Housing Loan Servicing – Cash or CPF?

Should you use cash or CPF to service your housing loan? Most people would use CPF, so as to conserve the cash for other purposes. Moreover, CPF money is considered as being "locked up", so you cannot use it for most other purposes. However, if you have the cash, does it make financial sense to service the housing loan using cash?

The main argument for using cash to service the housing loan is because interest rates for cash savings are so low, at around 0.05%, whereas the interest rate for CPF Ordinary Account (OA) is at 2.5%. By using cash to service the loan and keeping CPF untouched, effectively, you gain 2.45% on the loan repayment annually. Considering the effect of compounding over time, this can add up to quite a bit of money over the length of the loan tenure.

Besides these 2 options, there is a middle option, which is to service the loan using CPF and top-up the CPF using cash. Effectively, you are servicing the loan using both cash and CPF. (Note: the cash top-up into CPF goes into the Special Account (SA). When the upper limit for SA is reached, the balance will overflow into OA that is used to service the loan. But when the limit is reached, it also means that no further top-ups are allowed under the Minimum Sum Scheme). When you top-up CPF using cash, you can also claim for tax deduction for up to $7,000. If your marginal tax bracket is 7%, that means a tax savings of $490 annually. That can also add up to quite a bit of money over time. So, the question is which option makes the most financial sense -- servicing the loan using cash, CPF or CPF top-up?

To answer this question, let's consider the following scenario:

Loan Details
Loan Principal	$200,000
Loan Tenure	25 years
Loan Interest Rate	2.60%
Annual Loan Repayment	$  10,980
Income Details
Annual Income	$  60,000
CPF	$  12,000
Annual Taxable Income	$  48,000
Annual Income Tax	$    1,110
Cash	$  46,890
CPF Top-up	$    7,000
Cash Interest Rate	0.05%
CPF Interest Rate	2.50%

Let's further assume that all the cash earned is not spent but saved in the bank. At the end of the 25-year loan tenure, the total amount of cash + CPF for the 3 options are as follows: 

	Using Cash		Using CPF		CPF Top-Up
Year	Cash Bal	CPF Bal	Cash Bal	CPF Bal	Cash Bal	CPF Bal
0	$             -	$             -	$             -	$             -	$             -	$             -
1	$      35,910	$      12,000	$      46,890	$        1,020	$      40,380	$        8,020
2	$      71,838	$      24,300	$      93,803	$        2,066	$      80,780	$      16,241
3	$     107,785	$      36,908	$     140,740	$        3,138	$     121,201	$      24,667
4	$     143,749	$      49,830	$     187,701	$        4,237	$     161,641	$      33,304
5	$     179,731	$      63,076	$     234,685	$        5,363	$     202,102	$      42,157
6	$     215,731	$      76,653	$     281,692	$        6,517	$     242,583	$      51,231
7	$     251,749	$      90,569	$     328,723	$        7,700	$     283,084	$      60,532
8	$     287,785	$     104,833	$     375,777	$        8,913	$     323,606	$      70,066
9	$     323,840	$     119,454	$     422,855	$      10,156	$     364,148	$      79,838
10	$     359,912	$     134,441	$     469,956	$      11,430	$     404,710	$      89,854
11	$     396,002	$     149,802	$     517,081	$      12,736	$     445,292	$     100,121
12	$     432,110	$     165,547	$     564,230	$      14,075	$     485,895	$     110,644
13	$     468,237	$     181,685	$     611,402	$      15,447	$     526,518	$     121,430
14	$     504,381	$     198,227	$     658,598	$      16,854	$     567,161	$     132,486
15	$     540,543	$     215,183	$     705,817	$      18,295	$     607,825	$     143,819
16	$     576,724	$     232,563	$     753,060	$      19,773	$     648,508	$     155,435
17	$     612,923	$     250,377	$     800,327	$      21,288	$     689,213	$     167,341
18	$     649,139	$     268,636	$     847,617	$      22,840	$     729,937	$     179,545
19	$     685,374	$     287,352	$     894,930	$      24,431	$     770,682	$     192,053
20	$     721,627	$     306,536	$     942,268	$      26,062	$     811,448	$     204,875
21	$     757,898	$     326,199	$     989,629	$      27,734	$     852,233	$     218,017
22	$     794,187	$     346,354	$  1,037,014	$      29,448	$     893,039	$     231,488
23	$     830,495	$     367,013	$  1,084,422	$      31,204	$     933,866	$     245,295
24	$     866,820	$     388,188	$  1,131,855	$      33,005	$     974,713	$     259,448
25	$     903,164	$     409,893	$  1,179,311	$      34,850	$  1,015,580	$     273,954
Cash + CPF	$1,313,057		$1,214,161		$1,289,535

