The 411 on starting your investment property business

BOITUMELO NTSOKO: Welcome to the Money Savvy podcast. I’m Boitumelo Ntsoko. In the last episode of this podcast, I spoke to Richus Nel of PSG Wealth about some of the things you need to consider before venturing into rental property, and whether you’d be better off creating wealth the traditional way versus through buy-to-let properties. If you missed that episode, head to Moneyweb.co.za to listen it. You can also find it on Spotify or Apple Podcasts.

In this episode, we’re continuing with this theme. Richus joins us again to address questions from Moneyweb readers who are starting their investment-property businesses. So let’s get straight into it. Welcome, Richus.

RICHUS NEL: Thank you, Tumi. Thank you for having me.

BOITUMELO NTSOKO: Now, the first question from our readers centres around getting investors to help them achieve their rental property ambitions.

Here’s the question:

“I would like to know how I would go about finding investors to buy out an entire sectional title complex. The apartment building, which has less than 15 units, is located in a very popular suburb in Bloemfontein. The building itself is 35 years old and very well maintained. The building is being managed by a third party and, as an owner, I can see how the monies are not used correctly; or rather, I could run the building much better with a lot less money.

“I have purchased a couple of the units, and only 10 units are left. My aim is to, of course, own the entire complex, but how do I go about getting investors to assist me to buy out the entire complex? I have set up a business plan and I will be able to manage the rentals on my own as I’m already doing it, as well as general maintenance.”

RICHUS NEL: Okay. So Tumi, I think before we jump into the question, because I think it does go hand-in-hand [with] how people will actually look at the opportunity – property owners looking for partners in owning this business together, but eventually probably buying them out and owning the whole building himself or herself. But there’s clearly some sort of a finance objective here, because in the owner’s own capacity it doesn’t look like he or she could immediately [buy all the units themself]. But nevertheless, whoever this person will approach, there are just a couple of principles about an investment most informed people would regard as important.

The one is liquidity – if something is liquid or highly liquid. Then when an asset is illiquid, it should be a great consideration [as to] whether to proceed into that investment or not. If you look at your investment professionals, liquidity is one of the most important considerations. Without liquidity, the immediate price at that point in time can be debated or considered to be nil, and they would not proceed.

The second part is the diversification consideration. Is everything in one basket, [and] at what sort of risk rate? How are the rewards aligned with those risks that investors take up – or is this actually a well-diversified investment where, if something unforeseen happens, the whole investment case does not fall over?

Then something that goes hand-in-hand a little bit with liquidity is price evidence. Does the investor have a relatively good idea of the actual value of that investment at point of entry, and while owning it? Obviously, that’s very available in the financial market system that investors invest in, but is less so and sometimes completely absent with property.

So if you think about that, if investments do not have these, let’s say, attributes, that investment can most probably be regarded as more risky than others. So illiquidity [and] not well diversified I would consider to be a higher risk and hence would expect a higher return.

So to come back to the reader’s question, I think we are talking about an [apartment] building with about 15 units. The owner at this stage already owns [some units within the] apartment block.

The aspiration is to own the full building. I think what comes with that is obviously the concentration risk that I regard as high. The question would be: are there not other opportunities of a similar kind or something of a completely different nature that can help with the diversification concept that we have actually just pointed out?

The reader points to the 35-year age of the building; the person refers to [the fact] that it’s well maintained, but then the reader also points out that the monies can be better spent, and so on. The reader is not the same as the person that’s doing the maintenance at the moment, and one would just like to point out that, as owner, you’ve got a vested interest in the building, so surely there are some things that you would do either cheaper or sometimes for free that a third party would never do. So I don’t think it’s a valid point to point out that it can be run cheaper or the monies can be spent differently. It would be, but the fact of the matter is would the investor or the reader be remunerated for the time invested, or is it merely just something that will need to be caught up with the investment value that appreciates?

