When it comes to investing, it really is about understanding the numbers and managing the emotion.
What we look for when selecting a property for investment
The Role of Direct Property in an Investor’s Portfolio
We believe investments clearly should only be selected to become part of a client’s portfolio based upon clear investment principals including:
- the level of expected return
- the degree of risk and volatility
- the extent over time, to which the investment returns move up and down in the opposite direction to the remainder of the portfolio (also referred to as portfolio negative correlation)
- tax position
- capital growth outlook
- rental demographic suitability
- government infrastructure ie: transport hubs, road and rail upgrades & master plan integration, health care, permanent infrastructure ie: port facilities
- the required effect upon a family financial plan reflecting the client’s needs and expectations
- emergency and expected exit strategy
- protective plans to protect the income of the investor (and hence their tax position)
- estate planning to ensure the significant values involved are including in a person's estate plan.
Technical speak: Investments should be selected for their contribution to the risk and return profile of an investor’s overall investment portfolio, or in technical terms, the risk-adjusted return of a portfolio.
5 Key Identifiers of a successful direct property
We believe each investment must
- either increase the return without adding unexpected risk,
- reduce the risk without increasing the return, or
- a combination of both.
So the question is does direct property investment meet these criteria?
Here are five key identifiers of a Successful Direct Property Portfolio
- Over the last 20 years, geared residential property investment has provided an effective way to accumulate capital for retirement more than a direct investment in superannuation funds. This performance has been delivered even after accounting for the tax advantages of superannuation funds investing. Selection, when investing in a new property, is pivotal to its success.
- Residential property is about half as volatile as shares. Direct property investments should be held for the longer term, therein making the price fluctuation between purchase and sale less significant. In practice, risk in direct property investments is even lower.
- The returns from direct property and shares or fixed interest tends to move in the opposite direction. Thus, the addition of direct property into a share or fixed interest portfolio will also reduce the risk. Well selected direct property can form a significant component of most portfolios that have a prime exposure to equities of fixed interest.
- With the emergence of reverse mortgages as a retirement income and aged care accommodation bond solution, the previously ill-liquid property investment now provides an additional benefit not previously enjoyed as investors either borrow against the property to fund retirement income streams or to make non-deductible contributions in the new superannuation regime.
- With the emergence of reverse mortgages as a future retirement income solution and the new to the market establishing of equity pledges, where parents can pledge a specified amount of equity in a property, for their children or grandchildren to utilise as an equity deposit for their first home, interest in direct property investment is now more than ever a pivotal asset class in any quality investment portfolio.
Technical Talk about Investment Performance Summary
In comparing direct residential property with other investment asset classes, its consistent ten-year history remains as follows1:
- Housing investments are generally attractive with higher returns at relatively low risk.2.Only LPT’s come close with both these issues whilst treasury notes are less risky than most property and non-property investments.
The typical 10 Year Treasury bond will be most likely to under perform inflation, whilst the All Industrial Stocks are the most volatile.
- As the investment term increases, the risk reduces, and at the conclusion of approximately 10 years, there is usually only a small difference between the asset sectors in terms of risk and volatility.
- Over the last 10 years “An investment in Brisbane houses produced the highest gross real return (14.34%) whilst having the least chance of underperforming inflation (4.88%) making it very attractive. However, such investment is moderately volatile with a standard deviation of 6.36%.”
- Expenses have a major impact on housing investment as housing-related expenses are significantly higher than other investments.
- Taxation has a major impact on investments. However, it is impossible to determine the cost-benefit as it depends upon the tax rate of the investor. In general terms, the following should be noted in regards to taxation.
- The higher the taxation rate for the investor the more valuable the taxation benefits
- Direct property investment has more tax benefits than available for other investments. For example depreciation benefits.
- Owning your own home provides an investment free of capital gains tax and this is generally worth an amount in the order of 0.5% per annum in return.
- An investment in direct property will usually allow a higher level of gearing, and thus potentially has an ability to provide positive taxation benefits from the investment. This is largely brought about by rental income being fully set off against the holding costs of the property.
- A direct property investment will usually attract the benefit of capital gains tax indexation even when you are borrowing funds.
A leveraged investment in a portfolio consisting of industrial stocks will usually be more difficult to gain capital gains tax benefits from, as you are potentially seen as a trader in stocks and shares.
- In regards to our comments of industrial stocks in a portfolio, we make no allowance for franking credits on dividends.
Given the low-risk nature of direct property investment, it may be prudent to leverage an investment provided the net return from the investment is not lower than the cost of the mortgage funds. Leveraging will increase the return in these circumstances. An investment in one’s principle place of residence ie: the family home, has a positive advantage in that the owner will be able to borrow more funds using the house for security than using an investment secured by a portfolio of shares. This aspect has a tendency to close the gap between investment in an industrial stocks portfolio and a house.
Remember: All gearing (borrowing) increases risk.
Direct property investment should be a part of any investment portfolio as it has a slight tendency to perform in the opposite way at any particular time to other asset classes. This means when the stock market is booming, the housing market may be more stable or alternatively only showing modest rates of growth. Conversely, when the stock market is flat, there is a tendency for the housing market towards a boom period. Usually, the closer a property is to the centre of a favourable demographic the higher the cost of direct property investment and the higher the rate of return.
Direct property investment can be a useful low-risk investment provided a client is not inappropriately geared and that the choice of property suits there needs and objectives. Given the slight negative correlation with other asset sectors, it should be part of any well-balanced investment portfolio.
Caveat: When investing in high-rise apartments, their high expenses can diminish net return. Particular care should be taken to ensure investments in these subclasses are not made in areas with the potential for oversupply and an absence of an effective exit sales strategy.