Property vs Shares - the real story!?

I've been thinking about debt and asset allocation lately... (as you do )

According to Vanguard's booklet on investment returns ( http://www.vanguard.com.au/library/pdf/Realistic_Expectations.pdf ) Australian shares over the 20 years to June 2006 have returned 11.9%pa on average. Whilst we could slice and dice the figures further to find out large caps vs small caps, which industry sectors did better or worse etc, let's just take it that Australian shares have done 12%pa.

Warren Buffett is regarded by many as the world's best investor. His investments have grown at an average rate of 27.6% pa according to www.warrenbuffett.com.au.

So we can expect that our returns, assuming we're average or above average will be somewhere between 12%pa - 28% pa over the long term. Certainly quite a range. Let’s say we’re slightly above average and can do 13%pa.

How does that compare to direct residential property? According to this Russell report residential property has returned 12.1%pa over the 20 years to 31 December 2005 (ASX Russell Long Term Investing Report 2005)

Of course 2006 hasn’t been too kind to the East coast so perhaps we can just call it even and say residential property will do around 12%pa on average.

But what about if you’re a below average property investor? What if your properties only grew at say 7%pa or maybe even 6%pa on average over 20 years?

Is there a way you could still end up ahead using property rather than shares?
The answer is, of course, YES. Through the power of gearing.

Gearing will magnify your losses but it also magnifies your returns.

On my calculations if you had $200k to invest, borrowed 80% to buy a $1m property and got only 6%pa growth, then assuming interest rates at 7.5% and maintenance/rates at 3% of the property value, then after 10 years your net equity (after paying the interest and costs) would be around $877k. In contrast with ungeared shares where you managed 13%pa (i.e. slightly above average) over 10 years (a record many fund managers would be very happy with) then your equity would be only $679k, over $200k less.

Of course, over the next 10 years, assuming the same results the power of compounding starts to clawback the advantage so that in year 20 the property equity is $2.25m and for the ungeared shares it is $2.3m. The ungeared shares over 20 years have it by a nose! But we’re ignoring here the fact that in year 10 perhaps you took your $200k equity and invested it elsewhere (maybe even in shares!) and started earning a return on it as well.

Ah, you say, that’s fine but what about geared shares? If you add a 50% margin loan @ 9%pa to the mix things look a lot different. At the 10 year mark the geared shares result in equity of $1.14m well ahead of property geared at 80% with a 6% return. Of course the 20 year result is a massively ahead, with equity at nearly $4.4m!

So does that mean the case is closed and geared shares are the way to go?
Well, let’s see what happens when you crank up the gearing on the property to say 90%. The result is very interesting. At the 10 year mark we have equity of $1.54m, $400k ahead of our 50% geared shares which had a return of more than twice our below average property. In 20 years’ time, the result geared shares have again won by a nose, with property resulting in equity of only $4.29m.

Now of course on day 1 you would have had to pay some lenders mortgage insurance, perhaps $8-10K or more and of course a substantial amount of stamp duty. But over the long term those amounts become inconsequential.

What if you really cranked up the gearing on property to say 95%? I’ll let you do your own sums ;-) but you’d need a return of around 16.5% from 50% geared shares to match the outcome over 20 years and your equity only catches up very late in the day. Meaning a lot of lost opportunity cost from not having the equity earlier to deploy in further investments. I might add that if you can do 16.5%pa year in, year out over 20 years you should immediately march up to a large fund manager and demand they give you an 8 figure salary, massive bonuses and a big office with harbour views

Of course if you’re the next Buffett and can do 28%pa on ungeared shares for 20 years then you’ll trounce the opposition and make a motza. But bear in mind you’ll only catch up in the equity stakes by year 12…

So, apart from having some fun with modelling the future, what can we learn from these projections?

A very average property with good leverage can beat a sharemarket expert with less leverage over the long term.

Just as we all think we’re above average drivers, most investors think they’re above average when it comes to investment. Of course that cannot be true.
So if we assume we’re about average when it comes to investing then when it comes to property, highly leveraged, maybe, just maybe, that’s okay. We can be average when it comes to property selection provided we gear to 80% or more and hold on for the long term. Which I guess is what authors like Jan Somers have been saying all along. To achieve the same results as a pretty ordinary property investor with shares requires above average skills over the long term.

