Doing the property numbers

Record low interest rates and the continuing search for yield has many wondering (and worrying) if we are on the cusp of another boom in residential and small commercial property prices.

When it comes to asset allocation recommendations for individual investors, direct property especially sits strangely absent from recommendations about balancing between shares and bonds. Take for instance the lifecycle investment mantra that says “have your age in bonds”; it doesn’t even contemplate an allocation to property. This leaves many confused about whether they need an exposure to property, and if so how much?

Not knowing your mix of equity-like investments is a shame as it can be a shortcut for you and others to work out whether you are taking on too much or too little risk. Here I’ll answer whether you should count property as a bond or equity, or something else, and how you can think about it in your investment allocation.

Is property a bond or equity?

The answer is yes and neither.

Yes in that property has characteristics that are safe and “bond-like”. Like a bond (which includes deposits) it pays you a regular income, being rent. Because part of the return from property is uncertain price appreciation, it is also part equity. You expect that the property will rise in value, but you don’t know by how much and by when. You are speculating and taking a risk you expect to be rewarded for with above-bond returns. All kinds of tenant, market timing, concentration and tax risks also make it equity-like.

So yes property is actually part bond and part equity. They are similar to inflation-linked investments having income and capital growth components, which I wrote about in Inflation-friendly bonds. We’ll come back to this as these bonds, especially if bought also directly, are one alternative to direct property investing.

In order to collapse investment property into a convenient equity-bond mix framework you could count your property holding 50% bond-like and 50% equity-like. So if you have a $500,000 property, $200,000 in cash and $400,000 in shares you would calculate you are invested roughly 60% in equity-like investments (and conversely 40% in bonds, though the convention is to focus on the equity percentage). That is a “Balanced” mix, one notch less adventurous than the most common 70% “Growth” style adopted by large group super default funds. It is a style that might suit near or retiree investors who are slightly above average risk takers.

• Note for this estimate I recommend you exclude your family home and holiday properties as these are non-productive, lifestyle assets that you aren’t seeking to earn a return from – though some might later access their equity.  

Not all property investments are an equal and a “Moderate” 50/50 mix of bond and equity like characteristics. To more accurately work out your mix along the scale between safe and low-growth bond-like, and higher but uncertain growth-like investments, you could adjust a starting 50% equity mix assumption about your actual property holding(s) per the following.

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Think two-dimensionally

An alternate argument to force fitting property into a highly simplified trade-off between bonds and equities is to simply treat it separately. There is merit to this argument because property is driven by completely different fundamentals. Figure 2 shows how you might visualise the make-up of portfolios (i) equal in equity and bonds and (ii) equal in equity, bonds and property. In the one dimensional world these are hard to differentiate.

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Why property deserves to be treated as a different asset class

Property should be treated as a separate asset class because it behaves quite differently than equities and bonds and its return is driven by different factors. This is good. The below figure shows the average asset allocation for individuals and family investors, who don’t (symbol A) or do (symbol B) directly invest in property, and institutional super fund investors (symbol C). This is shown alongside the drivers of investment performance for each investment class. The closer each dot is to a corner the more the noted factors (in order of impact) drive their longer-term investment return. Feel free to place yourself in this area to work out what drives most of your overall investment return.

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An important observation about Australian property is how expensive and hence “lumpy” it becomes in one’s asset allocation. Owning it, or not directly, dominates asset allocation and therefore the investment returns of individual and families with investment balances below about $2-3 million.

You can see this in the the chart identifying the investment allocation of Australians who don’t (symbol A) and do (symbol B) own investment property directly, who are poles apart. This data is sourced from Wealth benchmarks (www.wealthbenchmarks.com.au), a database of slightly wealthier and active investors who are a good proxy for SMSF investors and Eureka Report readers. In this group, 60% of investors do not directly own investment property but 40% do. Of those who do, about 60% own only one property and about 20% each own two or more than two.

Investors who don’t own direct property directly (symbol A) instead get that exposure through listed and unlisted real estate investment trusts (REITs). In 2012, institutional super fund investors had on average 12% (http://researchbank.rmit.edu.au/view/rmit:21781) invested in this form of property. As not all retail investors invest in property trusts, the average proportion invested in property overall is less in this subgroup.

Not all property is the same

Direct and indirect property investors are usually investing in different things. Indirect investors earn the returns from a diversified holding of large commercial properties (retail shopping, office and industrial) through institutional investment trust holdings and often also own companies in the business of managing and developing property. Individual and family direct property investors are mainly investing in one or a limited number of residential properties and sometimes small commercial premises like a retail shop or warehouse.

These are different asset classes and perform differently. Commercial property returns are more likely to correlate with company profits given the overlapping tenancy (that is companies rent offices and industrial properties and own shops). Funds don’t passively invest in residential property because of poor after-tax and cost returns (including stamp duty, rates and painfully aggregated land tax). This is unfortunate as there is a ready market for some investors needing a divisible, unitised residential property holding.

Stockmarket listed REIT investors participate in a liquid divisible investment that they can enter and exit quickly and cheaply, but suffer greater price volatility. Unlisted and direct property investors enjoy a more perceived price stable investment but can’t access their funds easily and often without significant wind-up costs. Because of these differences sophisticated investors see merits in having an allocation to both of these fund types.

