Many investors only invest in bricks and mortar, believing that, regardless of what else happens, they’ve still got the property. But history tells a different story, with underwhelming price performance in real terms and many pitfalls for this asset class.
The value of bricks and mortar goes up and down, like all other asset classes, and property values can fall, sometimes dramatically. Ultimately, many investors are comforted more by the perceived rather than the actual security of property values, and that is reinforced by the fact that, whilst the rise and fall of share prices might be reported on the nightly news, nobody values their property every day. Infrequent valuations tend to reinforce long-term thinking, which is of course very important to investing success. But intelligent investors focus more on facts than feelings, so let’s explore a few facts about property prices, and the risks involved in investing in real estate.
How has property performed over the long term?
According to a School of Economics Discussion Paper: 2010/18 prepared by the University of New South Wales Australian School of Business (now known as UNSW Business School), entitled “A History of Housing Prices in Australia 1880-2010”, since the early 1970s, house prices in Australia have risen on average by 3% per annum in real terms, i.e. after inflation. In the 70-odd year period from 1880 till the mid-1950s, there was negligible change in prices for houses in real terms, and periods when prices fell quite significantly. Then, from the mid-1950s, there was a change in direction, with house prices commencing an upward trajectory.
Taking 1955 as the turning point, over the 50 plus year period 1955-2009, the median house price for the All Capitals shows a rise in real terms of 3.6 times or 2.5% per annum. Over this period, Sydney prices rose about 2.7% per annum, while Melbourne prices rose about 1.8% per annum.
The bottom line is that the available academic research in Australia shows that over long periods of time, property prices rise by approximately 1% per annum over and above inflation, after adjusting for changes in the housing stock. Globally, this view is supported by research conducted in the US and Europe. In the US, Professor Robert Shiller of Yale University examined property prices from 1890 to 2004, and found that inflation-adjusted prices increased by only 0.4% per annum. A European study spanning over three centuries found inflation-adjusted returns to be only 0.2% per annum. What does all this mean? It means that in a portfolio context, you can reasonably expect that real estate will protect you from inflation over long periods of time—in other words, property maintains its value in real terms, which is a strong argument for including real estate in a diversified portfolio. The key lesson to take from this data, though, is that expectations of high growth rates for real estate are not supported by long-term data.
The last ten years
Whilst Australian residential investment property performed quite strongly over the ten year period ending 31 December 2015, producing a gross return of 8% per annum (Russell Investments 2016 Long-term Investing Report), it should be noted that some of the increase in property prices is due to renovations and other property improvements, and that this performance rode on the back of a resources boom, followed by a tailwind in the form of falling interest rates that is unlikely to be repeated in the foreseeable future. This falling interest rate environment increased affordability dramatically and allowed prices to rise significantly, but what does the future hold for property as interest rates start to rise? The important thing to consider is that real estate doesn’t exist in a vacuum. Periods of falling interest rates make assets such as real estate and bonds appear to offer better returns than they do if you take a “through-the-cycle” perspective.
Property has a few characteristics that keep prices grounded
It should be remembered that housing represents a depreciating asset sitting on a block of land. If the value of that depreciating asset approximates to its replacement cost, which in turn moves closely in line with general inflation, then house price movements are primarily a function of land. Apartment investors need to be very mindful of this.
Further, high acquisition and maintenance costs, as well as tenancy issues and poor liquidity, are a constant concern for property investors. This is particularly true for older investors who may require funds for medical emergencies, travel, or general living expenses. After all, it just isn’t possible to sell off a bedroom when you need some extra cash.
In October 2016, the Reserve Bank of Australia stated that about 16,000 apartments were expected to be completed in Melbourne over the next two years, 12,000 in Brisbane, and 10,000 in Sydney. This oversupply, coupled with the likelihood of increasing interest rates over the coming years (which will reduce affordability), will put downward pressure on house prices. And continuing requests to financial institutions by APRA to tighten lending to investors will see residential investment property struggle to produce significant real returns in the coming decade.
Investors need to be mindful that they may need to hold property for long periods at poor rates of return and increased vacancy rates, whilst enduring fairly insignificant increases in property values.
It should also be noted that negative gearing is a double-edged sword. What is real and certain is that when an investor negative gears, they take an immediate drop in salary, in the hope that the property value will increase over time to compensate them for accepting a lower salary. The income losses are definite, whilst the gains are uncertain.
Many investors have taken a huge reduction in salary through negative gearing, only to find the properties they have purchased have subsequently fallen significantly in value, which puts them in a difficult position – they cannot sell the properties, as the sale proceeds are insufficient to pay out the mortgage, so they must endure a poor lifestyle on a reduced income for many years, hoping for the properties to eventually increase in value. The hardest hit are older investors, nearing retirement, who have been lured into negative gearing on the basis that they will save tax. Whilst property is a useful inflation hedge, as most older investors already own a home, they should think carefully before increasing their asset allocation to include additional property investments. Ultimately, property has an important and valuable place in your asset allocation, but as with all things related to investing, maintaining prudence and balance is critical. This means not falling in love with a particular asset class, but simply recognising that every investment presents a range of possible future returns, and a set of risks that need to be managed within the context of a diversified portfolio.