As shown in the scenario above, using cash to service the loan is still the best option. Using only CPF to service the loan is always the worst option because of the higher CPF interest rate. Although the CPF top-up option generates tax savings, the amount of tax savings is insufficient to compensate for the loss in interest for keeping as much money in the CPF as possible.

There could be other scenarios in which the CPF top-up option might be better than the cash option. Some of the factors that could affect the outcome are as follows:

• Cash interest rate versus CPF interest rate. By design, the CPF interest rate will always be higher than the cash interest rate. The higher the CPF interest rate relative to the cash interest rate, the more beneficial it is to keep as much money in the CPF as possible. But when the cash and CPF interest rates are close to each other, the tax savings from CPF top-ups will make this the best option.
• Amount of CPF top-up versus CPF draw-down for loan repayment. In the scenario above, the amount of CPF top-up is $7,000 while the amount of CPF draw-down to service the loan is about $11,000. Hence, $7,000 of the loan repayment is serviced by the cash top-up into CPF while $4,000 is serviced by money originally in the CPF. Over the loan tenure of 25 years, the tax savings from CPF top-ups is insufficient to compensate for the loss in net interest from a smaller CPF balance. If the amount of CPF top-up and draw-down is close to each other, the tax savings from CPF top-ups will make this option the best one.
• Loan tenure. As explained above, the longer the loan tenure, the larger is the compounding effect of the higher CPF interest rate.
• Marginal tax bracket. In theory, the higher the marginal tax bracket, the greater the amount of tax savings from CPF top-ups. However, you will need a really high income for the tax savings to outweigh the loss in net interest and the effects of compounding.

In conclusion, based on the current interest rates and policies, using cash to service the housing loan usually makes the most financial sense. Nevertheless, servicing the loan using CPF and topping-up the CPF using cash provides greater flexibility in the future when interest rates and policies might change.


See related blog posts:

• Clean Out CPF Balance When Taking HDB Housing Loan?
• Is CPF Accrued Interest Double Counting of Housing Loan Interest?
• Stretch Loan & Invest the Rest

Properties and the Population Picture

I've written a couple of times about the potential impact of demographics changes to the property market in future. However, I'm not sure how many people actually noticed and think of it in the current rage over properties. Since words did not effectively convey the message but a picture can say a thousand words, let's try showing pictures instead.

Below is a picture taken from the Opening Address at the “Our Population, Our Future” Townhall Dialogue in Oct 2012. It shows that with a Total Fertility Rate (TFR) of 1.2, the size of every subsequent generation will be reduced by 40%.

Do take note that the picture below does not reflect the current demographics figures. It is reflective only if the TFR persists at 1.2 for at least 2 generations. So, the discussion in this blog post on the potential impact on the property market applies in the future when we are about to retire and not currently.

