R 500 000 in cash for the property, which is incorrect. You actually paid a 10% cash deposit (R 50 000) and borrowed the rest of the purchase price from a bank (that is a 90% bond) .

Net monthly rental income in the above example per month is R 3 300 less your bond repayment of R 3763 = -R 463 per month, or negative R 5556 income per annum. (It costs you R5 556 in the first year).

Looks bad doesn’t it  – but stay with me!

The other very real source of wealth we need to consider, is capital growth.

While you were merrily collecting rental and subsidizing the bond by R 463 per month all year, your townhouse was growing.  If the national average house price increase (as published by most major banks) was 7%, and you cleverly bought you townhouse in a high growth area, it would have grown by at least 10 or 12% in the last twelve months

( At year end it would now be worth R 560 000 — a  R 60 000 increase)

To calculate your “income”, subtract your annual negative income of R 5 556 from your income of  R 60 000 to arrive at  R 54 444 net annual “income”

Now to calculate your ROI the property investor way, we need to divide the income by the amount invested and express it as a percentage,

Income R 54 444

Amount invested R 50 000 ( your 10% deposit )

ROI  is R 54 444 / R 50 000 = 108 % in year one!

Now, does this make the investment decision a bit easier? ( it actually looks too good to be true, doesn’t it?)

The defenders of “conventional wisdom” will cry out that this thinking is wrong, as you have not realized the capital growth yet and therefore cannot include it in the calculation.

My answer to them is that the above-mentioned example would be 100% correct if I sold my townhouse exactly 12 months after buying it. But it wouldn’t be too wise to sell such a fantastic investment, wouldn’t it?

As an afterthought, I have to confess to having sold such fantastic investments a few years ago, and regretted every one. I call it chopping down fruit trees: a topic for another day.

Do you agree with my logic?

Am  I smoking my socks- or have you seen it this way before? 

Please comment below freely, I would love to know what you have to say.

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About the Author

Neil Vorster is a property investment coach, investment author and co-founder of Organic Growth. Aerobatics pilot and cycling nut.

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