Property versus Shares, using a Perth Example
6 October, 2016
There would be tens of thousands of Western Australians sitting on huge capital losses in the Perth property market, in all sectors – residential homes, apartments and commercial property. But most people will never admit it to themselves, thinking that if they hold on to the property long enough, then they will be able to sell it at a profit eventually. That is true, but at what opportunity cost? In the real life example I have shown below someone who invested in an inner city 3x3x2 apartment 6 years ago, could have had almost twice the value, and twice the income, had they just invested in our best known bank.
Best Place to Invest Long Term
I often get questioned about investing at social events. It is a topic I had to avoid when I was a licensed Securities Dealer and practising Certified Financial Planner. It would be unprofessional to give any advice without knowing a person’s complete financial and taxation picture. Something which is usually built up during a lengthy consultation, not a chat at a barbecue. I would usually get by with a general comment like “if you are investing for the long term, then it is a truism that on average shares will outperform property, and property will outperform fixed interest investments and cash deposits.”
Later I would sometimes hear that they had invested in a property, justifying to themselves that property values don’t go up and down like shares, and you always have the rental income coming in. Or that they were too nervous to invest in shares or found it too complicated.
Note that when I talk of investing in shares or property or fixed interest, the ‘on average’ rule applies, whether you get a good spread of investments by investing directly, or by investing via managed funds. Of course individual investments can disprove the ‘on average’ rule. For instance if you invested in just one property, or just one company’s shares. The company you chose could go broke and the shares would be worthless, whereas, you’d still have the property regardless of the market conditions.
The reason that the investment return relationship I mentioned has to be a truism on average can be understood if you consider a bank.
A depositor places money with the bank, and is paid a certain rate of interest on that deposit. The bank may lend that money to a corporation to expand their business. That corporation has to achieve a higher rate of return on that money employed, than the interest it pays to the bank, otherwise there is no point. Of course the bank is charging a much higher interest than it is paying the depositors so that they can make a profit too.
If you check many corporations’ books you will find they are leasing their business premises. For instance Wesfarmers does not own the buildings in which their Bunnings or Coles stores operate. The Commonwealth bank does not own many of the buildings from which their branches operate. Most are in shopping centres owned by large property managers like Westfield. Wesfarmers, and The Commonwealth Bank know they can get a higher return on their capital by investing in their operations, not their premises.
Commercial property values rise and fall in value based on the demand for space from tenants — that is businesses. So businesses have to perform well, for commercial property to perform well. Businesses have to get a better return on their investment than the cost of leasing the premises from which they operate, otherwise they may as well close their doors.
If the economy or a market sector declines, then a company’s share price will fall because their profit expectations will be lower. Investors will sell those shares looking to invest elsewhere. Eventually the value of commercial property will follow suit because there will be less demand for space and therefore lower rental income.
Impact on Perth market
In June it was reported that, The downturn in the mining industry has been blamed for a 23-year high in the office vacancy rate in Perth.
A report by forecasting firm BIS Shrapnel has revealed 22 per cent of office space in the central business district is empty.
That is the highest vacancy rate since 1993.
Rents have also collapsed, falling by more than 40 per cent since the peak of demand for office space in 2012.
BIS Shrapnel commercial property project manager Lee Walker said the vacancy rate had not peaked and the downturn had at least two more years to run.
The downturn in the resource sector was reflected in the share prices of resource companies and ancillary businesses. If the resource sector turns around, the first sign will be their rising share prices, followed slowly by rising commercial property values.
Where does residential property fit into the scheme of things?
If the economy is doing well, businesses employ more people, salaries rise, and as happened with the WA resource boom, we attracted tens of thousands of workers and their families to move to Perth for the high paying jobs. Since the amount of available residential property can’t be dramatically increased overnight, property prices went up as people were prepared to pay more for what was available. And everyone had a positive outlook about their future financial position.
In Perth the increase in apartments prices was particularly noticeable because there was a strong demand not just from young well paid and generally childless professionals who wanted the benefits of inner city living; there was a growing number of baby boomers who were retiring and downsizing from their suburban blocks, to a more convenient lock-it and leave-it type property which requires less maintenance.
The only thing which stopped apartment prices growing substantially quicker than suburban properties is that apartment complexes could release up to two hundred residences in one hit off-the-plan, to be completed within a couple of years or so. And there was always a long list of future developments planned. Whereas it is much more difficult to increase the number of residences available in established suburbs because most councils do not allow multi-storey properties. This is why property prices at the lower and mid-level price ranges in established suburbs have held up a bit better than expanding outer suburbs, where more new builds are coming online.
Understanding Real Property Growth Rates
Never trust the real estate industry’s reported capital growth figures because they are statistically flawed and virtually meaningless.
They only measure the change in the median price of properties sold. Properties which can’t sell, or don’t sell because they can only attract offers below the asking price aren’t accounted for. It is also simply recording the change in the median sale price of properties successfully sold.
Their reports also don’t account for stamp duty, settlement fees, agent’s selling fees and importantly upgrade and renovation costs. It is the rule, rather than the exception that a property owner spends money on the property between buying and selling, more than just maintenance. For instance kitchen and bathroom upgrades, landscaping, extensions, and so on. All of this extra investment is not accounted for in the real estate industry growth figures. Imagine a property which is purchased at a selling price of $500,000 and sold for $700,000 5 years later. As far as the real estate industry statisticians are concerned that has achieved a capital growth of 40% over 5 years or 6.96% pa over 5 years.