Figure 1: Impact of TFR of 1.2 on Generation Size

How will the above picture impact the property market in the future? Each generation does not operate independently in the property market. When Our Generation retires, we will need to find alternative sources of income to support our retirement. Since quite many people are asset-rich but cash-poor (and assuming this trend continues), one possible option is to sell our properties to those who are buying, i.e. the Grandchildren Generation who are setting up their families. Even if some of Our Generation do not need to sell or downgrade their homes, eventually their properties will be passed down to the subsequent generations as inheritance.

Hence, based on the above picture, we are looking at 36 nos. of the Grandchildren Generation buying/ taking over the properties of 100 nos. of Our Generation. I cannot see how 36 persons can absorb the properties of 100 persons. We can only hope that our grandchildren will be 3 times as rich as us.

To be fair, the demographics picture above cannot be directly applied to the inter-generational transfer of assets. People are marrying later nowadays, at a median age of 29. So the inter-generational age gap is about 30 years, i.e. when Our Generation reaches the retirement age of 65, the Grandchildren Generation is only about 5 years old, hardly able to support themselves, much less to take over the assets from us. Readjusting the demographics picture to an inter-generational age gap of 20 years, the relative size of each generation would be as follows:

Generation	Age	Size
Our	65	100
"Children"	45	71
"Grandchildren"	25	51

The age of each generation in the above table looks more reflective of the actual age of the net buyers and sellers in the property market, with Our Generation planning to sell at the retirement age of 65 and the "Grandchildren" Generation (in "quotes" to differentiate it from the actual Grandchildren Generation) planning to buy around the marriage age of 29.

Based on the above table, there will 51 nos. of the "Grandchildren" Generation buying/ taking over the properties of 100 nos. of Our Generation. While the figures are better, it still does not change the overall picture that there will be more net sellers than buyers in the property market when we are ready to retire.

Having said that, there are many other factors affecting the property market besides demographics, such as migration, new housing supply and property regulations. A lot of these factors are unpredictable, especially in the long term. But the one fairly predictable factor that is demographics shows that the property market when we retire will be quite challenging. For a more complete discussion of the impact of migration and new housing supply, you can refer to the post on Properties, the Population White Paper and the Land Use Plan.

Interestingly, how did Our Generation end up in such a situation? The figure below shows the relative size of each generation based on an inter-generational age gap of 20 years:

Figure 2: Relative Size of Each Generation

 
The relative size of the "Grandparent", "Parent" and Our Generations are based on the actual population statistics in Jun 2011 for the age groups 75 - 79, 55 - 59 and 35 - 39 respectively (Note: I am in the 35 - 39 age group, but you can recalculate the relative generational size for your own age group using data shown in the post on Properties, the Population White Paper and the Land Use Plan). However, do note that there is higher mortality among the "Grandparent" and "Parent" Generations, so their sizes are smaller than they should be. The relative size of Our, "Children" and "Grandchildren" Generations are based on the TFR projection mentioned above.

As can be seen in Figure 2 above, when Our Generation is buying properties to set up families, the "Grandparent" Generation is much smaller and buyers outnumber sellers. But when Our Generation is going to sell properties when we retire, the "Grandchildren" Generation is also smaller and sellers outnumber buyers. In short, Our Generation is at the short ends of both sides of the transactions.

Nevertheless, there are actions that Our Generation can take to avoid such a situation. We could either have more babies, or avoid being asset-rich and cash-poor when we are about to retire.

See related blog posts:

• Properties 
• Properties, the Population White Paper and the Land Use Plan
• Properties and the Arrival of Robots and Automation

Why Warren Buffet's Rule No. 1 Is Not "Always Make Money"

Everybody knows that Warren Buffet's famous Rule No. 1 is "Never lose money" and Rule No. 2 is "Never forget Rule No. 1". However, why is it that his Rule No. 1 is not "Always make money" but "Never lose money"? By right, if you aim to always make money, won't the outcome be the same as never lose money?

Since Warren Buffet is heavily influenced by the teachings of Benjamin Graham, we have to bring in Benjamin Graham's concept of "margin of safety" (MOS) in this discussion. Imagine that the intrinsic value of a stock is $1, if the stock trades at $0.90, it would have a MOS of 10%.

