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When to jump off the buy to rent wagon?

Real estate has always proved to be an investment opportunity popular with many investors. Locally, the trend is popular and has been picking up over the years, especially amongst young adults, intrigued by making profitable rental income over and above their annual job salaries.

Taking out a mortgage requires relatively minimal equity investment by the investor other than the down deposit requirements set by their banking institution. The renting out of the purchased property thereafter, pays off the monthly mortgage payments, leaving the investor many a time with excess net income after mortgage and tax payments.

It is a smart approach to adopt when the market is researched thoroughly. Modigliani and Miller, two renowned economists, in part of their famous Modigliani-Miller theorem, state that in a world with taxes, bankruptcy and agency costs, the value of a firm increases with the added use of leverage financing, up to an optimal point where bankruptcy and agency costs beyond that point would then begin to affect value.

For individual investors, the same could apply in terms of value when exhausting leverage to finance investments. As interest income is tax-deductible, the added use of leverage increases value or profitable opportunities. In this case, the more mortgages taken out for rent, the higher the increase in an investor’s rental income potential.

The above however is far from risk-free. I was reminded of a catchphrase recently, which applies to the above scenario and most of life’s important investment decisions: ‘No Risk, No Reward’

The higher risk one undertakes, the higher the potential to reap increased benefits.

However, timing is equally important, as witnessed by the number of asset property bubbles worldwide and subsequent economic slumps.

The 2007/2008 credit crisis, leading to the global recession, was triggered on the back of the bursting of mortgage-backed credit bubbles in the US.

Property prices were inflated, after years of mortgages taken out for varying reasons.  Included were the above rental investment opportunities, where there came a point that housing indicators and the mismatch between demand and supply caused the bubble to burst, deflating home prices and resulting in individuals holding higher mortgage payments to repay than the actual cost of their purchased properties.

What follows usually is declining GDP, caused by homeowners reducing consumption to meet their mortgage payments, banks becoming reluctant to lend on an increasing number of loan defaults and the economy shrinking as a result of these interlinked factors, and worse than that, a large chunk of the economy sitting on negative equity.

Real estate as an asset is less liquid than stock market securities, in that it takes much more time to find a suitable buyer to sell property to, hence, when a real estate bubble bursts, the price deflation and economic slump as a consequence usually lasts longer than an economic slump brought on by stock market bubbles.

Locally, the Maltese real estate market was considered as inflated back in 2004/2005, with the real year on year increase in home prices, peaking at 33% in 2004, as per a published report by Gavin Putland, which studied global property bubbles back in 2009, which Malta formed a part of.

Whilst the local market seems to have held its ground, our limited land space seems to have propelled demand to all new levels. Though, demand and supply lag each other and are almost never in sync.

What will certainly happen sooner or later, is a fall in demand, or rather, a rapid decline in the increase in demand, whilst supply continues to increase, fueling a bubble, as more individuals want in on the buy to rent opportunities. What follows as demand and supply widens is an eventual bursting of the property bubble.

Luckily, given our tiny land mass, deflation of property prices shouldn’t be as substantial as property price deflations in larger sized countries, when such an event should occur.

Though nonetheless, caution should always prevail prior to making the decision to buy to rent. Housing indicators such as Loan to Value, Down Deposit to Income, Housing Starts can all help identify the stages of disparity between demand and supply.

After all, the housing market like any other abides by the wider economic rule of long term mean reversion. What goes up must come down, and whilst locally, property owners are enjoying the upside, we’ll be hoping that the downside, when and if it eventually materialises, won’t be a massive thump.

Disclaimer: This article was issued by Mathieu Ganado, Junior Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.

 

 

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