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Sunday, August 14, 2011

Residential properties: Why are investors still buying?

- tag from Propwise

Despite round after round of cooling measures in 2010 and 2011, many investors remain eager to park their funds in residential properties.
The tightening measures have merely relegated a fraction of the investors to the sidelines and, while they watch the market closely, others continue to invest.
Why are investors so attracted to residential property investments?

Low interest rate environment

Savings interest rates are at an all-time low of 0.1 to 0.2 per cent per annum, while fixed deposit rates average about 0.3 to 0.8 per cent per annum, well below the rate of inflation, estimated at 3 to 4 per cent for this year (Feb 17, 2011, Ministry of Trade and Industry).
On the flip side of the coin, home loan rates start from below 1 per cent per annum. Interest expenses on property investments have never been so low since 2003 to 2004, right after SARS. Currently, floating rate home loan packages are priced at 0.65 to 0.80 per cent above the three-month SIBOR or three-month SOR or, in the case of ANZ Bank’s package, a blend of both. These home loans cost borrowers about 1 per cent per annum.
Therefore, for those who are already invested in properties, there is no urgency to sell even if rental returns edge lower, because holding costs are low. Although rental returns average about 3 to 4 per cent yield per annum, the interest coverage ratio is high, at 2.5 to 6 times. The interest coverage ratio here refers to the number of times rental returns, net of expenses, can cover interest costs.
A rental yield of 4 per cent per annum is double the bond yields of about 2 per cent on securities recently issued by Temasek-linked companies. And those bonds were two to four times oversubscribed by institutional and retail investors.
Interest rates and mortgage rates are expected to remain low for another 12 to 18 months because the money supply continues to grow strongly. In the 24 months of 2009 and 2010, M3 money supply — the widest form of money supply measured in Singapore, defined as coins and notes in circulation, money in savings accounts, fixed deposits, demand drafts, etc — grew by S$67.7 billion or almost 20 per cent.
The Monetary Authority of Singapore (MAS) has stated that it will allow the local dollar to gradually strengthen against a concealed basket of currencies of the country’s major trade partners, a move that will alleviate the pressures of imported inflation.
In addition, global investors, especially high net worth individuals from Europe, are confident about the strength and stability of the Singapore economy, and are driven to sell their home currencies to park their funds here.
Banks take in the new deposits, and after setting aside the reserve requirement, they may lend out the money, adding new money supply into the system. But when money supply growth is faster than the pace of lending growth, i.e. lenders are holding more money than borrowers are allowed to borrow, interest rates will continue to be pressured downwards.
So, we have on the one hand low interest rates that are reducing the value of our money, because the interest we earn from our savings is only about 0.1 per cent while the costs of living is expected to rise by up to 4 per cent. On the other hand, we have mortgage rates of less than 1 per cent, meaning the costs of borrowing money against a residential asset is so low that the cash flow from rentals is attractive even at low rental yields.

An actual example

An actual example illustrates: Our clients acquired a mid-floor three-bedroom apartment at Blue Horizon in West Coast Crescent. Blue Horizon is a 99-year leasehold condominium with full facilities and beautifully landscaped grounds. It was completed about six years ago and very popular with expatriate tenants. More than half of the 616 units are occupied by foreigners.
This particular apartment has a strata area of 1,152 sq ft and came with an expatriate teacher from an international school as a tenant. The lease runs until November next year. The transacted price was S$1.02 million, or about S$885 per sq ft, which was similar to other transactions in Blue Horizon at the end of last year.
Our clients funded the purchase with 40 per cent cash, i.e. S$408,000. Their CPF is used to fund the home they are staying in today. Stamp duty and legal fees added another S$25,200 and S$2,500, respectively. The total cash outlay was S$435,700 for this investment. They took up a loan for 60 per cent of the value at 1 per cent on a floating rate package with a local bank.
Rental income for the unit is S$3,800 per month or S$45,600 per year (Note: This produces a gross rental yield of about 4.5 per cent per annum). Expenses for property management and sinking fund amount to S$3,120 per year, while interest expenses at 1 per cent (assuming interest rates neither went up nor down during the first year) cost S$6,120 per year. Making provisions for property tax at about 10 per cent of the annual rental income means we deduct another S$4,560 from the equation.
Now, rental income minus expenses produced a net surplus of S$31,800 (=S$45,600-S$3,120-S$6,120- S$4,560). This would have gone towards paying down the principal part of the loan. If the loan was taken over a 25-year term, they would need to contribute S$2,040 a month or S$24,480 a year towards the principal. Still, they are cash positive.
Note that the cash surplus of S$31,800 versus the clients’ total cash outlay of S$435,700 implied a cash-on-cash return of 7.3 per cent. This is 10 times higher than the cash returns of placing S$435,700 into a fixed deposit. The return is also higher than the expected rate of inflation for 2011.
The example above is conservative in that I have included the maximum costs such as legal fees (which are usually subsidised by banks that provide the mortgage) and I did not deduct expenses before applying the 10 per cent property tax. Furthermore, as we pay down the principal of the loan, the interest expenses will drop.
Therefore, I believe the clients are making a cash-on cash return that is higher than 7.3 per cent this year.
Property investment come with its own risks: Tenants may move out and the apartment may be empty for a while, costs may rise, etc. Rentals may come down but we have room to absorb that slide.
In the event global stock markets take a second plunge, interest rates will be forced even lower, and a secured rental income will limit the downside of the property’s value. What happens if interest rates rise? In that case, the economy must be growing fast and there is a good chance we can raise the rentals on the tenants during contract renewal.
This is why real estate assets are a hedge against inflationary growth.
And for many of the foreign investors whose base currencies are the euro, British pound, Hong Kong dollar or US dollar, the strength of the Singapore dollar will add to their total returns when they divest and convert the returns back to their home currencies.
Originally published in Today, this article has been written and shared by Mr Ku Swee Yong, founder of real estate agency International Property Advisor, which provides services to high net worth individuals. 
He is also author of Real Estate Riches: Understanding Singapore’s Property Market In A Volatile Economy, available in bookstores now. I have bought his book and found some really great advises and would like to share his view in this blog. Thank you Mr Ku.