Let's now consider 2 investors, one who subscribes to "Never Lose Money" (LNM) and another who subscribes to "Always Make Money" (AMM). Other than this investment principle, let's assume that both investors have the same investment characteristics, e.g. same amount of capital, same rules in selling, etc.. Given this investment principle, the AMM investor will always go for an investment so long as it has, say, a 10% MOS. On the other hand, the NLM investor will never go for an investment unless it has say, a 40% MOS. 

In terms of investment opportunities, there will be more investments with 10% MOS compared to those with 40% MOS. The AMM investor will be more busy investing compared to the NLM investor. However, the AMM investor will quickly find that he has a shortage of capital to take advantage of all the investment opportunities (with 10% MOS) while the NLM investor will always have sufficient capital for an investment opportunity (with 40% MOS).

Assuming that the stock realises its potential and rises to its intrinsic value, the AMM investor's profit margin will be 11.1% ($0.90 to $1). On the other hand, the NLM investor's profit margin will be 66.7% ($0.60 to $1). On profit margin alone, one profitable trade of the NLM investor is equivalent to six profitable trades of the AMM investor. If we include trading costs, the difference in profit margins will be even greater. Now, let's not forget that the AMM investor have spread his capital thinly across many investments with 10% MOS while the NLM investor can only concentrate on a few investments with 40% MOS. The capital outlay on the stock by the NLM investor will be several times that of the AMM investor. In total, the NLM investor's absolute profit will be many times that of the AMM investor. Having said that, it should be noted that it will take a much longer time for a stock to rise from $0.60 to $1 than from $0.90 to $1.

Assuming that the stock continues to be undervalued and trades around $0.80, the AMM investor would suffer a loss while the NLM investor would not be invested yet.

Finally, assuming that the stock is a value trap and falls to say, $0.40. The loss margin of the AMM investor will be 55.5% ($0.90 to $0.40) while that of the NLM investor will be 33.3% ($0.60 to $0.40). Factoring the larger capital outlay, the NLM investor would probably lose more money compared to the AMM investor. However, to watch a stock falls from $0.90 to $0.40 will be a much larger psychological blow to the AMM investor. This psychological blow may have a greater impact to the AMM investor's investment philosophy. He might lose patience with the stock and sell it off. More seriously, he might even lose faith with the concept of value investing which has proven to work so many times.

In conclusion, the rule of "Never lose money" will lead to less frequent losses, less frequent but much larger gains, and less emotional distress and more faith with a proven investment philosophy. It's no wonder that Warren Buffet's Rule No. 1 is "Never lose money" and not "Always make money". It's just 3 words, but a lot of intelligence packed into it.

See related blog posts:

• Different Tastes for Different Folks
• Behind Every Successful Bear Market Recovery is A Cash-Like Instrument 
• A Comparison of Risk Management Tools & Strategies

Cash Over Valuation for REITs

Price-to-Book (P/B) ratio is actually a measure of cash over valuation (COV). Since no buyers like to pay high COV for properties, should REITs be treated the same way? This question has baffled me for some time, and my position has shifted a couple of times. Let us try to tackle this question by understanding why shares can trade above book value and whether the same arguments apply to REITs.

Why Shares Can Have COV

Shares typically trade at a P/B ratio greater than 1. The main reason is because the assets bear very little relation to the earnings power of the company. A company can have very little assets but have considerable earnings power due to its brand value, intellectual properties and/or favourable regulations. As these factors are considered intangible, they cannot be included as assets in the balance sheet (unless they are taken over by another company, after which these intangible assets become reflected as "goodwill" in the new company's balance sheet). However, these intangible assets have real earnings power, which allows the share price to be higher than the book value.

