The Formula for Riches / The Difference Between Rich and Poor - by Dr. Hannes Dreyer / Chapter 8 / Part 1.

Investing in Real Estate.

General Overview.

Real estate offers investors the opportunity to get exceptional growth on their surplus money. There is the condition that they invest in themselves first and make sure they know how to get the maximum growth on their investment. 

They also need to know how to avoid risk.

As you know, it is my belief, that the biggest risk is ignorance. Ignorance is behind most people’s property investment choices.

It makes them vulnerable to hype and sales talk, to being rushed into a decision so as to avoid “missing out” on a “bargain”.

• Ignorance is why they still believe that what matters is location, location, location.
• Ignorance is why they believe they should buy the best house they can in the best area.
• Ignorance is why they believe they should buy if they feel an affinity for or attraction to a house.
• Ignorance is why they believe they should buy now so as not to miss out on a boom.
• Ignorance is why they believe they should buy because the market is “guaranteed” to keep rising.

All of these reasons are why most property purchases are not good investments.

But to my mind, all of these faulty assumptions could be eliminated, if you know how to measure the risk and the growth in a property transaction.

With the Property Pro Investment Program it is possible to identify, measure, understand, and manage all risks relating to different property investment strategies such as speculation, refinancing, and long-term investments relating to property investments such as residential and commercial properties. It is the only way I know of to avoid all the pitfalls I discussed earlier.

Reasons Why Wealth Creators like Property Investments 

Reason 1: They can Compare Them.

You must know how to compare the property with other investments by looking at the IRR (Internal Rate of Return).

If you can’t compare it, you can’t measure it. You need the tools to be able to make comparisons, and these tools include applied knowledge, the right attitude, and investing in yourself.

Reason 2: They use Other Peoples’ Money.

Using other people’s money is one of the principles of property investment. You don’t have to use your own money – the bank will lend it to you. You may not even need a deposit – and so there is no other deal or investment like it.

The reason banks will lend you the money is that they will make the investment (the property) as security. This is why it is called “real” estate. To the banks the security is real!

A word of warning, unless you know what you are doing you can increase your risk by following only this strategy and in doing so become the slave to the “other person” or the financial institution.

Reason 3: They can Gear Up.

After the bank has lent you the money (capital) to buy real estate, they will use the value of that real estate to secure the loan. And this is unique. You can’t gear a mutual fund or unit trust; no one will lend you money to buy a mutual fund (unless, of course, you give your real estate as collateral security).

Reason 4: They use Other People’s Efforts.

Using other people’s efforts is similar to employing someone, but this way you don’t even have to pay them. Let them work for you, but don’t pay them – let them work and use their income to fund your investments by paying you rental. This is a unique advantage of property investment.

Reason 5: They can pay minimal or no income tax – legally!

I love the government’s tax collection arm, the Inland Revenue Service. Yes, really! I love it, because I know how to get the government to help me create wealth! For example, with property, you can use strategies like the roll-in techniques as an entirely legal way to pay little or no tax.

Simply put, if you have two investment properties, you can offset a positive cash flow in one (which will attract a tax liability) against another investment property that has a negative cash flow (and hence no tax liability).

The positive cash flow merely subsidizes the negative cash flow and thus creates a balance without a tax liability, while still ensuring huge capital growth.

But be warned: if you get the tax aspects of any deal wrong, it could cost you a fortune. Make sure you really know what you are doing first.

For example, in South Africa, if you buy a property in a company and that property has a negative cash flow, you cannot deduct that loss against your personal income because it is in a different entity.

This may have severe negative cash flow and tax implications. 

Firstly, you cannot deduct the loss from your personal income (the loss will accumulate within the company) and secondly, you will have to pay the negative cash flow with after-tax money, in other words, you will subsidize that loss with money on which you already have paid tax!

This just shows again how important it is to get the right advice from professionals and to do your planning in advance. But before you get advice, always remember that many “experts” with all the degrees in the world cannot manage their own finances, so make sure you choose with great care.

Reason 6: They can Reduce their Personal Tax by using Property.

You can use negative income gearing to reduce your personal tax liability. It is possible to deduct a loss that was created in investing in property against your personal (work) income.

You can use negative income gearing to reduce your personal tax liability. It is possible to deduct a loss that was created in investing in property against your personal (work) income.

The negative cash flow gearing can qualify for a tax rebate. Negative gearing is sponsored by the receiver up to the maximum of 40% (depending on your marginal tax rate and your country’s legislation). All this while your capital is growing! Again, make sure, you know and understand the rules.

Note: Take care when using negative gearing for any reason – we have already discussed the pitfalls. Remember my first rule: “You must first invest in yourself before you invest in any property, business, or other investment”.

Reason 7: Quick Cash Flow is Good for Tax.

Almost all revenue services around the world will allow the taxpayer to deduct losses incurred on a property against their own tax liability.

