Financial Freedom Engineer – Page 37 – Financial Freedom Engineer

Australian’s love property, we have tv shows about it; constant conversations on the latest trends in housing design; and a supposed entire generation that got rich off investing in it. In this post I wanted to look at the asset class objectively and compare it to Australian shares to help you decide what to invest in.

Growth rates
According to a report by Aussie HomeLoans the historical annualized growth rates for houses and units from April 1993 through to April 2018 (25 years) across all capital cities has been between 5.9% and 8.1%. The data for houses is presented in the table below:

*Reference: 25 years of housing trends (Aussie, 2018)*

For houses, the markets of Sydney and Melbourne, have produced strongest annualized growth rates of 7.6% and 8.1% respectively.

From 1/4/1993 to 1/4/2018 the All Ordinaries grew from 1681.5 points 6071.6 which equates to an annualized return of 5.27%, excluding dividends.

*All Ordinaries Index ex dividends from 1/4/1993 to 1/4/2018*

Incoming cash flows
The numbers presented above do not take into account the incoming cash flows produced by each of the asset classes. In the case of property, we would be referring to rent and for shares this refers to dividends.

From 1980 to 2020, the dividend yield for the shares comprising the All Ordinaries index has averaged a little over 4% (Market Index 2020). This brings the total return, from 31/3/1993, to the 31/3/2018, to 9.40%.

According to SQL research the average rental yield for Sydney property peaked at 4.1% in late 2011 and steadily declined to 2.4% as of December 2020. For Melbourne it has peaked at 3.9% in April 2013 and fallen to 2.6% as of December 2020.

Share investment related costs

Share funds typically have a management expense ratio (MER) that is paid to the fund manager for providing the service. There is also a bid/ask spread which represents the difference between the buy and sell price. The following table shows the investment related costs of 2 Vanguard products that can be used as a proxy for the All Ordinaries index.

Fund	MER	Bid/ask spread	Benchmark
Vanguard Australian Shares ETF	0.10%	0.05%/0.05%	ASX300
Vanguard Australian Shares Index Fund	0.16%	0.05%/0.05%	ASX300

Reference: Vanguard 2020

If you were using the ETF, you’d likely have brokerage costs each time you purchase units which can be the greater of $30 or 0.3% if you are using an expensive online broker such as Westpac.

Wrap platforms
If you use a wrap platform to combine all of your holdings into one account there will be a fee involved for this as well. Typically, this fee falls as your account balance grows. The fee structure usually looks like this:

Admin fee for balance under $50,000	0.35%
Admin fee for balance over $50,000	0.05%
Min chargeable fee	$400 p.a.

Reference: Macquarie Wrap 2020

Tax benefits of share investments
Franking credits are often attached to Australian shares. The franking system avoids the double taxation of having to pay company tax and income tax on a shareholder’s dividends. This means that grossed up dividend payout rate is a little higher than the 4% quoted above.

Under the Australian tax system, share investment related costs can be tax deducted (ATO 2020). This means that if leverage is used, the interest can be deducted to reduce an individual’s taxable income.

Property Investment related costs

Direct property investment has very high entry and exit costs. A few of these costs include: Agent fees; stamp duty; settlement costs, property inspection costs and lender’s mortgage insurance (if a 20% down payment can’t be made). Of these costs stamp duty is likely to be the largest. To purchase an investment property in Sydney at the median price of $872,934 (Budget Direct 2020) stamp duty would cost $34,912.80 (Canstar 2020). This alone equates to 4.0% of the purchase price. If we assume an additional $1500 for the property inspection and settlement costs this increases the entry cost to 4.17% of the purchase price.

Direct investment property also has high ongoing costs. Smart property investment magazine has summarized some of the fees involved:

Council rates	$1,662
Insurance	$1,423
Property management fee	7.7% to 8.8% of rent collected
Maintenance:	$1,000

Reference: How much does it cost to hold a rental investment property? (Needham, J, 2015)

If an investment property is purchased using a mortgage then the investor is liable to pay interest. Given that a median priced Sydney home in 2020 is $872,934 (Budget Direct 2020), for an interest only loan at a rate of 2.74% (ING 2020) with a 20% down payment this equates to $872,934 x (1 – 20%) x 2.74% = $19,135 p.a.

