Residential property – safe as houses?

Australians love investing in residential property. In fact, many use it as the backbone of their retirement income strategy, viewing it as a relatively low risk investment with the potential for impressive gains. Just look at the price increases over the last 10 years. But what about the future?

In this Q&A, Tom Threlfall, an investment specialist from Perpetual Private, takes the emotion out of residential property and analyses the fundamentals as he would a stock.

Why do you think Australians have such a love affair with residential property?

'As safe as houses’ is the expression that comes to mind. There’s a strong narrative in Australia about the importance of buying a home rather than renting and ‘paying off someone else’s mortgage’. This psychology underpins Australians’ love affair with property. And of course the property price increases over the last decade have validated this view for many—particularly, if you live in Sydney or Melbourne.

From an investment perspective, I think Australians feel comfortable with residential property as an asset class. More so than they do with other forms of investment, like sharemarkets. It stands to reason because people live in homes and keep an eye on property prices. They think they know how much residential property is 'worth'.

What makes a successful family home purchase versus an investment property?

This is a very important distinction and one that is often blurred. You buy a home to live in so the success of your purchase is largely based on lifestyle factors. Is the house big enough for your family? What schools are in the area? How will you get to work? From a financial perspective, I think a key measure of success is how long you live in your home because this reduces a very real enemy in the property market - repeatedly paying stamp duty.

When you buy an investment property, you need to ask a different series of questions:

• What is the potential for future capital appreciation? (investment property price going up)
• What is the potential yield? (the amount of rental income, less all expenses: land taxes, maintenance, agent fees etc.)
• What level of mortgage could I comfortably afford when rates go up?
• How will the investment property fit within a broader portfolio? (and importantly will it diversify risk?)
• Has the illiquidity of the investment property been factored in? (It is easy to sell a portion of an investment portfolio but it is very hard to sell just one room of a house)

Property is such a tangible and seemingly familiar asset class that people often invest on ‘gut feel’ and an assumption that the trends of the past will continue in the future. Residential property investors are less likely to seek the level of financial advice they would when investing in other areas, like the sharemarket. It’s a risky scenario in my view.

What do you say to people who ask about investing in residential property?

I start by posing two questions:

1. Do low interest rates promote growth in residential house prices?

   Yes, more people borrow in a low interest environment which increases demand for residential property and inflates prices.

2. Are interest rates near the bottom of the current cycle?

Yes, they are at historic lows.

These two questions are a useful starting point for a discussion about residential property. It is not about ‘timing’ interest rates or property cycles, but rather appreciating how they drive prices and recognising they are currently at record lows and how few people consider this as a risk.

If you analysed the property market as you would a company on the sharemarket, where would you see the risks to capital growth?

Let’s say all of the residential property in Sydney was represented by one stock on the ASX. Let’s call it RESY. Contrary to popular belief, historically strong RESY price gains are not reliable predictors of future growth. In fact, the more the price of an asset goes up, the lower the expected return, all else being equal.

The huge RESY price gains in Australia from the mid-1990s to the mid-2000s were a result of two mostly non-repeatable factors:

Financial deregulation which started in the 1980s, increasing household access to finance

Inflation targeting by the RBA starting in the 1990s, which has brought down inflation and also the cost of borrowing money

What did investors use their increased borrowing capacity for? You guessed it, buying residential property. And since the Global Financial Crisis, low interest rates have seen people continuing to fund residential property purchases. The worrying aspect in all of this is that low interest rates have underpinned the continuing growth of the residential property market, not an increase in household income.

Looking at our stock RESY again, the outlook for the stock to continue to go up will depend on two main factors – wage growth and the cost (and availability) of borrowing money. When we compare long term return data from the US and UK, their property markets suggest we should be more moderate in our expectations of future growth in residential property. Between 2.5–4% pa or 0–1.5% in real (after inflation) terms.

The two most obvious counter arguments are there’s a limited supply of property in Australia and offshore buyers have been driving demand in the absence of significant wages growth.

So let’s get back to an investment mindset when we look at the future of RESY. Given the recent rapid price appreciation and stretched valuations of RESY, the investment case would revolve around limited supply and demand from offshore buyers. Both of these are fickle, impossible to measure and certainly not reliable.

Investment properties also generate a rental return – just like a yield from shares. What factors determine the real value of rental return?

On the positive side, investment properties generate a rental return and have a significant tax offset. The current gross rental yield in Sydney is around 3.1%, but this is more than halved after land taxes, maintenance and debt costs. And don’t forget the likelihood of periods of rental vacancy. By comparison, the current yield on the ASX is close to 4%, without the cost of land taxes, debt and repairs.

Then there is (il)liquidity – when times are good all property feels easy to transact, we all read about houses selling in a matter of days. But when the residential property market is not so hot, shares are far easier to sell than bricks and mortar.

How should people think of residential property in the context of their broader investment policy?

The best way to lower risk in portfolios is through diversification. Given residential property is the largest asset that most people own, it is important to think in a whole portfolio context. You don’t want all of your eggs in the residential property market, just as you wouldn’t for any other asset class. The obvious answer is to look at other investment options like the sharemarket. But you can also invest in real estate outside the residential market through investment vehicles like real estate investment trusts (REITs).

A REIT is a company that owns and often operates income-producing real estate like office buildings, hospitals, shopping centres and hotels. My clients can’t walk off the street and invest directly in these sorts of assets, but they can by investing in the REITs that own them. This is just one way we help people to diversify their real estate investments across Australian and global markets.