Is residential property a good investment?

By Wealth Foundations

There has been a surge in residential property prices recently, apparently driven by investors rather than homeowners.

Like most Australians, their answer to the question, “Is residential property a good investment?” would clearly be “Yes”. And typical reasons given would include:

– It’s safe and always goes up in value. In fact, it was recently suggested to us that residential property should be regarded as a defensive rather than a growth asset, indicating that it was seen as safe as a term deposit or government bond;

– In contrast, shares are too volatile and more like gambling;

– Unlike shares, I can see and touch the asset I own. If all else fails in the world, at least I have my bricks and mortar to live in or rent; and

– I am familiar with and knowledgeable about property and the geographic area in which I have invested.

Most of these rationales are pretty flimsy.

In particular, to view property as safe as a defensive asset is a troubling misconception. Residential property owners in Europe and the US would attest to this.

The chart below shows the performance of US residential property (measured across 10 major metropolitan areas) since 1985. After rising strongly from about 1995 to 2007, there was a fall of approximately 35% to the trough – defensive assets don’t behave like this!

The last really significant fall in Australian residential property occurred in the early 1990′s, when in Sydney it generally fell about 25% from late 1980′s levels. Some prestige properties sold by banks as mortgagees in possession at that time went at prices 40-50% below the valuations provided for lending purposes only a few years earlier.

Before including a residential property as part of your investment portfolio, we think you should consider the following:

– It offers few, if any, diversification benefits – for most holders, it is a large sum of money (relative to total investment wealth) held in one, lumpy concentrated asset. You cannot expect to be rewarded for this concentration risk;

– It’s fairly illiquid i.e. it can’t easily and quickly be bought or sold (without providing a significant incentive to the party on the other side of the deal). Neither can it be sold off in parts – you can’t sell a bedroom to raise emergency cash;

– There is a lack of price transparency – valuation is difficult. The only time you know what a property is really worth is the day you sell it;

– The costs of ongoing management are high, in terms of agent’s fees, legals, body corporate fees, maintenance costs etc. Investor involvement is also likely to be much higher than with direct share and managed fund investments, particularly if tenants prove undesirable;

– Transfer costs, in terms of agents’ fees, marketing, legals and stamp duty are high; and

Usually, it is necessary to borrow a significant amount of debt to purchase the property. While this may provide desired tax deductions, it adds considerable additional risk beyond that already inherent in residential property.

All growth assets should have a minimum 10 year holding expectation

So, purists argue that directly held residential property is a less than desirable investment. But it is ironic that some features that make it a poor investment, in theory, are what make it a potentially better alternative to other growth assets, such as direct shares and managed share and property funds.

The fact that residential property is illiquid, has high transfer costs and poor price transparency means that investors:

– intuitively know they must adopt a buy and hold mentality; and

– won’t be distracted by daily updates in the value of their property.

As a result, the only time they are seriously interested in what their property is worth is the time they decide to sell it. Often, this may be 10-20 years after purchase. While we don’t have the data, we suspect that for most ten year periods over the past 30-40 years residential property values in Australia would have been considerably higher (on average) at the end of the period than they were at the beginning. Hence the perception that property always increases in value.

Our view is that serious investors should take the same approach with all their investments. Unfortunately, some characteristics that are regarded as benefits of direct shares and managed share and property funds (i.e. their price transparency and ability to easily and quickly sell either in full or part) expose investors to the distraction of continuous price fluctuations and, potentially, encourage a short term mentality.

To illustrate this point, the chart below shows the growth of a $1 invested in the largest 300 Australian listed shares, by market weight, plotted monthly (on a log or proportional basis) for the thirty year period from July 1983 to July 2013:

It reveals that while the trend has been upward, there was significant volatility, including some major falls that shook out many ill-disciplined investors.

However, if this actual experience is broken down into three ten year holding periods, with values only plotted at the beginning and end of the periods (to replicate the approach taken by residential property investors), a completely different picture emerges, as charted below:

All the continuous pricing “noise” disappears. The underlying rationale for investing in the share market and the need for discipline to obtain the potential rewards becomes obvious. The (erroneous) conclusion may also be drawn that shares always go up in value!

Some readers may also be surprised that share market performance over the last 10 years, that encompasses the GFC and would generally be remembered as traumatic, was similar to the previous 10 years and strongly positive!

There are better alternatives than residential property

In summary, most investors in residential property, particularly if largely financed by borrowing, don’t appreciate the significant risks they are exposed to. These risks are not the type that can be expected to be compensated with additional return. Fortunately, the patient approach almost imposed on residential property investors has, historically, resulted in a satisfactory investment experience for many.

However, provided you are prepared to adopt the same long term discipline as residential property investors, we believe there are considerably less risky, more flexible and cost effective approaches to realising your financial goals.

Wealth Foundations (ABN 95 965 896 114) is a corporate authorised representative of Wealth Leadership Services Pty Ltd (Corporate Authorised Representative No. 319641). Wealth Leadership Services Pty Limited (ABN 36 121 535 993) is a licensed Australian financial services firm (AFS Licence No. 317369).

Click on the links below to read other articles from this week’s newsletter

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