April 2010

Given the recent worldwide stock market correction, there has been increasing interest in property investment. Quite unsurprisingly the flight to intrinsic assets is very common after a stock market fall and the subject of whether shares or direct property is best has been one pondered for many decades. The truth of the matter is that in the interest of diversity, both of these growth assets should be constituents within an investor’s portfolio. The more important question is what are the benefits and costs of holding both investments and what proportion of each asset class should an investor hold?

3 simple steps to get you started:

• An often over looked step is to establish some investment goals before investing in either asset class. This will help you monitor the investment and it also helps take the emotion out of the process.

• The second step is to undertake a risk profile process – This will often reveal a person’s real attitude towards investment risk and return. Risk profiling can also highlight a preference for some asset classes over others based on identified objectives.

• Third step would be to determine how much experience you have with either asset class. If you have more experience with property, then a larger weighting to direct property might be warranted.

Tax and Ownership

The investment structure you choose, will determine the amount of tax you pay and ultimately affect your net return from the investment. There may be other personal liability and estate considerations as well as transaction costs that the right investment structures can help mitigate. The most common types of ownership structures are tenants in common or individual owner, a trust / super fund or a company. All of these structures have different tax outcomes and costs associated with them and some can minimize liability, so it is important to choose
the best structure before investing.

The basis for buying property

The fundamental argument for buying property in Australia rests on the fact that house prices are determined by supply and demand factors. In Australia unlike the US, we are faced with a growing population, low unemployment (5.9% -RBA) and an undersupply of property. These factors rightly make property a highly sought after asset.

Property never falls?
The perception however, that direct property significantly outperforms shares, or worse still, never goes down, is a very dangerous assumption to make. From 2003 to 2006, we witnessed the decline of prices on most of the eastern seaboard metropolitan areas and while the impact has not been devastating, it certainly has affected the balance sheet of many mums and dads. It is also common knowledge that the efficiency of pricing data for unlisted assets like residential real estate leaves a lot to be desired. There is no accounting for ‘added value’ that owners may contribute towards a property, an example of which is, renovations and improvements. Factors such as these can add stability to price movements, along with the fact that the average Australian typically holds onto their home for at least seven plus years.( ABS – census) The more recent practice of purchasing multiple properties was prevalent due to lose lending conditions and the perception that property is safer than any other investment. It is worthwhile noting, that when the residential property market takes a turn for the worse you can be severely disadvantaged if the majority of your assets and income sits outside of the highly tax advantaged superannuation and pension system. Most of us have heard stories or know of friends and colleagues that have overstretched their financial resources by purchasing more than one investment property at the same time. While they typically adopt a sound ‘buy and hold’ strategy, the unfortunate fact is, from 2003 to 2007,they would have sacrificed an opportunity cost in the Australian share market (e.g. ASX200 – last equity bull market) where returns were 20% plus over this period. The lesson to be learnt is that, having all of your eggs in the one basket (or asset class) can have dire effects in achieving your wealth creation goals.

Yale economist and author of Irrational Exuberance, Robert J Shiller has created a real house price index (US property market) for existing dwellings dating back to the 1890s.He points out that in the last decade there has been a tremendous, irrational growth spurt in housing asset prices. Ignoring the effects of inflation, house prices have doubled in 10 short years. In Australia since 1986, house prices have gone up more than 400%, and when the effects of inflation are removed we have seen prices more than double. Shiller’s analysis should be enough
for anyone to question if property growth is sustainable at present levels.

The Reserve bank of Australia’s governor, Glen Steven’s recently expressed similar concerns, about property investment as a “riskless” path to riches. He said “I think it is a mistake to assume that a riskless, easy, guaranteed way to prosperity is to be leveraged up into property.” This is a very popular
misconception and one hopefully that all investors will take notice of.

The only real thing that separates shares from property as far as tax goes is that the return from shares comes mostly from capital gains, but the return from property comes mostly as income. Capital gains are generally more tax efficient than income because capital gains tax can be deferred indefinitely by holding off selling and also attracts a discount for long term investors (unless you are a company); whereas income is taxed in the year
it is received. On this basis, it can be argued that shares are more tax efficient than property.

Asset Class Performance
To put this argument into perspective, let’s look at the returns for different asset classes over the last twenty years. What we know is that there were times when shares underperformed direct property, listed property trusts and even fixed interest, however, generally for over a 10 to 15 year period, shares have historically
outperformed. The research conducted by the AXA research team, upon common indices across asset classes, highlights the annualised returns from:

Cash: 5.7%
Median House Price: 8.75%
ASX 200: 10.2%
ASX 200 Property Trust: 8.1%
MSCI World Index 5.9%

Other considerations: Holding costs

So finally we come to costs. There is no doubt that the higher acquisition costs involved with property, such as stamp duty, land tax, loan application fees and the ongoing costs of council rates, utilities and property management fees, can compare unfavorably with shares and managed funds. One very important factor to consider is that property is not as liquid as a share or managed fund investment and while the disadvantage of shares, is lower borrowing ratios and higher borrowing rates, compared to property; all without the effect or fear of margin calls; the overall cost to return and time management benefits, suggest that shares might be a cheaper and easier to manage investment, than property. The reason however for the popularity of property investments can be attributed to the familiarity and intrinsic nature of property assets, compared to shares and managed funds.

Summary:

There is little doubt that any investor would be doing themselves a disservice if they were not to invest in direct property. Having said this, the price you pay and the location in which you buy, will ultimately be the difference between good and great returns. From a tax, cost and quality of asset perspective, both property and shares are equally appealing. The evidence though seems to slightly favour shares as a better holding, due to the better tax treatment of capital gains and the lower costs, compared to direct property ownership.

It must be said though that, quality research and a thorough assessment of any investment must be made when purchasing either shares or property and it is reasonable to say that, Investment property should not be ignored as part of a diversified portfolio, but it should however be treated as no more
than just a slice of the investment pie.

Written by Robert Joseph – Practice Principal Freedom Wealth Advisers

SOURCES OF DATA:
• Irrational Exuberance, 2nd Edition – Robert J Shiller
• RBA governor Glen Steven’s comments on property – AAP March 29th 11.18am
• Australian Housing figures: Australian Property Monitors
• AXA Research team
S&P/ASX 200
MSCI World Index
Cash returns – based on the 90 day bank bill rate
ASX – Listed property
• Nicholson Cartoons -

This editorial provides general information only. Before making any financial or investment decisions, we recommend you consult a financial adviser to take into account your particular investment objectives, financial situation and individual needs. (AXAFP) and its Authorised Representatives do not accept any liability for any errors or omissions of information supplied in this editorial.