Countries have different tax laws relating to property investments. 

Usually, these laws deal with income, capital gains, and estate duties. Make sure you understand them and know how to apply them to get the maximum tax benefit in your real estate investments.

In the US it is possible to get a negative cash flow on a property, but because of depreciation on the property, the government will subsidize you. If you look at the net cash flow situation over a year, you may find that with the right structuring it is possible (because of the depreciation and therefore tax subsidy), to end up with a positive cash flow.

In South Africa and the UK, depreciation under normal circumstances is not tax-deductible and care should be taken when structuring a deal.

Reason 8: Why Wealth Creators Love to Pay Taxes –

but Hate to Pay more than they need to.

Some people, if given the choice, will do anything to get money out of their tax authorities – no matter what the cost!

Let’s look at a typical example, and just to make the calculations easy, say hypothetically that you are in a 50% marginal tax bracket. 

This simply means if you make an additional dollar, the Receiver will take 50% of it. At the same time, if you can save a dollar, the Receiver will subsidize that saving to the amount of 50%.

If you had the choice of getting $5,000 a month back in taxes on property investment, or instead you had to pay the receiver $5,000 per month on a property investment, which one would you choose?

The right answer is not to be greedy and to calculate the cash flow of both situations.

Some people are so obsessed with getting money back from tax, that they never do the calculations. I would much rather earn $10 000, pay the Receiver $5,000 and keep $5,000.

But some people will avoid earning $10,000 income so as to qualify for a $5,000 return. My choice would be to at least get a positive cash flow of $5,000.

Think bigger than just the tax, think cash flow, not just capital gain.

Reason 9: Property is Inflation-Indexed.

Capital, as well as income, is linked to inflation. Property is the only investment (apart from your own business), where you can index your capital as well as your income against inflation.

Capital, as well as income, is linked to inflation. Property is the only investment (apart from your own business), where you can index your capital as well as your income against inflation.

For example, if a fixed deposit earns 10%, and inflation is also 10%, the real income is zero. With property, if the rental income increases every year by 10% and the value of the property increases by 10%, the real return is 10%, which is a lot higher than the person who is receiving 0%.

Reason 10: Property has Perpetual Succession.

Unlike pension funds, property ownership does not necessarily cease when you die; it can be passed on to your children and carry on earning income and growing their wealth.

Reason 11: You can Double your Pension.

Plan to adjust your income for tax purposes in the last few years of employment and then peg your actual pensionable income to inflation for the rest of your life. It can only be done by buying a property that is pegged (and geared) against inflation.

The stock market requires a technique to outperform the averages. With shares, you have a peak and a valley in one sector and then a mediocre average.

With shares, outperforming the average is a matter of luck. But with property, you hunt for a bargain and then test or measure how good a bargain it actually is, with a program such as the Property Pro Investment Program. 

So with property, it is not luck, it is finding the right property (which can be hard work depending on the property market).

If you buy a bargain and exceed the average by only 2%, your IRR shoots up. The graph for a property is gentle and stable, not up and down as with shares.

Reason 13: They can make use of Different Financial Structures.

The main objective for using financial structures is for security and financial planning reasons.

People tend to buy everything in their own names, instead of using a financial entity. At retirement, everything could be wiped out.

Why not spend the money now and pay the legal fees in order to get the right structure? Create a trust, incorporate or register a company and protect your property. It’s best to get the structure in place before you go out and invest.

Reason 14: It is a Secure Investment.

Property is called “real” estate. There is a perception that your fixed deposit is safe in the bank, but remember banks can and do go under. Nothing which exists merely on paper is actually “safe”. It is nothing more than a pledge, subject to many conditions and no guarantees. It is not tangible. Property is tangible. Property exists.

Reason 15: They are in Control.

There are things in life that one cannot control, such as politics, inflation, interest rates, and corporations’ performance. These factors drastically affect any investment.

You have much more control over the property. You can sell when you want. If you manage it yourself there is no risk of corporate mismanagement, fiddling with the annual reports, etc. If interest rates drop, you still have the capital value in the property to fall back on even if other investments start failing.

Reason 16: They can Manage the Risk.

By plotting the results of a variety of variable conditions (such as interest rate hikes), you can minimize the risk.

In this way, you can predict the outcomes of several “What-if” scenarios. With other investments you have other people deciding what to do and you don’t know what the end result will be. 

You have to trust their judgments. Why do you think companies go to such lengths to build trustworthy images in the public’s eye?

With property, you can withdraw whenever the risk exceeds the limits you set for yourself, and you know immediately what the outcome will be (if you have the Property Pro Investment Program and know how to use it).

Reason 17: They can Analyze the Deal.

Look at all the variables and identify what would happen if any of them increase or decrease.

They are all visible and identifiable, so one can manage and measure them. There is not much that is unpredictable. One can factor in every variable upfront.