So, perhaps the question should be, why are we holding shares/managed funds instead of property? The analysis above would suggest the only correct answers to that would be:
a) I’m using it to cashflow my negatively geared properties; and/or
b) I’m using it as a saving vehicle to get the deposit for my next property.

Perhaps the third acceptable answer is that we’re holding shares/funds to have ready access to some liquid assets rather than holding cash.

Ultimately then, the answer to the title of this post is that the REAL story of property vs shares is a story of different permitted levels of leverage.

What do you think?

 

Nice article Nigel, food for thought

 

Gday mate
Cheers for the thread.
This is something I have been thinking about a lot recently, trying to determine the best way to go.
A couple of points that could change your calculations:
1) to be fair, it is probably better to compare the commonly held gearing level for property at 80% and for shares at 67%. This seems to be the most widely accepted gearing ratio vs risk (taking leverage high, but not riding too close to the edge).
2) An advantage of shares/managed funds is that you dont have to wait to reinvest while you are waiting for your equity to grow in property. For example, you start with a $300k property. You have to wait about 2 years growing at 10% to be able to get the next $300k property at the same 80% LVR. With shares, you can reinvest continuously throughout the year as long as your portfolio increases. This changes the picture dramatically over the long term.
3) Lets assume that on the average $300k property, the negative cashflow is around the $200 mark each week. This is gone forever. With income focused managed funds, not only is it possible to have them positively geared, but if you invest the $200 you would otherwise lose on property, again this adds up to a substantial difference over the long term - this gives you more growth, more income, and subsequently the ability to borrow even more shares
4) This may be a touch obscure, but if you are able to get into a managed fund that distributes largely tax deferred income, you tax benefits go through the roof without actually affecting your cashflow.
5) Another obscure one - as far as I am aware, for Family Tax Benefit claims, you have to add back rental property losses. If you were involved in a fund from 4) above, you would be very close to 100% negatively geared, without any need to add back your managed fund losses. This COULD mean that your spouse could possibly earn $40,000 a year if you were negatively geared in shares to the tune of $40,000 and STILL receive your family tax benefit (this is not confirmed, just a possibility, I havent really looked into it fully). This could potentially be pretty cool.
6) Just as another point, if you were a first homebuyer in Perth at the moment on an average income (or even a reasonable single person income) you would struggle to get your foot in the door. Managed funds seem to offer many of the same investment benefits as property without the high entry cost.

Theoretically at least, it would appear that with the benefits of 2) and 3) above, I think you will find a different picture for managed funds/shares over the longer term.

It is definitely something to consider (as I have always just assumed property was better without ever actually investigating other options)

 

Great Post Nigel


Individual Shares like properties also have great performers (have a look at WA for property and Paladin for shares over the last three years) and poor performers (look at...hmm, dunno my IP's are in WA ..how about Sydney and Chemeq over the last three years).

Its all a bit to confusing for me..is Shares the All Ords or the ASX200 and Property the Australian Median?

How about rent, dividends, fees,tax treatment etc etc honestly it gets confusing for me..

 

For the purpose of the exercise, 66% seems a much more appropriate figure for the comparison, then people can work out their own risk factor from there.
Is 80% to high a LVR for property and 66% to high for shares/funds? Depends on your risk factor and stage of investment career. If you have already built a reasonable base, then these LVRs are both probably to high. If you are buying your first property or making your first step in managed funds, chances are you dont have the cash behind you to even stay at 80%/66%. Does this mean you shouldnt invest? Up to you.
If you just say that we should compare 80% for property with 40% for shares, I would suggest that this will lead to meaningless results. How do you quantify an 80% property lend, and then the price of property drops (ala Sydney), and all of a sudden you are at 100% LVR or even negative equity situation? In the early part of an investment career, this would mean you could be out of the investing game for maybe 5 years. How does this work with the 10% average property growth? Sure, Sydney will bounce back and will probably maintain the long term average, but in the meantime that person has lost all ability to leverage or invest again.
How do you quantify the ability to get say a $20k Line of Credit against your own home, and keep that there for emergency in case of a margin call situation (probably more than enough to be able to fund the margin call on a young portfolio, as your portfolio gets bigger maybe you can increase the LOC).
Its just not a fair comparison to allow one asset class to borrow to the hilt, yet be quite conservative in another asset class, it doesnt allow property informed decisions. After making a reasonable comparison, then add provisos for risk management.