As I said, the building is well maintained according to the reader. You would also like to hear a bit more about the experience of the reader in maintaining a bigger sort of apartment block. It’s not the same as just normal residential.

I think the question referred to it being in Bloemfontein. That location – has it got a great future? So we are talking about the location, location, location consideration again, and the diversification of that again.

And then in terms of the business plans, the client or the reader [asks] where he or she finds investors.

So if it’s a great business plan, they would be able to either get bank finance on that business plan, or they would find willing investors to actually partner with them, actually going ahead with these plans. I do want to point out finance, let’s say bank finance or lending finance, is cheaper over the long run than giving someone an equity stake in something.

And then just something else that I just wanted to point out that’s not in the question: is this entity in a type of structure, is it in this person’s personal capacity as a sole proprietor? I think if you start holding apartment blocks – and let’s say even commercial or then residential buildings – I think it would be a good consideration to start questioning in what sort of suitable structure these buildings should be, from not just a cost perspective, but definitely from a liability and a risk perspective, and then obviously the operational side that goes hand-in-hand with that.

BOITUMELO NTSOKO: With regard to the reader mentioning that the monies are not being used correctly, what due diligence do you think they should undertake before going ahead with the plan to own the entire complex?

RICHUS NEL: There’s not much detail in terms of the ‘money is not spent correctly’ sort of phrase. But seeing the current owner probably considers that some maintenance work can be done cheaper, cheaper is not always better. That’s why I’m saying it goes very much hand-in-hand and, because this person has already got a vested interest, it’s very important for this reader to probably try to be neutral and unbiased in terms of his or her own sort of maintenance experience, [and] time availability.

In our previous conversation, we talked about the health considerations of these individuals who actually take something up like this. An apartment building with 15 apartments is not a small building to maintain, so it’s difficult to say what due diligence; I think the person just needs to try and make that decision unbiased, but understanding that a third party will never do it at a cost that the owner will probably do it [for].

BOITUMELO NTSOKO: I don’t know if you’d be comfortable addressing this question, but what would go into managing a complex?

RICHUS NEL: A lot of time. So what you would need to understand is there are 15 units; that means those tenants come and go. There are people moving in, reparations need to be made, there are contractual sort of obligations that need to be overseen, a very strict sort of process I would regard as prudent – literally inspections with the clients or the tenants as they move in, photos being taken of the apartment to have evidence that everything was sound as the tenant moved in. I think what is probably under-appreciated out there is how debatable an apartment’s condition becomes if you don’t have the sort of evidence on a picture to say: ‘Listen, this window was actually in good repair as someone moved in; now it’s broken and who is going to pay for it?’

So I think you’ve got all of those movements, tenants coming in, tenants going out, obviously things that break while the tenants are there. Some of those obviously are the obligation of the landlord to repair, things like the apartment’s actual upkeep from a tidiness and hygienic perspective.

The moment you start renting property out to different people, everyone’s got their own sort of idea of what is hygienic and clean and, and looking after a property – something like people moving out again, those inspections and all the other maintenance that goes along with it. Even things like pipe bursts, electricity supply, water supply, obviously your accounts, running that building as a business, having proper record-keeping, having proper processes in place so you can actually pinpoint responsibility.

A lot of the time, if you run, let’s say, three or five units, it’s actually fine. If you start running more than that, a lot of the time you start needing staff. Now you need to sort of oversee that responsibility as well. And then obviously [there are] all the accounting things and taxes that come with it.

BOITUMELO NTSOKO: Now, moving on to the next question from another reader, here it goes:

“I’ve just started my investment-property journey, which will eventually lead me to pursuing it full time. I currently have two properties, one being rented out at a 10% gross yield, and one being primary for now until I purchase my next one with a realistic expectation of also receiving a 10% to 11% gross yield. My plan is to start purchasing initially one to two properties per year, gradually increasing the number each year with a goal of reaching into the hundreds of units, both residential and commercial.