In order to analyze the deal, there are two types of analysis you have to do in order to evaluate any property anywhere in the world.

The first is the fundamental analysis.

This will include the inflation rate, interest rates, capital growth rate of a property in a specific area, rental income in that area, and rental increases. 

There are many more variables and with the help of the Property Pro Investment Program, this becomes a breeze.

A tip: Always work on the moving averages when taking the fundamental information. Personally, I always work on ten-year moving averages. By doing it this way, you can evaluate your investments on a year-to-year basis and make informed decisions relating to those investments, based on the outcome of the analysis.

The second is the financial analysis.

Once you have all the fundamentals relating to the specific property, you can do the financial analysis. In order to do the financial analysis, you have to have a system in order to take all the variables into consideration.

What you want to achieve with the financial analysis, is to be able to determine the risk and growth potential of a specific real estate investment.

Once you have determined the potential, you want to apply different investment strategies in order to lower the risk and at the same time increase the growth.

Unless you have a financial system that can take all of this into consideration, it will be impossible to make an informed decision.

Later on in this book, I will take you through a typical exercise.

Reason 18: They can Improve the Investment with Little or No Cost.

Fixed deposits cannot be touched or improved – the rates are quoted in advance and you are locked into the deal for the duration of the term (with heavy penalties for withdrawing early).

But by changing the nature of the property – e.g. from a block of flats to sectional titles; if done properly it can cost you nothing, but your income and value could rocket. Rezoning is another example.

Reason 19: There are Amazing Bargains.

If you differentiate between the price of a property and its value, you can pick up huge bargains by offering cash, or other terms which will influence the person to sell at a bargain.

On the stock market, this is only possible through futures and warrants, and even then, the discount in property out-performs these speculative investments.

Learn to look at the deal behind the deal. The best bargains are hidden behind face value. You need to teach yourself to look beyond the obvious. 

The fastest way to learn the different strategies is by ordering the Property Pro Investment DVD series and Property Pro Investment Program – for more information, you can go to https://www.learn-to-invest-money.com/property-investment-executive-course.html.

Reason 20: They can Negotiate.

Fixed deposits are not negotiable, the rate and term are fixed upfront.

With property one can negotiate with almost every participant in the deal: with the owner (price), the agent (commission), the lawyer (fees), the bank (term, percentage, overdraft facility).

You can even negotiate the amount you pay back – e.g. an interest-only loan, or alternatively, you can pay only 50% of the repayment for the first two years and capitalize the rest.

Reason 21: You can Predict Economic Cycles.

A fixed deposit is fixed at a level; it is not matched to a cycle.

With real estate investments, you can act against a cycle when it suits you, or with a cycle when it is on the up. You cannot predict what effect a down cycle is going to have on another investment.

Reason 22: They are Counter-Cyclical.

Buy when everyone is selling. This rule applies as much to the property market as to the stock market.

But when the bond rate is 24%, not when it is 9%. If you buy at 9% and the repayment is the maximum you can afford (you break even when you do the financial calculations), then if it increases you’ll be in trouble.

In the US it is better to buy at 6% than at 1%. The effect is just as powerful in the US, if you take all the factors into consideration, even though the interest rate is different.

If you buy with a positive IRR at 24%, and the rate goes down to 9%, you’re in the pound seats for the rest of the journey!

Reason 23: They can Easily get Access to my Money.

One often hears people saying “My money is tied up in property” but this is not true. If you take a bond that is worth the value of the house, its value grows immediately. This means that almost immediately there is a surplus.

Also, you are paying into the bond so that excess cash is instantly available. All you need to do is call the bank. You can cash in on a house while still retaining the investment.

Reason 24: They can Save on Running Costs.

You need a separate team for the maintenance of your property. You need a plumber, an electrician, and possibly a general handyman. Make a deal with them for discounted charges in exchange for early settlement (or even cash payment).

Buy loyalty by paying quickly. Their cash flow matters to them, so they are usually prepared to pay for it. Costs on many other forms of investments are generally not negotiable.

Reason 25: It is Possible to Manipulate the Average Tax at Retirement.

It is possible to reduce the tax one pays at retirement. Simply predict what the pay-out will be at retirement, buy a house (to that value) two years ahead of retirement, ensuring that it has a negative cash flow.

This reduces your actual income over the last two years of retirement (which is the basis for calculating post-retirement tax rates).

When the lump sum of your pension fund does payout you can use this money to settle the bond, and then peg the value and income against inflation. By using this technique, it is possible to get the Receiver to subsidize your pension without it costing you a cent. Again, you would probably need to get expert advice.

Reason 26: They Plan on Paying very little Estate Duty.

Say you buy a property, your tenant pays the entire bond, and it is probably paid up by the time you die. Assuming the value is $15- million when you die, that is what you have to account for as personal estate duty.

