Once upon a time a scorpion wanted to cross a brook.
On the bank he saw a frog and asked if the frog would give him a ride to the other side.
“Oh no,” said the frog, “If I carry you on my back you will sting me.”
“But why would I sting you when we would both surely perish,” replied the scorpion.
The frog eventually conceded that the scorpion had a point, and agreed to the request.
Half way across, the scorpion stung the frog, and they both began to drown.
“But why did you break your word and sting me, knowing it would be certain death for us both?” cried the frog. “Because it is in my nature,” said the scorpion.
I’m not sure if it is a peculiarly Kenyan characteristic, but we are obsessed, nay, possessed with property ownership.
For many of us, owning the ubiquitous plot, house or apartment is commensurate with success, achievement and self-actualisation.
But how often do we take a step back and ask ourselves if these investments would be better off liquidated and the funds placed with the Central Bank of Kenya in Government Securities?
Why you ask?
The Government as a borrower is perceived in financial circles as the safest debtor to have.
Serikali always pays. As a result, the interest paid on government debt paper is viewed as the risk free rate of return since the government as a borrower is deemed to be a guaranteed payer of its debts.
Consequently, if you ever enter into a heated debate with your banker about the interest rate they are charging you on your business loan, they will typically look you dead in the eye and start by saying: “Well, let’s unpack your interest rate of 18 per cent. Seven per cent is the interest rate for the five year Treasury bond which is the risk free rate and our opportunity cost. Add to that five per cent which is the credit risk of lending to you, three per cent operational risk for the bank and a small, negligible, tiny, inconsequential three per cent profit margin and you arrive at your 18 per cent per annum rate.”
If you are thinking of borrowing, or perhaps have actually borrowed, to purchase a property as an investment, perhaps this would be a good time to see if your investment is yielding you a proper return or whether you are better off placing your money in Treasury paper.
Take, for example, purchasing a maisonette whose purchase price is Sh10 million.
You put Sh4 million of your own towards the purchase price and borrow Sh6 million from your bank.
You proceed to rent out the premises for say, Sh60,000 a month to get a total income of Sh720,000 per annum.
You pay Sh50,000 per month in your mortgage (or Sh600,000 per annum), Sh10,000 in land rates, and Sh10,000 in small repairs during the course of the year thereby paying Sh620,000 in expenses during the year.
What would your return be?
You would calculate your Net Profit/Equity Investment.
Your net profit would be Sh100,000 and you would divide this by your equity investment of Sh4 million to arrive at a return of 2.5 per cent.
Considering that you have taken your mortgage for say 20 years, if you compare this with the yield curve on Treasury Bonds, you would see that 20 year bond is yielding close to 10.5% today thus if you invested the same Sh4 million in government paper you would be earning about four times more in a far less stressful investment.
Meanwhile, your property appreciates the following year and now has a market price of Sh12 million.
You have also received a good bonus at work and used it to pay down the mortgage in the year, reducing the principal amount from Sh6million to Sh5million.
Your equity investment has therefore increased from Sh4 million to Sh7 million. How?
The increase in property value of Sh2 million essentially goes towards your equity in the property as does the reduction in mortgage of Sh1 million.
Your rental yields, however, remain the same as the market is awash with rental properties.
Does your return increase? By doing the same calculation of Net Profit/Equity Investment you will find that your return has actually dropped to 1.43 per cent.
You will have to raise your rent in order for you to get a better return, which is a very unlikely scenario where there are plenty of rental properties competing for the same clientele.
It is at this point that I expect those of you doing feverish calculations on your own investments to argue that actually, you bought the property for capital growth prospects and not for the rental yields.
Using the same example then, the property whose market price has moved from Sh10 million to Sh12 million has appreciated by 20 per cent in one year.
If you decide to sell the property there and then, assuming that there are no costs to the sale such as legal costs etc for purposes of this example, then you will have made a return of Sh2 million on your total investment of Sh5 million (remember your bonus payment into your mortgage counts towards your equity) or a 40 per cent return using the bank’s money.
However, let us call a spade a spade: just like it is in the scorpion’s nature to always sting, it is the typical amateur property investor’s nature NOT to realise the gain on the investment and to sit tight awaiting an even higher property price.
Strangely, even doing the above math does not dissolve our emotional attachment to property investing.
Only a property market crash will crystallise the sting of missing past opportunities to realise investment gains.