Now is the time to sell and rent - right?

Hot on the heels of my article last week about why it is still better to buy than rent, the Erwin Rode website and July newsletter said the following in their 5 July article:

"If we weren't so emotional about our homes, the best financial decision for us to make at a time like now when real house prices are near or at the top of the property cycle, is to sell and rent, and to buy again when house prices are on the decline. In the meantime we would invest the profit from the sale and the difference between our monthly rental and the bond payments we used to make, and invest it in another asset with higher returns.

This would make the most financial sense, says property economist Erwin Rode, CEO of Rode & Associates. However, when it comes to residential property, emotions play a far bigger role in buying and selling decisions than probably any other investment decisions. "Somehow, I don't think Mrs Rode is going to be too happy to go along with this financially prudent plan and give up the home she has put so much into setting up", quips Rode." http://www.rode.co.za/news/article.php?ID=2130

My Take

So the idea is to sell now and rent while investing that profit in another investment vehicle? With apologies to Mr Rode, I have a differing view and think that this only makes sense under a very limited number of circumstances, which I will elaborate on later. Let's set up a hypothetical example to work through this position.

Assumptions:

  • You bought your house 3 years ago for R500 000 and it is valued at R1 million today.
  • You can rent an equivalent R1 million property for R5 000 per month.
  • Your property is privately owned and profit <R1 Million so CGT is 0%
  • Transfer costs are worked out on privately owned property and not property held in another legal entity.

So the question is: Does it make sense to sell your house and rent? On the face of it, it looks like you'll be saving R5000 per month and realise a handsome R500 000 profit to re-invest.

Rands and sense

In reality, if you do sell you'll make the following profit:

Purchase Price R500 000
Transfer duty * + 35 000 * tax and conveyancing costs. Approx.
Incidentals# + 5 000 # moving, deposits etc.

Total outlay R 540 000

Income derived from sale of house
Selling Price R1 000 000
Agent's fee @ 5% -50 000
Incidentals# -5 000
CGT tax payable 0
Nett Sale value R 945 000

Nett Income= Nett Sales value -Total Outlay = R945 000 - R540 000 = R405 000.

Even if you bought another house for R1 000 000 later on when you thought it wise to re-enter the property market (assuming that you can find an equivalent property for R1 million) you would again have to pay the transfer and conveyancing costs of, in this case now, approximately R80 000. Your cash situation then is R405 000 - R80 000 or R325 000.

If you did realise your profit now and invest the R405 000 (not R325 000 because the cost of a future transfer hasn't happened yet) you would need to make an after tax return of more than 25% or 40% before taxation to match the R100 000 return on a 10% increase in the property market. (Or 33% and 50% respectively if you do take the R80 000 into consideration.) You could make more money if your alternative investment can outperform the property market by that 500% over the same time period. (10% to 50% = 500%)

It could be true if…

The very limited restrictions that make Rode's statements correct are:

  • A Property Price Collapse
    If you expect property prices to fall. Not if they don't keep up with inflation, but if the values actually drop, i.e. the R1 million property in the example drops its value to lets say R800 000. Even then the drop in value might not offset the costs of selling and renting now and re-purchasing at a later stage.
  • New entrants
    If you were thinking of buying in the current market. Then the dilemma of choosing a different investment and ploughing the savings back from your 'cheaper' renting lifestyle could make sense but again, not necessarily. Go to this article at www.thepropertygame.co.za/html/cyberprop010705.htm for more info.

Renting is better?

In terms of renting something cheaper: In our example you'd be paying about R5000 per month repayment on a 100% bond of R500 000. If you rent an equivalent property at R5 000 per month, you're not saving any money; you cashflow stays exactly the same and now you're making someone else rich.

Really?

As I asked at the outset: Does it make sense to sell your home and rent another property and invest the proceeds somewhere else? I'm sure you've worked out by now that you are ALREADY 'renting' a property for R5 000 per month - your own! And you've already got your money committed to a particular investment - your home. Your cost of living is dropping every year in relation to inflation and an added bonus is that you will also benefit from any further capital growth and a reduction in your mortgage debt the longer you stay in the same property.

If the above example is worked out with a longer ownership period and lower purchase price, the rental component gets worse as you'd be renting at more than your bond repayment would be. Alternatively, the shorter the ownership period is, the less the growth and subsequently the profit to re-invest although your immediate cashflow might improve. In these instances the frictional costs of changing homes will all but erode your profit.

The final cost

I have left out a final cost - the cost of a divorce lawyer.

Conclusion

Thanks again to Mr Rode for the article and food for thought. I think the point is made that the residential property market could be at a high point and foolishly buying with unrealistic emotional expectations instead of calculated forethought could land you in trouble. And the people jumping into the buy-to-let market with only an eye on short-term capital growth are in for a nasty surprise if the market doesn't continue to perform as it has in the last 3 years.

In the final analysis, the high transaction costs of selling and purchasing property are stumbling blocks to changing your investment strategy and taking advantage of the low rental environment.

Article by: Dave Welmans - (www.thepropertygame.co.za)