But if you bought the property in a trust, then it belongs to the trust, not the individual. Estate duty is not applicable. Capital Gains Tax will not be applicable.

Different laws apply in different countries. Please make sure you understand the law of the country you are investing in. Consult a properly qualified and experienced professional before making any decisions regarding financial, legal, and tax matters.

Reason 27: They can Reduce Personal Estate Duties.

You can reduce the value of your estate by loaning money against a trust.

At death, the estate has to pay the loan back to the trust and this is a liability that reduces the size of the estate. Also, if you have a loan account in the trust, you can make individual donations to the trust and thereby reduce the size of the estate.

It is also possible to use debit loan accounts and the structuring thereof to optimize your taxes.

Again, remember that different laws apply in different countries. Please make sure you understand the law of the country you are investing in. Consult a professional before making any decisions regarding financial, legal, and tax matters.

Reason 28: They don’t have to pay Capital Gains Tax.

If a property is bought in a trust and is not sold within that trust in your lifetime, then there is no CGT to be paid. You need never sell – just borrow against that property to buy another (gearing).

Please make sure of the rules and legislation in your specific country before making any financial decisions.

Reason 29: Governments often Subsidize Mistakes.

If you make a mistake, the government can subsidize over-expenditure by up 40% or even more depending on your personal marginal tax rate, if you know how to achieve this.

Any loss is subsidized by the Receiver. Bear in mind that you must get professional advice before you implement such strategies, and remember cash flow is king.

On the other hand, if you are at a 40% personal marginal tax rate and you lose money on a mutual fund or shares; no one will subsidize the loss!

Reason 30: They can Structure their own Tax Incentive.

Many people work towards receiving a golden handshake from their employer at retirement. Not much of the golden handshake remains after tax.

Although it is possible to deduct the payments of a deferred compensation plan up to a certain limit, only a portion of the ultimate payout will be tax-free – the balance will be taxed according to a set formula.

However, by investing in property and using financial strategies within the company, it is possible to structure a superior “golden handshake” property.

Types of Property Investments.

In general, there are two classes of real estate investments. They are residential properties and commercial properties.

What are the main differences between the two classes of properties, from an investor’s point of view?

Advantages and Disadvantages of Residential and Commercial Property Investment

Residential: With residential property, the rental is normally quoted on a monthly basis.

Commercial: With a commercial property the rental or the lease can be quoted either monthly or annually.

Residential: The tenants have little interest in maintaining or improving the property.

Commercial: The tenants have a very strong vested interest in keeping the property looking good and functional and even improving it because they normally trade out of that commercial property.

Residential: With residential, the leases are non-existent or tend to be short-term.

Commercial: The leases tend to be long-term, five years or more are not uncommon, with an inflation escalation linked to that.

Residential: The tenants tend to complain about minor problems to the landlords.

Commercial: The tenants tend to the minor problems fix themselves, depending on the lease contract.

Residential: Bureaucrats and the government tend to stick their noses in your business, protecting the rights of the tenant.

Commercial: Normally the bureaucrats tend to leave you alone.

In South Africa, there are two laws that basically govern the residential side - the housing rental act and the prevention of illegal evictions from the unlawful occupation of land or the so-called “PIE” act. These laws all have to do with the residential side of the property and have no bearing on commercial property.

Residential: The capital required to buy residential property is minimal. You can buy, for example, a residential property without even putting a deposit down.

Commercial: The capital required to buy commercial property can be large; at present in South Africa, the bank requires at least a 35% and up to a 50% deposit when you buy a commercial property, although the bank will approve a 60 to 70% bond depending on the appraisal.

There are options available relating to commercial property which favors the lender more, but this is a little bit more advanced. Important: Remember there may be ways to structure the deal which can be to your benefit.

Commercial: Basically the tenant makes up the value. In other words, you’re going to get a better valuation if there’s a tenant, especially if it is what we call an anchor tenant. You will qualify for a better bond than you would if the property was vacant.

Residential: New tenants are relatively easy to find.

Commercial: It might prove to be very difficult to find a new or suitable tenant for that specific property.

Residential: Sometimes the management expenses can be relatively high.

Commercial: In terms of the amount that you’ve invested, the management expenses may be a little bit lower. One reason may be that the tenants maintain the property, which is not the case with a residential property.

Residential: You’re going to deal with people directly unless you’ve got a letting agent.

Commercial: You basically deal with contracts, especially if you rent them to larger companies or organizations.

Summary: Properties are divided into two main categories, commercial and residential. We have discussed the main differences between the two. Commercial can be retail, offices, shops as well as industrial. The residential side includes the land, new developments, houses, sectional titles as well as flats and townhouses.

I have found that different parts of the world have different terminologies for the same concept. So please make sure of the terminology is applicable in your country.

For more information on the Formula for Riches book;