Currently, the local real estate market remains relatively depressed and this will persist as long as local income does not increase. But, if you are a business owner, is this the right time to get into real estate?

Today, profiting big in local real estate is about investing in them at a discount. Typically, it is possible to obtain as much as 15% discount for their properties from their market valuations.

For instance, it is common for an investor to buy a property, let’s say a 1,000 sq ft condominium worth RM500,000, for RM450,000 (10% discount from its market valuation). Instantly, the investor makes a nice RM50,000 in capital gains.

Let’s assume Shirley, a business owner below 35 years old, finances her property purchase through a mortgage with an interest rate of 4.25% per annum. The property purchased is tenanted to a family of four for RM1,800 per month. Therefore, the property details are as follows:

Net worth

Shirley will need to fork out a 10% down payment and property-related costs of RM60,000. She would successfully increase her net worth to RM95,000, a 58.3% jump from RM60,000 prior to acquiring the property.

Monthly cash flow

At a glance, Shirley incurs a negative cash flow of RM600 per month from this property. This is not the complete picture because the mortgage installment comprises two parts, namely bank interest payments and repayments to reduce the loan principal.

Repayments on the loan principal is likened to ‘forced savings’ as Shirley would have gotten back this money if she does dispose of this property in the future. Typically, the proportion of interest payments to the bank against one’s total mortgage instalment is 75% for the first ten years.

Thus, the breakdown of mortgage instalments is as follows:

Hence, the true breakdown of cash flow after investing in the property is as follows:

Shirley would incur a net loss of RM136 a month and would be down by RM600 a month after including the repayments to reduce the loan principal.

Taxman perspective

Let’s assume the tenancy agreement for the property is stamped after Jan 1, 2018.

Shirley is entitled to a 50% income tax exemption on her rental income in 2020, as the condominium is a residential property and rental collection is below RM2,000 a month.

In addition, Shirley is able to deduct a couple of expenses from gross rental income to compute her final chargeable rental income. These expenses include bank interest payments, maintenance fees, quit-rent and assessment. The final chargeable rental income is:

Under Section 4(d) of the Income Tax Act (ITA) 1967, this loss is treated as a permanent loss. In other words, the taxman views that Shirley has incurred a loss from renting the condominium and hence, would not charge Shirley a single cent in income tax.

Banker perspective

The banker views this rental income as a legitimate source of income, thus, will raise Shirley’s credit eligibility. How?

First, we need to understand the concept of debt service ratio (DSR). Let’s say, a bank sets its credit policy where it limits the amount of any individual borrower up to a DSR of 60%.

It means that if a borrower earns RM10,000 per month, they can obtain a maximum loan amount with a monthly debt instalment capped at RM6,000, which is 60% of his monthly income.

Second, we need to understand the Rule of 200. It helps to estimate the mortgage loan amount an individual borrower may qualify for.

If the borrower has zero debt, they can obtain a maximum mortgage of RM1.2 million, which is RM6,000 in debt instalment quota multiplied with 200.

Thus, the maximum amount of mortgage an individual can qualify is as follows:

Let’s say, the bank views the rental income as a valid source of income. As such, the rental income of RM1,800 would raise the mortgage eligibility by RM216,000, which can be used in Shirley’s next investment property. This is a type of phantom income.

Conclusion

In summary, if Shirley buys the condominium, she would incur RM136 in losses each month or RM600 in negative cash flow a month. However, she would reap a net capital gain of RM35,000 (non-taxable) as long as she keeps the property, and gain an increase in mortgage loan eligibility of RM216,000.

So would you, as a business owner, invest in real estate? Think about it. It costs RM136 per month or RM1,632 per year to earn an instant net capital gain of RM35,000.

If you try and earn an additional RM35,000 in income from your business, you would be subjected to a personal income tax bracket of 24%, which works up to RM8,400 in income tax.

As such, if you are a business owner, you should consider incorporating real estate as part of your game plan to build long-term wealth.

This article first appeared in kclau.com

Ian Tai is a financial content machine, dividend investor and author of over 450 articles on finance featured in KCLau.com in Malaysia, and ‘Fifth Person’, ‘Value Invest Asia’, and ‘Small Cap Asia’ in Singapore. He is a regular host and presenter of a weekly financial webinar with KCLau.com.