Tax benefits of property
Investment properties are a tax efficient vehicle in Australia as the system allows investors to offset losses from investment costs from their income, this is known as negative gearing. This also includes depreciation, which may not represent actual cash outflow, but used to offset incoming rental cashflows to reduce taxation.

What the data doesn’t show

When looking at property price graphs, the price movements tend to be a less accurate than those of share price graphs. This is due to the high ongoing costs and the fact that people can renovate their property to increase its value. For example, a suburb might see it’s last sale price rise from $400,000 to $500,000, due to a property investor making $80,000 worth of renovations. To an outsider this appears to be a huge jump in valuations, however the information presented does not factor in the renovation cost. This means that the buy and hold investor will experience different returns to the buy and renovate investor.

For shares, because transacting is so easy, the temptation to move in an out of the market to perform market timing can be very high. The 9.40% growth rate discussed above is for an ideal investor that buys an instrument that acts as a proxy for the All Ordinaries index, holds for 25 years and reinvests all dividends. In many cases investors are unable to capture the full return of an index due to moving in and out of the market or not reinvesting the dividends.

Projecting returns into the future

Assuming that the growth rates from the past 25 years continue for a further 25 years into the future let’s look at 2 hypothetical investors, each with $200,000. The share index investor will purchase a fund that replicates the All Ordinaries Index with an MER of 0.16% and a wrap platform fee of 0.137%¹. This means that the annualized return is 9.40% – 0.0137% – 0.16% = 9.103%.

The property investor will purchase an investment property in Sydney at the median price of $872,935 using the $200,000 as a down payment for a loan with a 2.74% interest rate. They will collect a gross rental yield of 2.40% (SQM research 2020) and the ongoing costs will be as listed in the table above.

Represented as table, the property investor’s journey is as follows:

*Investment property position projected over 25 years*

In a graphical format, the property and share investors’ journeys are represented in the graph below:

*All Ordinaries vs direct investment property equity positions projected over 25 years*

What we see is that after 25 years the property investor has $4.8M of equity vs $1.76M of equity for the share investor. That means property is the better investment, right? The answer is it depends on your risk tolerance and how active your want to be with your investment.

Leverage is the reason for outperformance
In this case, the reason for the outperformance is because the property investor used leverage. With a 20% down payment on the house, she is effectively leveraged 5-fold, which will almost quintuple her returns. In addition to this, I have assumed that the interest rate remains fixed at 2.74% (ING 2020) and the ongoing costs only increase by 2% p.a. If the share investor had used a $709,348 loan for leverage his final portfolio value would have reached $7.87M with $7.16M in equity. This represents a significant outperformance as well as a significantly lower total investment cost.

Risk

No discussion about investments is complete without discussing risk. Despite property prices fluctuating less than share prices, I would argue that direct property is a much riskier asset class for the following reasons:

Liquidity
Share fund units are far more liquid than direct property investments. Individual units worth tens or hundreds of dollars may be bought and sold easily, at low cost using an online broker and the transaction is usually complete within a few working days. Compare this with an investment property where you must sell an entire property worth hundreds of thousands of dollars. This process may take months to complete and real estate agent fees can cost thousands.

Diversification
Due to the size of the units purchased it is very easy to reduce individual company (idiosyncratic) risks in a share portfolio. An investor can purchase numerous shares to diversify against particular company risks; there are even single products that can provide investors with a portfolio of hundreds of companies. With direct property investment you will require a minimum down payment of tens of thousands of dollars to purchase a single investment property. This exposes the investor to all of the unique risks associated with that particular property. Diversification is possible, however buying numerous properties across different states or countries requires a large amount of capital and significantly more effort than doing so with shares.