Property investors often use borrowed money hoping to enhance returns, and in the case of less wealthy individual investors to buy into property earlier or at all. The more money borrowed the more uncertain, or equity-like, returns become as well as the more sensitive one becomes to interest rates. As banks (and investors) are much more willing to lend against property and investors are more willing to use those borrowings to buy more property, many long-term investors have made more money from property investing than they would from shares ungeared.

By now you get that property investment allocation isn’t straightforward, which is perhaps why many investment theories struggle with recommending an ideal asset allocation or logic.

A recommended property allocation?

An age-old tradition suggests the ideal asset allocation is to have one-third of your wealth in property, one-third in equities and one-third in cash/bonds. More recently Dr Marc “Doom” Faber (http://www.marcfabernews.com/2013/06/marc-faber-these-are-my-asset-allocation.html) adds a fourth asset class, gold, to split your wealth 25% equally across. If you don’t agree with these or can’t allocate $500,000 or more to property directly, you need an alternate approach.

One way to answer this is to look at returns.

Over the very long term I expect and observe residential property prices especially to follow wage growth inflation (about 4-5% annually) and share prices to follow corporate earnings growth (about 6%). Add in net rent of 3-4% and mostly franked dividends of 5%, you might expect property investment (before gearing) to deliver about 8% annually versus 11% for shares. Owing to various factors including increased availability of debt and the move from single to multiple family incomes, property over the last few decades has delivered a higher return.

Regardless of your view, both expected returns beat those from low volatility cash and bonds. By the way, gold isn’t an investment; it’s an insurance policy for bad times – its return is highly speculative in the short term and inflation-matching only in the long term.

Given the higher expected returns from shares, in an ideal world then we would only invest in them as they offer the best prospects for making money over the long term. Since experience painfully teaches us we can’t rely on this even over a 10-year period or tolerate them during the interim, we need other asset classes in our portfolio to help us more reliably reach our goals.

Most need cash and bonds to dilute the wild volatility of equity returns, to sleep at night and stay invested and sometimes to pay the bills. Retirees especially need “bonds” to help pay a pension when the sharemarket retreats. Investors are willing to accept a lower overall portfolio return incorporating these lower yielding assets, though sometimes with rebalancing a diversified portfolio can outperform.

Weatherproofing your portfolio

Property offers another way to diversify and weatherproof your portfolio, and for a better return than from cash and bonds. Depending on the overall equity mix being targeted one might surmise then an average property allocation of as high as 20 – 40% would be reasonable in a multi-asset portfolio – the amount always less than your equity holdings. However it’s not this simple.

First, property investing comes with an important behavioural dimension. Some really love bricks (I left out mortar as it’s a myth anyone really loves that). These people often fear shares – so the only way they are going to grow their wealth is to follow their heart. These investors will have a portfolio often 80% or more in property and are happy to live with the risks concentrating their wealth. Others have the opposite view and don’t want the hassles of being a landlord, and don’t like auctions or agents. They won’t invest in property directly and need another solution.

For those wanting a diversified portfolio, at least two other characteristics complicate the asset allocation of property. The lumpy and indivisible nature of direct property also means that you can’t easily fine tune your allocation to it and certainly not buy or sell slices of it to keep your targeted portfolio allocation in balance. Direct property just comes along for the ride in a multi-sector portfolio.  

Its indivisibility along with the low after multiple-taxes yield also makes direct property allocation problematic for pension funding investors. At some point a direct property has to be sold to fully fund retirement, unless you don’t mind funding an overly generous inheritance and retiring on less.

Investing some monies in commercial property trusts is one strategy to top up or replace a direct property allocation, but because these assets are more equity-like, they aren’t a complete replacement.  

The high cost of property also means that property selection and buying and selling timing are critically important and a big source of risk (and reward). Shares and bonds can generally be acquired more progressively for better “temporal diversification”.

Lastly, property is an immovable asset and the government knows it. While there are incentives for investment like loss subsidisation (negative gearing), there is no other asset in Australia that is taxed by three levels of government and both on its asset value and income produced. In the recent WA state budget, even this prosperous state did not hesitate to increase land tax. Expect more to follow.

A property investment logic?

So what does all this mean?

• From an asset allocation perspective, property is an “ideal” asset to incorporate alongside equities and bonds given its different drivers of performance and low volatility … however it is not practical for everyone
• Unless you have a substantial investment portfolio, the purchase of a $500,000 to $1 million property however can easily dominate your returns and create concentration and property-market timing problems. It is also requires more management than a share and bond portfolio. 
• Some don’t mind this at all and load up, but others do and need an alternate solution 
• Investing in property funds can be used as part of that solution, but the amount invested in them should be less (say max 10-15%) given other baggage. To make up an intended allocation an investor could look to adding “property-like” investments such as infrastructure and inflation-linked bonds (direct versions of the latter more likely to match the low volatility of direct property). Or they could simply have more bonds and equities, which is common institutional and individual investor practice.   
• If you have a large multi-million-dollar portfolio you could target a more ideal property allocation of perhaps 20 to 40% built up using REITs and directly. Ideally you should own multiple properties of different types in different places – though you can still enjoy a great retirement without having any.  

For various reasons direct property is an optional asset class – for most their allocation is nil, for many others it averages as high as 80%, and for but a wealthy few it could be a more ideal allocation of about one-third. It’s up to you.

As to whether now is the right time to buy property, well that’s an even a harder question to answer.

Dr Douglas Turek is Managing Director of family wealth advisory and money management firm Professional Wealth [www.professionalwealth.com.au]