Another reason why shares trade above the book value is because the assets are depreciated annually but seldom revalued. For example, a company might own the land on which it is sited. The land might appreciate in value over time, but the value of the land in the balance sheet is reflected at historical cost, which could be just a fraction of the prevailing land value. Investors who understand this would price the shares higher than the book value.

Since the subject of this topic is REITs, the shares that bear the closest relation to REITs are that of property developer/ holding companies and hotels. Interestingly, property shares generally trade below their book value. Examples of property developers are Capitaland (0.9x), City Dev (1.2x), Keppel Land (0.8x), UOL (0.8x) and Wing Tai (0.6x). Examples of property holding companies are Bonvests (0.6x), GLP (1.3x) and Hong Fok (0.4x).

Why REITs Should Not Have COV

Having understood the reasons why share prices can exceed book value, we can now review whether the same arguments hold for REITs. The assets of REITs are mostly properties. While they are allowed to engage in some property development that might lead to increased future earnings, their core business must be in holding and leasing out properties. Therefore, the earnings power (i.e. rental income) are closely tied to the assets. Unlike shares, REITs value their properties on a regular basis. Any increase in rental income will translate to increased valuation and is reflected in the balance sheet on an almost annual basis. Hence, the book value reflects the prevailing value of the assets.

On brand value, while some properties are more desirable than others, this is reflected in the rental income and eventually the book value. Nevertheless, there could be some premium attached to the sponsor company of the REITs. This will be discussed further in the next section.

On management skills, while REITs have engaged in Asset Enhancement Initiatives (AEIs) to enhance the rental income of their properties, the increase in rental income is relatively small compared to the overall portfolio and should not confer a major premium over the book value.

Why REITs Can Have COV

As mentioned in the earlier section, there is some brand value in having a strong sponsor company for the REIT. Firstly, the sponsor company could have the financial strength to support the REIT during a difficult period. This is evident during the Global Financial Crisis when many REITs faced difficulties in refinancing their loans. REITs with strong sponsors generally fared better than REITs that do not. Secondly, the REIT may have a right-of-first-refusal over the sponsor company's properties, which could generate a pipeline of yield-accretive acquisitions for the REIT. Investors who like the pipeline of potential acquisitions and its impact on future earnings will have to pay a premium for this REIT.

Perhaps the biggest reason why REITs can have COV lies in the differences valuation is carried out for physical properties and financial assets. For properties, valuers would consider the prices of similar properties and/or compute the discounted cashflow of the rental income that the property can bring. The asset value thus computed, minus the debt, becomes the book value. Property valuers are limited to similar properties in this valuation. However, for financial assets, investors can compare across all asset classes (shares, bonds, commodities, etc.). The discount rate that valuers and investors use to value the income stream of the property is thus different and can lead to different asset values.

Conclusion

REITs can have COV because of different discount rates adopted by property valuers and financial asset investors. However, the COV for REITs should never be as high as those for shares, as assets for REITs are mostly tangible properties and the valuations are updated regularly. It is always safe not to pay a high COV for REITs.


See related blog posts:

• REITs Are Not Forever Attractive
• Do REITs Overpay for Their Acquisitions? 
• The Hidden Risks of Buy-and-Leasebacks for Industrial REITs

REITs Are Not Forever Attractive

REITs have been an attractive asset class since their introduction in Singapore in July 2002. They provide regular distributions with opportunities for capital gains. However, unlike shares, REITs are not exactly forever. The main reason is because the assets that REITs hold are mostly leasehold properties with expiry dates. When the leaseholds expire, they will lose the properties and will no longer be able to lease them out for rental income. Of course, REITs can always renew the leaseholds and/or buy new properties to rejuvenate their asset portfolios, but that will mean going back to the shareholders for money. Let us consider the case of a single-property REIT.