Leverage
Most property investors will use leverage to purchase an investment property. As I have discussed earlier leverage multiplies risk in both directions, which bodes very well for the investor that experiences rising asset prices, but can be terrible for the investor that experiences falling asset prices. With share investments, because the funds units are relatively cheap, the investor has the flexibility to use leverage if they wish or remain unlevered; whereas property is almost always a leveraged purchase.

It is at this point where I’d like to talk about the case of the Perth property market to illustrate the dangers of using leverage. Between 2010 to 2019 the median Perth property asking price has fallen around 10% (SQM research 2020). If an investor purchased a $500,000 property with a $100,000 down payment using a loan of interest rate of 3.50% and rental yield of 4%, after 9 years their investment portfolio would look like this:

Property Value	$450,000
Loan:	$500,000 – $100,000 = $400,000
Rent Collected	$500,000 x 4.0% x 0.923 x 9 = $166,140 (after 7.7% agent fees)
Interest paid	$400,000 x 3.50% x 9 = $126,000
Ongoing costs	$4,045 x 9 = $36,405 (costs estimated from table above)
Stamp duty paid	$18,211 (REIWA 2020)
Total equity	$35,524

Leveraged investment property position after a 10% decrease in asset value over 9 years

From an initial equity position of $100,000 after 9 years the Perth property investor has an equity of $35,524, which equates to a loss of 64.5%. An unlevered portfolio would have fallen to $90,000 in the same time, which is a much more palatable loss. As a result, the levered investor will be much further from their financial wealth building goals than the unlevered investor.

Additional considerations

Active input
Direct property investment can be very costly in terms of your own time maintaining/upgrading and managing the property. Of course, a property manager can be paid to look after all of this, however their fees are significant. During my research for this article, I’ve come across a figure of 7.7% to 8.8% of gross rental yield, but please let me know in the comments below if this figure is unrealistic.

The requirement for this kind of effort is both a positive and a negative feature of property investment. On the one hand it costs time, effort and energy, but on the other hand you can make changes in order to increase your returns. You can not do this with shares… …unless you own enough to influence the board of directors!

Low rental yields
Australian residential property has typically had low rental yields compared to other property markets around the world. Often, the rental yield is not able to cover the cost of the interest payments which means that property investors need to be prepared to experience multi-year periods of negative cash flow on their investments.

Leverage
Because property is seen as less volatile it is much easier to take a loan to purchase property investments than it is for shares. Investors can also take advantage of much higher leverage ratios with property than with shares. If an investor has the capacity and tolerance to take on high leverage risk then property can be an effective vehicle to do this.

Concluding thoughts

When choosing investments, you should not simply ask which investment produces the highest returns but more so which investment suits your risk capacity; risk tolerance and life goals. You also need to look at how an investment fits with your current portfolio. At the FFE house we have a preference for the share asset class due to its simplicity, liquidity and ability to diversify to suit our risk tolerance. Currently leverage represents about 20% of our portfolio and is done via a debt recycling arrangement to suitably increase risk. With that being said we do have exposure to real estate through our REIT holdings. Since we want our investments to be passive and diversified REITs are more appropriate than direct property investment.

If you are considering direct property investment, I urge you to do a thorough analysis on any prospective investment. When estimating future returns you need to take into account as many of the entry, exit and ongoing costs as possible. Since property is highly sensitive to interest rates it would be wise to look at your cash flow position and see what sort of tolerance your household has to upward movements in interest rates. Also, take the time to look at the scenarios where your investment does not perform as required to meet your financial goals and how you intend on getting back on track. If all this sounds too hard, then you probably shouldn’t be doing any sort of direct investment, let alone taking on a leveraged position.

The example that I’ve used above has been focused on Sydney, which has been one of the best performing capital city markets in Australia over the past 25 years. Whether this will continue over the next 25 years is anyone’s guess. However, over the same time period, the Australian share market, when dividends and fees are accounted for, has provided a similar rate of return with lower downside risk and far less investor effort.

Engineer your freedom

Notes
1 Wrap platform fees assumed as fixed percentage even though it will fall as the account balance increases

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Comparing Australian property to Australian shares