As an aside, most financial advisors I know about are not anywhere near wealthy, and would not invest in the majority of recommendations they give to their clients, so probably not the best idea to be leaning on these people for risk management advice. Remember that there are risks other than risks the market will crumble - what about the risk of waking up at 55 years old and realising you have no money to fund your future, and have taken no steps to help yourself in the last half a century.

 

Remember we already went through this a while ago? Check out http://www.invested.com.au/2/i-just-invested-equation-829/#post6170. I put up a spreadsheet to compare leverage. I could have been way off and it may be full of errors, but at least it was pretty.

Anyway, I think the important point missing is risk/volatility. You don't just get better returns for free; usually it's a risk-related premium above some sort of risk-free rate. If (I'm not saying it's true) property and equities both returned 12% and had the same transaction/tax costs, you would go for property immediately because it's a lot less risky on average (regardless of what Peter Spann says; remember he makes much more money from a 4% application fee on his funds than recommending you buy property).

But... this is a big but... transaction costs are much different and so is risk. You fork out maybe $20k on transaction costs for an average house, whereas a similar sized equities portfolio with margin loan gearing may cost less than $1k upfront. Then you have ongoing costs; land tax, vacancy, maintenance, body corp, etc, etc, etc.

I'm not saying I have the answers, but I think gearing is *almost* irrelevant to the fundamental decision because it only creates greater returns due to more risk; it doesn't change the fundamentals of the investment, just the utility from it. It’s a similar case with the interest rate available; in the same way gearing can add value, lower interest rates can. If you can get 6.5% on a home loan compared to 8.5% on a margin loan, then that has to come into the equation somewhere.

With all of that said, in terms of a passive investment, I think a lot of the decision has to come down to timing (contrary to what many people say). If you entered a portfolio representative of the ASX/200 at the worst possible time in the past 20 years, I’d imagine the annualised return would be much much much different to the market average. So much so it may have been better to be in fixed interest, residential property or whatever else. Conversely, if you bought in the top quartile of value in the past 20 years, you could be surpassing Buffett’s returns (until of course std deviation takes over and you regress to normal distribution). I think it only takes a reasonable amount of research to buy at a reasonably good time with a long-term view. Buffett does this by considering real economic value of investments and buying when value is good, as do many property developers. This idea of "time in the market is better than timing the market" is the catchcry of the mediocre investor…. I believe

 

I think it does depend of what you expect from your investments. For instance, I don't expect my investments to provide the income I need to live, I want my business provides all the income I need to live and grow the investments. So, I am using real estate and shares as a medium to keep my wealth. The basic idea is money from the business go to investments.

I strong believe that both, RE and shares, will growth in the long term, so I declare myself a mediocre investor. For me average returns are greats.

I don't know which one is better, I think they are just different. RE is great because its leverage and shares are great because it's the liquidity.

Just my opinion.

Cheers

 

Hey Dinky

Yeah, I think you're right. I re-read what I said and it didn't quite come out the right way; I too only need average returns to meet my goals. However, the point I was making was if you buy at the wrong time, you don't get average returns until a lot further down the track; maybe 25+ years. There are times in the history of property and shares where if you bought at the worst possible time, you could be on an average return of 0% 15 years later. Lots of people will disagree, but remember to take into account transaction costs, taxation, inflation, opportunity costs, etc.

Again, I'm with you on only needing average returns to build a good portfolio, but guaranteeing average returns means holding all stocks at all times with the right weights. That's basically impossible, so there is a serious possibility of doing much worse than average.

I think the same applies to your business as an investment (for the record I see business in the same context as equities and property). If you enter the market with the wrong product at the wrong time then you won't see average returns. I've seen this so often with my family's businesses (and my own). If your business is doing well, then although it may have not been a conscious decision, you've timed the market with some form of accuracy.

Anyway, it's not a big deal, I didn't mean to call anyone a mediocre investor, I was just hinting to what I believe are the consequences of not considering timing.

Later

 

One thing people sometimes forget is that investing is in many ways a zero-sum game. Any stock market index return is the average return of every dollar invested in that index. So for every person who outperforms the index by X% there is a someone underperforming the market. The same applies to property. Keeping that in mind, getting above average returns perhaps isn't as easy as people think.