But purchase costs such as stamp duty and settlement would have been about $20,198 which would add to the ‘investment’ cost. Well negotiated agent’s selling fees and settlement costs would come to about $18,906 which comes off the sales receipts. What if immediately after purchase the owners installed reticulation, re-did the lawn and landscaping, renovated the two bathrooms, and the kitchen, and they did a lot of the labour themselves so while that should be costed in to the investment it isn’t. So those costs were able to be kept down to a total of say $55,000.
The original investment cost becomes: $500,000 + $20,198 + $55,000 = $575,198 The net selling receipts become: $700,000 – $18,906 = $681,094 This is a more modest 18.41% growth over 5 years or 3.44% pa.
So you see in this fictional example the average annual capital growth rate that the real estate industry implies, (using median sale prices), is more than halved from 6.96% pa to just 3.44% pa. If investors were more aware of this, and understood that the property does not always ‘go up’, in fact it declines, as a trailing indicator to the economy and share prices, they might be more circumspect about investing in property.
Before I go on, remember I am talking in generalities. There are always exceptions. Any area experiencing a high population growth rate will have a better performing property market for that period. Indeed, because of immigration, Australia has had the highest population growth rate in the last 30 years than any other developed country. This is why our property market has performed better than other countries.
Indeed former Minister for Foreign Affairs Bob Carr said in February that Australia’s ‘breakneck’ population growth is flooding major cities and putting huge pressure on house prices. We’ve got a third-world style population growth rate and I think the Australian people need to be alerted to this.
‘There’s a case for pegging immigration back by easily a third, perhaps 50 per cent. ‘We are going for breakneck population growth and it’s all about supply and demand. ‘The former NSW premier said Australia’s growth rate outstripped Indonesia’s and was the highest of any developed country.
It is this artificial growth rate which has supported property prices on Australia’s Eastern seaboard, particularly in the affluent suburbs of Sydney where wealthy Asian business immigrants are competing for the most prestigious homes.
So what has happened in the Perth apartment market?
I believe the following real life example is typical of what Perth apartment buyers have experienced over the past six years. The picture is potentially worse if someone purchased at the peak of the apartment market in 2007.
So let’s have a look at how two investors may have fared making an investment decision at about this time 6 years ago in Perth.
The Apartment Investor
Today I received notice of an apartment which has just gone on the market at 10/153 Kensington Street East Perth WA 6004. The property is advertised at ‘offers above $580,000’.
I can see from here that on average it takes 72 days to sell a property in Perth and they are currently selling at an average 6.8% discount to the asking price. Of course as explained earlier, this data tells us nothing about properties which are on the market for much longer and are eventually withdrawn from the market unsold because the sellers can’t get what they want.
If this East Perth property sold for a 6.8% discount on $580,000, that would be a discount of $39,440 or a selling price of $540,560. But as the asking price is from $580,000, I will be really optimistic and assume the sellers are able to achieve $570,000, which I think unlikely, but I don’t want to be accused of showing an overly pessimistic example.
From here we can learn that the property last sold on 19 October 2010 for $625,000. From a purchase price of $625,000 6 years ago to a hoped for sale price of $570,000 today looks bad enough, but the real picture is as follows:
Purchase price 19/10/2010 $625,000 Stamp duty and settlement costs $ 26,506 Total Purchase Price $651,506
Sale price 19/10/2016 $570,000 Agent’s commission and settlement fees $ 15,576 Net sales proceeds to investor $554,424
This equates to a loss of -14.9% over 6 years or -2.65% pa. If the property was rented (currently there is a record 6.7% vacancy rate on all properties, closer to 10% on apartments, it would fetch about $400 pw net or $20,800 pa.
The Share Investor
Let’s say this investor took a similar risk and put all their $651,506 in one share and being unsophisticated just chose Australia’s biggest bank the Commonwealth bank (CBA).
CBA Share price at 19/10/2010 $51.10 the lowest price CBA hit in the last 6 years was $43.33 on 23/09/2011 a fall of -15.2%. Less than 12 months into the investment this investor might have been a bit nervous while the investor with the apartment might have thought they made the right decision.
Today, 5/10/2016 the CBA share price is $73.59 which is a 44.01% increase on the purchase price 6 years ago and an average annual growth rate of 6.27%pa which doesn’t sound spectacular, but it has clearly outperformed the apartment and bank interest rates. But it also has a current dividend yield of 5.71% and that is fully franked, which means that the investor gets a credit for the company tax of 30% already paid before the dividend distribution. What this means is that the CBA share investor would have shares worth $938,233.99, and providing dividends of about $53,577.16pa or $1,030,25 pw largely tax paid.
This is $383,809.79 in capital, plus $630.25 pw in income, more than the poor apartment investor, in just 6 years!
Capital Gains Tax: Note if sold the shares would attract some brokerage, but online brokers do it for a fraction of a percent or a flat fee. Capital gains tax would also be payable on the capital gain. In an individual’s hands only 50% of the gain is taxed at their top marginal tax rate. In this case that would be 45% plus 2% Medicare levy and 2% Budget Repair Levy, for a total of 49% on 50% of the gain, i.e. 24.5% on the total gain = CGT of $94,033.40. That still leave a net after tax of $289,776.39 compared to the apartment investor.
But why would this unsophisticated investor sell down their CBA shares when they have done well over a difficult period, and are producing good income returns? If the resource sector starts to outperform, so will the share price and eventually the property prices. Simple rules to making huge differences to investment returns.