The assumptions adopted in this example are as follow:

Leasehold period	100 years
Purchase price	$100M
Equity	$50M
Debt	$50M
Rental yield	6.5%
Interest rate	3.0%
Discount rate	5.0%
Distribution rate	90.0%

Based on the above assumptions, the property will generate annual rental income of $6.5M, incur interest costs of $1.5M in the initial year and generate distributable income of $5.0M. As the REIT will distribute 90% of its distributable income, it will return shareholders with $4.5M in distributions. As for the remaining $0.5M, let's assume that it will be used to reduce the debt, thereby reducing future interest costs and increasing distributions to shareholders.

Based on Discounted Cash Flow (DCF) valuation, the annual distribution stream of $4.5M (gradually increasing to $6.5M as the debt is being paid off) for 100 years will be worth around $95M. The DCF valuation hovers above this initial value for the next 65 years. However, as the property nears its 100-year leasehold expiry, the DCF valuation will drop rapidly. See the figure below.

Figure 1: Valuation of Single-Property REIT over Time

To continue to operate beyond the 100-year leasehold of the property, the REIT will have to raise capital to renew the leasehold or buy a new property. It could do this in 2 ways: conserve cash from the distributable income in subsequent years, or raise fresh capital from new or existing shareholders. The first method will lead to a drop in distribution to shareholders for a prolonged period of time (e.g. if it choose to conserve all of the distributable income of $6.5M, it will need at least 7.7 years to raise $50M in equity). This is not very palatable to investors.

The second method of raising fresh capital could maintain and even raise the distributions to shareholders in the short-term. However, it comes at a cost of dilution of shares and reduced distributions in the future. From the figure above, it can be seen that the closer to the end of the leasehold period of the existing properties, the less the existing shares are worth and the more new shares need to be issued to raise the same amount of capital.

Now consider the case of a REIT that regularly adds a 100-year leasehold property to its portfolio every 20 years by raising fresh capital. For the first 20 years, it will have only 1 property. For Year 21 - 40, it will have 2 properties, so on and so forth. By the 80th year, it will have 5 properties. Beyond that, the no. of properties will remain constant at 5, as every new addition will only replenish another whose leasehold has expired.

Let's assume that the deal for every leasehold property remains the same, i.e. $100M purchase price, 50%-50% funding by equity and debt, 6.5% rental yield, 3% interest cost etc. The DCF valuation of the REIT over a 200-year period is shown below.

Figure 2: Valuation of Multiple-Property REIT over Time

Several observations can be made from the above figure:

• The jump in DCF valuation from every additional property reduces over time. When the property portfolio is small, every additional property represents a large % increase in the portfolio size and distributable income. However, as subsequent properties are added, the increase becomes progressively smaller.
• The DCF valuation increases for the first 5 properties and decreases thereafter. For the first 5 properties, there is increase in the portfolio size and distributable income, leading to increasing DCF valuation. Beyond the first 5 properties, there is no net increase in the portfolio size and distributable income. At the same time, the no. of shares is increased from every capital raising exercise. Hence, the DCF valuation decreases thereafter.
• At some point in time (200 years in this example), the DCF valuation will be below that at initiation and will continue to decrease.

Figure 3 below plots the no. of shares to be issued for each property acquisition. Due to the increasing DCF valuation for the first 5 properties, the no. of new shares to be issued decreases. Beyond the first 5 properties, the DCF valuation decreases, leading to increased no. of shares issued. The key point to note is that although the leasehold properties can expire, the shares issued previously will never expire. So, over time, there will be a lot of shares outstanding.

Figure 3: No. of Shares Issued for Every Additional Property

In conclusion, REITs may have been an attractive asset class to-date. However, it is important to note that the assets that REITs have are mostly leaseholds with expiry dates. As REITs rejuvenate their property portfolios to replace leaseholds that expire, it often means dilution and reduced distribution for shareholders. REITs are not forever attractive.


See related blog posts:

• REIT Asset Expiry Profile
• REIT Debt Maturity Profile
• Can You Count on REITs for Retirement?