“At the moment, both are in my name as it doesn’t make sense yet to have them within a business vehicle financially. At what stage or what net monthly profit would you suggest would be a good indicator to then look at forming a legal entity that can cover all financial costs, for example, accountant fees. I currently have a 41% tax rate, and I’m trying to ascertain at which point the 13% difference between my tax rate and the 28% corporate tax rate will pay for the added cost of operating a business with just myself in it.

RICHUS NEL: Tumi, again I think there’s a lot in there. Just off the cuff, I want to say it’s absolutely wonderful that someone can actually dream that big and, more importantly, here locally in South Africa. What I did enjoy seeing is that the reader is referring to residential and commercial already. So there’s a sense of a diversification, although it’s in the same asset class.

And then I think what was quite good for me as well is that the person is asking about whether it is in a suitable structure, as [per] what we ended off with [in] the previous question. I think it’s a very important consideration.

Without going through all the pros and cons of the different structures – there aren’t that many anyway – but without doing that, I think it would be worthwhile for this individual to get a great accountant, first of all. I think there’s a lot of discussion and address that can be gained from those encounters. And again, where this person is heading just in terms of their vision, obviously all visions and great things start just with one step at a time. It is important that those steps are taken correctly, in the right direction from the first step, because that’s normally the cheapest, even though it costs a fee or a consultation with an accountant, with an advisor, and so forth.

To come back to the structures, in my mind, as we talked about in the previous question, structures come down to not what it costs, not what the taxes are, [it] comes down mainly to where the most suitable protection is, from a legal separation between legal entities and risk management [perspective]. Then obviously the operational consideration that some entities are not suited for operations. So it’s more of a holding vehicle, and so on.

Although it makes sense from the start perhaps to start having these side businesses – which I regard as a property investment as well – I would regard that as a side business, while it’s initially cheaper to start that in your sole [proprietorship], it is a lot more expensive in moving those assets whenever – well, it is needed really from the start – but when that penny drops and someone actually needs to make that move at a later stage.

So I would regard it as prudent to, from the first step – and I want to focus merely on the investment property, not the residential property, that’s a complete different discussion – but in terms of the investment property to move that first property into a suitable structure similar to what that structure should look like right at the end, even when this reader owns the hundred properties or units or into the hundreds, what would’ve been a suitable structure.

I think what is evident in this question is that, if you do those calculations correctly and set up the right structures from the start, if you don’t follow the right route initially, what are the costs? I want to point to that as well. But if you do it correctly, that is where the argument comes in to say it is not as straightforward, and it is not as cheap, to get out of the blocks with physical property and investment property as a theme. It will take this reader perhaps longer.

In the question the reader refers to buying a property each year, or one or two each year. It might be a lot slower and I think most people out there will actually attest to that – that it goes a lot slower because there are affordability constraints if you structure these businesses correctly, and how quickly you actually can move ahead and turn a net profit out of the business.

In the question the reader refers to a 10% or a 12%, or 13% gross yield. That number has got no meaning, okay? It’s the same as what I would say, ‘I’ve got a factory, our turnover is R100 million, but if we’ve done everything that we should have done, I’m turning R100 million turnover into a R50 million net loss’. So the gross yield is a number that I would like property investors to move away from. We not talking about ‘gross’, we are talking about net – and that is what is going to be the bottom line, whether someone is making a profit or a loss, and whether the side business is sustainable or not.

I want to point out to the reader also the cost in terms of moving assets at a later stage, even if it’s been accumulated now or just this one property. There are only a couple of ways to actually move an asset and – because a sole proprietary legal entity is separate from, let’s say, a company or a trust – when you move that asset at a later stage, there’s a change of ownership. You can only do that in a couple of ways; one is by way or of a sale, okay, into the new legal entity. Obviously you can do it at a point of inheritance, but I don’t think that’s suitable here. You can do it by way of a donation. And then obviously, you can lend funds to the legal entity, and they can actually acquire assets in that entity.

