Is residential property the best investment?

Written by multiforte on . Posted in News

Many people love the idea of residential property as an investment. They like the tangibility of bricks and mortar, they often get excited by tax savings from negative gearing, and they are fuelled by stories of windfall financial gains from family and friends or the media.

The reality is that some people have historically done well by investing in residential property – which had its heyday in the 80s and 90s delivering average gross returns of more than 10% pa.

Did you know that residential property returns for the last 10 years (to 31 December 2012) were just 6.5% pa1? And with consideration for costs, less than 5% pa?

As you can see from the chart below, Australian residential property underperformed Australian shares, International shares and International fixed interest in this period.

Asset class returns for the 10 years to December 2012

Asset class performance

Source: ASX/Russell Investments, “Long Term Investing Report” June 2013

The outlook going forward is likely to be equally subdued.

If you own investment property – or are considering investing in residential property – here are key insights on the drivers of residential property and factors you need to consider in deciding whether to buy, hold or sell.

According to property expert, Dimitra Voutas of Advance Asset Management, the first thing to understand is the dynamics of supply and demand.

The supply side is mainly concerned with new home and unit construction but can also be affected by home ownership rates, demographic changes and loan default rates.

On the demand side, there are 5 fundamental drivers, according to Ms Voutas:

1. The economy – unemployment, wage increases, business investment and consumer confidence in the economy have arguably the greatest effect on the market.
2. Interest rates – lower interest rates reduce borrowing costs and make rental yields more attractive relative to cash.
3. Government incentives – for example the first home buyers grant and stamp duty discounts have an important bearing on affordability
4. Demographics – population growth, age and net migration affect demand over the long term.
5. Affordability – generally measured by price compared to income
On the basis of these fundamental factors, Ms Voutas says the outlook for residential property is subdued with expectations of small, incremental price improvements over the next 12-24 months.

“On the economic front, many people have been scarred by the global financial crisis and remain cautious on the economy and their future employment prospects, so they are tending to pay off their mortgages rather than seek investment opportunities,” she says.

The level of household saving has risen to its highest point in 25 years2 and household debt in Australia remains very high at around 147% of income3 so many people have reached the limits of their ability to borrow.

“At the same time, the cooling off in the mining sector has driven up vacancy rates and cooled demand for new houses in states such as WA,” Ms Voutas says.

“Interest rates are at record lows but are yet to translate to increases in demand or the willingness of small business to invest. On top of that, government incentives have been wound back in recent years and our population is ageing.”

Australia also remains one of the least affordable in the developed world, according to a survey by Demographia4. It has the third highest median home price to household income of the seven countries surveyed with a multiple of 6.5 times income. According to the report, the international norm is closer to 3 times household income. This creates a natural cap on price appreciation – significant price rises can’t be sustained because they are simply not affordable.

These factors help explain why the overall return from residential property has generally been subdued in recent years. According to RP Data, the median house price in Australia has risen only 10% in the past five years. Gross rental yields averaging about 4% over the period, which means overall return is less than 5% per annum, once property costs have been taken into account5.

That is just the median figure. There has also been significant variation between states as you can see in the chart below. For example, while Perth recorded average annual growth of around 10% in the past 10 years – thanks to the boom in mining exports and subsequent employment growth – Sydney’s median house price rose only about 4% per annum over the same 10-year period.

Median house price capital cities (2002 – 2012)

House prices

Source: Australian Bureau of Statistics (ABS)

Growth prospects aside, the biggest drawback for residential property is the size of the outlay required to secure the investment and the amount of capital tied up in a single asset holding. This adds risks to a portfolio due to lack of diversification, potentially high leverage and lack of liquidity.

 

1. ASX/Russell investments, “Long Term Investing Report”, July 2013. International equity and fixed interest returns are currency hedged.

2. Source: Australian Bureau of Statistics (ABS)

3. Source: Reserve Bank of Australia (RBA)

4. Demographia “9th Annual Demographia International Housing Affordability Survey: 2013”

5. Tim Lawless “The destruction and gradual reconstruction of rental yields in Australia” RP Data, 7 June 2013

With thanks to BT Financial Group for source information for this article.