Don't buy a second property for investment if you can achieve more than 5% CAGR with your portfolio

If your current investment portfolio is constantly achieving more than 5% CAGR and you are thinking of buying a second property for investment purposes, I will urge you to stop and read through this article first.

In this article, I will walk you through a typical scenario where most homeowners are in when they are looking to buy a second property for investment, and attempt to explain how the figure of 5% CAGR is derived.

Now, imagine this scenario.

- A married couple targeting to buy one private property each (hence no need to pay any ABSD)

- Each of them will buy a $1M private property

- The married couple will reside in the first private property and rent out the second private property for rental income

- Investment horizon will be 20 years with no sales of either properties in this period

In this scenario, the initial investment (comprising of downpayment, stamp duties, legal fees) for both properties will be $555,200.

There will also be additional costs due to renovating/marketing the second private property for rental purposes and paying an agent to look for tenants. To simplify things, let's assume the cost for all of these is $20,000.

This will bring the total initial investment to $575,200. This will be used as the initial value for our CAGR calculations later.

Let's add in some other details.

- The income from renting out the second property will be $2083 (based on average rental yield of 2.5%)

- To service the mortgage loan for each of the properties, let's assume a mortgage loan with an interest rate of 2% and a tenure of 30 years is taken

- Based on the above mortgage loan, the monthly mortgage amount for each of the properties will be $2772 ($1550 for the principal amount, $1222 for interest payment)

(Source: PropertyGuru)

With this information, we can now attempt to calculate the different losses and gains in this investment and derive a value for the annual net gain/loss.

In terms of losses, there are a few categories (mortgage interests, CPF returns, maintenance fees, taxes).

In terms of gains, capital appreciation is the main one.

Here are the specifics.

Loss due to mortgage interest payments after rental income deduction

The rental income isn't enough to cover the interest payments for both properties. Hence, a monthly loss (rental income minus interest payments) of $361will be incurred. Annual loss incurred will be $4332. For simplicity sake, amortization (where interest payment decrease over time as the balance of the outstanding mortgage loan decreased) is not considered

Loss due to CPF interests

Since the rental income is not sufficient to cover monthly mortgages for both condominiums, you will need to use your CPF/cash to pay the excess. There will be interest loss if CPF is used.

Based on the above details, the annual sum you will need (after deducting the monthly mortgage loans for 2 condominiums from the rental income) to contribute is $41,532. This additional sum can be in the form of CPF/Cash.

As CPF OA provides an annual return of 2.5%, this additional sum which you need to contribute will be missing out on this 2.5% annual return. Hence, the loss of returns from CPF interests in the first year will be $1038 (2.5% multiplied by $41,531).

Loss due to maintenance fees

Assuming a monthly maintenance fee for each of the condominiums to be $300, the monthly maintenance fees for both condominiums will be $600. Annual maintenance fees for both condominiums will be $7200.

Loss due to taxes

Let's not also forget the taxes you will need to pay (both property taxes and income tax from rental) for the 2 properties.

Property tax for 1st property is based on owner-occupier tax rate while property tax for 2nd property is based on non owner-occupier tax rate.

Rental income tax is based on an income tax rate of 7% on the rental income less 15% deemed rental expenses and mortgage loan interests.

Total taxes (on an annual basis) will be $4880.

Total loss (annual)

Total loss in the first year will be $17,450.

Gains due to capital appreciation

It's important to consider the annual gains you are getting from the capital appreciation of your private properties. Using data from Private Residential Property Index (based on the period Q1 2000 to Q4 2021), the CAGR of private properties prices is assumed to be 2.7% in this calculation.

Considering a CAGR of 2.7% for both properties (each having initial value of $1M), the total capital gains in the first year will be $54,000.

Net Gain

Summing up the gains and losses, the net gain will be $36,550 for the first year.

Let's now assume that both the capital gain and losses continue to grow at 2.7% annually (for simplicity purposes).

Based on an investment horizon of 20 years, the net gain after these 20 years will be $952,783.

If we add this amount to the initial value (initial investment) and minus the "unrecoverable" costs like stamp duties, legal fees, agent fees and renovation, the final value of the investment after 20 years will be $1,452,783.

With an initial value of $575,200 and a final value of $1,452,783 over an investment period of 20 years, the CAGR achieved from investing in a second property in this scenario is roughly 5%!

Hence, it probably does not make much sense for you to buy a second property for investment purposes if you are already achieving more than 5% CAGR with your portfolio!

Do also take note that the above scenario has the following assumptions.

- The second property is constantly rented out for 20 years

- No additional touch-up or renovation work is made to the second property for 20 years

- No cashflow issues in servicing the mortgage loans (Cashflow is very important in property investments)

- Cost of engaging agents to look for tenants throughout the 20 years period is ignored for simplicity purposes as it ranges widely

In reality, the first two might be hard to achieve and will adversely impact your CAGR.

To give a more complete picture, I did the same exercise with the below scenarios and these are the CAGRs achieved in each of the scenarios.

Even in the best scenario where the first property is fully paid, servicing of mortgage loan is only needed for second property and no ABSD is required, the CAGR only moves slightly up to 6%. In scenarios where ABSD is required, a drop of around 2% in CAGR is expected.

Please do not be mistaken and think that investing in a second property is not sound. A 5 to 6% CAGR return is nothing shabby and many people will be happy with such a rate of returns. The main purpose of this article is to run though a simple exercise (key note: not a professional one) to calculate what's a potential CAGR from the investment of a second property and use that to determine if the investment is still a worthwhile one based on your circumstances and returns expectations.

In fact, determining if investing in a second property is worthwhile has always been a question that bothers me and that's also why I decided to do this exercise to determine the answer. Contextualising the results in terms of CAGR allows me to better determine where I should put my funds and certainly helps in my decision making process.

I believe there are many who have the same question in their minds and are looking for some kind of metric to determine if investing in a second property is worthwhile.

I hope this article helps to shed some clarity on it.

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