Tuesday, August 25, 2009

New property purchased

In spite of the rise in property prices, I have kept looking at properties for investment. With interest rates being as low as they are (below 1% on mortgages and zero on bank deposits), even a modest yield from real estate looks attractive.

I looked at a number of properties before putting in an offer on a property being sold as part of a bankruptcy proceeding last month. It would have been a bargain apart from one small detail - the trustee in bankruptcy (i.e. the government) did not have the title deeds and expressly disclaimed any liability for providing them. In effect I would have no assurance that I would get title to the property, would not be able to get a mortgage and would not be able to sell the property. Needless to say, that offer was quickly withdrawn.

The second property I tried to buy was sold before my offer was submitted.

On Sunday afternoon I looked at some more properties and put in an offer on one which I thought was good value in the current market. After some haggling the offer was accepted last night. The next steps are:

1. get finance - I have started shopping around for a mortgage. Even with a mortgage I will need to sell some of my equity investments to complete the purchase;

2. get quotes for refurbishment - I am asking for quotes for (i) basic fit out and (ii) full luxury remodeling. I will then run the numbers and see which makes the most sense.

As a rental proposition, the apartment may rent best with a carpark (which it does not have). I will look into buying a car parking space separately.

8 comments:

James said...

Where did you end up buying?

From your post, it appears you are buying for an investment purpose rather than owner occupier.

Do you think its a good time to buy, since property prices are almost at the same level as the recent peak set in July 2008? If you paid the same price per square foot as everyone else, then if the entire HK property market falls due to a rise in US Fed Reserve interest rates, the capital loss could be 20% to 50% (cf: Andy Xie's recent article).

Where I live now, landlords are only yielding < 5% gross rental return on present market value for inclusive. Therefore, it is cheaper to rent because the tenant doesn't pay the large upfront capital costs of stamp duty, conveyancing and agent's commission which will need to be amortised by the owner.

Furthermore, the tenant doesn't lose opportunity cost. With their cash, they can easily deploy into the stockmarket or other investments, even REITs if he wants property exposure.

More importantly is that if the HK property market collapses, he can then purchase the same property he was interested in for 20% to 50% less as was seen between November 2008 to March 2009.

traineeinvestor said...

Hi James

Good points all. To address your comments:

1. I have purchased in mid-levels. The unit I have purchased is (IMO) in a block where price increases have trailed the general market without good reason. It is an investment property.

2. gross yields of around 5% usually translate into net yields of around 3.5% for middle market flats (cheaper flats offer higher yields). This is not exciting but is better than the 0.001% HSBC currently offers on deposits and similar to the HK stock market generally. The use of leverage (paying less than 1%) will inflate the yield (although reducing or eliminating the cash flow as most of the rent goes into servicing a P+I mortgage).

3. I will always choose a HIBOR mortgage over a Prime mortgage. The difference is currently running at around 1.25 - 1.5% pa. HIBOR has to jump at least enough to bridge that gap before I am any worse off - and it has to do it consistently but if HIBOR rises for more than a few months, Prime rates are likely to go up as well. Put differently, in the years I have been using HIBOR mortgages I can only recall 2 months where the HIBOR mortgage cost more than the Prime mortgage - the rest of the time the HIBOR mortgage has been cheaper. Perhaps the fact that HIBOR is set by the market and Prime is set by the banks explains this.

4. Investing in property does tie up a lot of capital (at least 30% down, stamp duty, fit out, legal fees, agency). But so do all investments. To date I have found that it is worth it. Transaction costs are high. It is not suitable for short term investment.

5. Rent v buy - which is better? This is debatable and depends on the specific property and a range of assumptions. When we purchased our current home in 2005, the P+I mortgage payments, management fees, rates, governement rent and a 3% opportunity cost on our equity added up to less than the rent we would have paid on renting the same apartment making the decision to buy a no-brainer. Unless at the bottom end of the market, I have not been able to find any properties which would produce those sorts of numbers.

5. Even if (as at present) it is cheaper to rent than to buy, it does not follow that buying property is a bad investment. I am primarily buying for long term yield that will (hopefully) keep pace with inflation. No guarantees of course. My choices are real estate, equities and bonds. I have plenty of equities and real estate (only a few bonds because the spreads are so wide).

6. People have been preaching doom and gloom about the HK property market for years. Even in 2003 around the time of SARS when various segments of the market had fallen 50-60%, there were plenty of people who said it was going to keep falling. The reverse has been true in bull markets when people think it will keep rising forever. I have no idea whether the property will keep going up or will fall in the short term. If prices fall I wil be holding an unrealsied loss for a time - but in those conditions, I will look to buy again. All my properties have plenty of equity and (apart from my home) positive cash flow so a downturn will not put me under financial pressure. If rising interest rates and/or falling rents put me into negative cash flow, I will simply pay down some of the mortgage until the situation is rectified (or extend the terms).

Cheers
traineeinvestor

James said...

Hi TraineeInvestor

Currently the difference between a HIBOR loan and Prime only loan is 1.2% from my recent enquiries with banks.

A HIBOR 1 month loan is 0.8% (0.7% plus 1 month HIBOR rate). A Prime only is 2%.

You can now get net dividend yields for blue chip shares in the stockmarket better than 5% for companies with a stable earnings history.

I don't disagree that investment property can be a good investment, but we are comparing it with alternative investments not just bank deposit accounts (which as you have correctly pointed out is probably worse than the inflation rate).

My preference is for liquidity in this phase of the economic cycle. There is plenty of volatility and emotion out there, and one who can move quickly can take advantage of these inefficiencies can generate great returns in a short time windows.