But all of those options go along with income tax implications, go along with capital gains tax implications, go along with estate and donation tax implications, and obviously transfer duty implications.

So, coming back to where we started off, saying the first step that you make when you set up the side business, it is advisable to actually have a very good understanding of what legal entity is suitable for this business, even if it held 100 units. Perhaps just to emphasise how complicated this can become, depending on the property, depending on the risk that goes along with ownership of that property, you might actually end up having one property in one legal entity, or one legal entity per investment property.

The last part that I actually want to point out, the reader referred to the difference in income tax between his or her individual income tax at 41% versus the company income tax of 28% – getting profits out of the company back to the individual also carries a 20% donations tax. So that difference between the maximum income tax rate for individuals and the income tax rates within companies, and getting profits out of a company back to where you actually want it – perhaps in the individual’s name – is actually a lot closer than the 41% versus the 28%. It’s actually 45% versus the 48% in the company.

BOITUMELO NTSOKO: Richus, what are some of the factors our listeners should consider before venturing into investment property on the level that these readers are pursuing?

RICHUS NEL: Tumi, I sense that a lot of people start with investment property as a side business; they actually want to start something separate to their perhaps career and formal earnings. That is all good and fine. Starting a business, [for] all of us who actually have ventured into that, and even people who have not ventured into that, it’s quite a daunting route and it is a challenging route and it is complicated. I think the perception out there is that owning physical property and starting that type of side business is a lot easier, because many people, before they actually buy an investment property, might perhaps have a primary residence. They get a feel for the asset class, what the price does over time, what the maintenance does at times, and so on.

So I think – and that’s part of the debate – the perception out there is that it is a less complicated side business to start. Having said that, being perhaps a little bit less complicated does not necessarily make that a good business.

The point I’m making throughout is that it has to be run like a business. If you have a lot of business sense and you are business-savvy – that’s quite overall sort of streetwise, legislative, accounting, management, operationally maintenance savvy – then I think you will find it less complicated and manageable. If you don’t have those attributes, not necessarily attributes, let’s call it experience, it means that you will need to acquire that experience, and not by making your own mistakes.

So I think for me, if you are asking what people should consider, it has to be run like a business. People have to be serious about record-keeping, [the] admin process, managing tenants in what could be a friendly way, but it’s a very formal way. It’s not a friendship. People tenanting from you it is not a friendship; there are other ways to make friends. But it’s going to need to be run like a business, and that business is going to come with unforeseen costs and surprises and market conditions and stress at times, and people who are up for that I would encourage to actually consider it. [For] people who are not up for that, I’m pointing out that there are different ways of wealth creation.

BOITUMELO NTSOKO: Just lastly, would you advise going into rental property on this scale?

RICHUS NEL: I think just start with one property. I mean, get a feel for it. So, as I pointed out, it’s fantastic that someone dreams big and you always want to encourage that and actually you also want to equip and support someone with that. But what this person also refers to is that he [or she has] just started this physical property investment journey and that he [or she] actually will need to prove to himself [or herself] and to everyone else that that might be involved, that he or she can run this profitably over a period of time.

So I would say start right. Start right, having the right advice, the right structures, the right sort of mindset and process.

If you’ve managed that, it’s almost like I’m very keen always to refer to cycling, because a lot of people can relate to that. If you start to cycle, you’ve got side wheels, and those side wheels are there for a very good reason, to actually hold you up when you lose your balance. As people progress, they can actually become a little bit more competitive out there, and they can cycle faster, at a faster speed, but still in a safe way. Later you start racing. But you can’t start racing before you’ve actually been on a cycle for a couple of years. So I would consider it wise to start with one property, prove yourself, hit the ropes, and understand what’s involved. Perhaps go through an investment cycle, perhaps, go through an interest-rate cycle, see what happens before deciding on how many horses you are going to saddle.

BOITUMELO NTSOKO: Thank you so much, Richus. That was Richus Nel, who is a certified financial planner at PSG wealth.