The biggest problem I see with property investment in general is that the initial capital costs are enormous: agent's commission, stamp duty, legal fees, 30% deposit to avoid mortgage insurance. Apart from the 30% deposit, the rest are expenses which would need to be clawed back through capital gain at the time you decide to sell.

Stocks, bonds, currency, structured products, REITs, etc do not have such large initial capital costs.

James said...

Hi TraineeInvestor

Currently the difference between a HIBOR loan and Prime only loan is 1.2% from my recent enquiries with banks.

A HIBOR 1 month loan is 0.8% (0.7% plus 1 month HIBOR rate). A Prime only is 2%.

You can now get net dividend yields for blue chip shares in the stockmarket better than 5% for companies with a stable earnings history.

I don't disagree that investment property can be a good investment, but we are comparing it with alternative investments not just bank deposit accounts (which as you have correctly pointed out is probably worse than the inflation rate).

My preference is for liquidity in this phase of the economic cycle. There is plenty of volatility and emotion out there, and one who can move quickly can take advantage of these inefficiencies can generate great returns in a short time windows.

The biggest problem I see with property investment in general is that the initial capital costs are enormous: agent's commission, stamp duty, legal fees, 30% deposit to avoid mortgage insurance. Apart from the 30% deposit, the rest are expenses which would need to be clawed back through capital gain at the time you decide to sell.

Stocks, bonds, currency, structured products, REITs, etc do not have such large initial capital costs.

traineeinvestor said...

Hi James

You are correct about the current difference between the HIBOR and Prime based mortgage products - my information was out of date.

I do not have charts to hand for the difference between the two products, but I can say that my own experience has been that the HIBOR product has worked out a lot cheaper over the years. If interest rates start rising, I would expect the HIBOR rate to go up first - but it has to go up by at least enough to bridge the gap between the two. Also, my expectation is that if the HIBOR rate goes above the Prime rate and stays there, the banks will raise the Prime rate.

On shares, assuming you are looking at HK shares, which shares currently offer yields of 5%? Among the HSI consituents only HSBC, Hang Seng Bank and Esprit offer training yeilds of greater than 5% (and I would expect the yeilds on at least two of these to fall this year). Among the HSCEI consituents, there are no stocks with trailing yields of more than 5% (and only two with yields of more than 4%).

As a general proposition, I agree with your points on the disadvantages of investing in property v shares. Property does have some advantages over shares (ability to use leverage which costs less without the risk of margin calls etc). I'll do a separate post on the pros and cons of each. My orginal retirement goal was to derive about half of my retirement income from rents and half from dividends (possibly with a few bonds and structured products thrown in). The mix has shifted around a bit, but I would still like to see at least 30-40% sourced from each of shares and property.

Cheers
traineeinvestor

James said...

Hi TraineeInvestor

I did some analaysis last night between the historical Prime and HIBOR rates in Hong Kong as far back as 2001 which is where my data ends.

The current Prime / 1 Month HIBOR spread at DBS for example is 5.25% - 0.1% = 5.15%.

Research articles suggest that the average spread has been 3.1%.

In fact, if the spread becomes less than 3.6% and not even return to the narrower average of 3.1% you would end up losing money with the DBS product (which is the most competitive I currently can find).

The comparison is between DBS HIBOR at 0.7% + HIBOR against HSBC Prime which is P - 2.95%. This means that as long as the current spread is greater than 0.7% + 2.95% = 3.65% you will be better off with choosing DBS HIBOR rather than HSBC Prime.

Forget about even considering the safety cap with DBS which is really bad at only P - 2.75%.

What do you think ?

Regarding 5% dividend yield on shares, I was looking at US, European or Australian stocks. I don't focus too much on HSI because generally I think there is irrational valuations in HK most of the time.

I agree with you on the advantages of property over shares: no risk of margin calls and lower interest rate. But I think the significantly lower up front capital costs and the ability to dispose of shares faster and a more liquid market, makes shares superior assuming you choose blue chip ones. Also, there is no risk of a bad tenant and constantly worried about damage to property, and rent not being paid.

In generally, I like to think of the example when and how often can someone have an opportunity to buy a great commercial investment property say on Queen's Road Central, versus the oppportunity to buy into a blue chip company like HSBC, etc.

traineeinvestor said...

Hi James

Your math on the spread between HIBOR and Prime looks good. A couple of queries:

1. are the DBS and the HSBC Prime rates the same? Last time I checked, not all banks had the same Prime rate; and

2. the spread calculation looks at a single point in time. The actual break even point will be based on the average rate for the average amount of prinicipal outstanding over the life of the loan. Several months of positive spread may outweight a short period of negative spread.

On the shares v property debate, again I agree with your points. In addition to the HK listed shares, I have a few shares listed in Australia as well. One issue with investing in some overseas shares is withholding tax. Losing 30% of your dividend in tax (when you would pay none in HK) is painful.

Cheers
traineeinvestor

James said...

Hi TraineeInvestor,

1) No, their Primes are different. DBS is 5.25%, and HSBC is 5%

The DBS Prime is only of relevance because of the cap in their HIBOR product.

But to compare whether HIBOR or Prime is better, I just compare the DBS HIBOR product to the HSBC Prime only product.

HSBC Prime only is P - 2.95%. DBS HIBOR is 0.7% plus HIBOR. The spread is 2.95% + 0.7% = 3.65%.

Therefore 3.65% is the current spread. If for more than 50% of the time you have your loan, the spread is > 3.65%, then DBS HIBOR is better. If less than 50% of the time,(the historic average spread is 3.1%), then Prime is better. There is a tendancy for interest rate spreads to be mean reverting. The gap only needs to close by 0.55% which isn't unreasonable.

2) Yes, you are correct. I will need to calculate this for a nominal loan amount.

But this is only a historical analysis, and well for the future - who knows.