Property Pariah

There’s a Ph D thesis going begging for anyone who can explain the deep social and cultural attachment Australians have for buying residential real estate. It must be cultural because in financial terms, it doesn’t quite add up.

The “click” you just heard might have been the many real estate-loving Eureka Report subscribers immediately closing this page, simply refusing to want to know. The Shares vs. Property battle is an old and messy one that is generally decided by individual prejudice more than facts '” especially when “facts” can be so flexible.

A prime example of that is a recent publication (click here) mentioned by Alan Kohler here a fortnight ago. It purports to show residential real estate is a better investment than shares on a “risk-weighted” basis. It’s no surprise that the research was commissioned by an investment company that’s in the business of persuading funds managers to back its shared equity mortgage scheme.

For more years than I care to remember, I’ve had a bottle of GIO Anniversary Port on offer for the first “independent expert report” that tells those paying for the report anything other than what they want to hear. NERA Economic Consulting, authors of the report commissioned by Rismark International, won’t be getting the bottle. (The GIO port is an apposite prize in view of the quality of the “expert” report done for GIO when AMP was taking it over '” it turned out to be a very expensive report indeed.)

The accompanying video interview with Motivated Money principal Peter Thornhill explores part of his prejudice in favour of a portfolio of industrial shares and against real estate. His interview last month on the short comings of fixed-interest versus shares received a good response from subscribers, but it will be interesting to see if his arguments against residential real estate are as willingly accepted.

Research, of course, is largely a matter of opinion and interpretation but, in my opinion, the NERA report isn’t worth much at all for retail investors. There might be a diversification argument for institutions, but the average individual is already very long property just by owning their house, let alone adding investment properties to the mix.

In reviewing research and checking its credibility, it only takes a few small doubts to undermine the whole case. This “NERA” report quickly provided doubts.

For a start, the basic numbers used are highly questionable. You have to go to the fine print of the footnotes, but the performance of equities is only measured by the All Ordinaries Accumulation index, which doesn’t account for the considerable benefits of franked dividends. (As you can see in video, Peter Thornhill thinks a more sensible comparison is just the industrial sector of the market, which leaves real estate in the shade.)

While equities miss out on the franking impact, NERA just uses gross rental and pre-transaction cost figures for real estate. That leaves out real estate’s very considerable transaction and maintenance costs, rates, insurance, body corporate fees and selling and leasing agents’ commissions.

Crikey! You still pay stamp duty on real estate investments, but not on shares. As plenty of property investors have discovered, all those costs can make a very large difference to the bottom line.

The All Ords and listed property trusts clearly outperformed the claimed residential real estate total return over the past 23 years '” 16.8% for shares, 15.2% for listed property trusts and 14.8% for residential real estate. Factor in the missing costs and the gap would be considerably larger. (The NERA report uses an average gross rental return of more than 6% cent for residential real estate in capital cities '¦ I wish I knew where I could find such properties today.)

As the NERA report suggests: “The results show that residential real estate’s total nominal returns have performed favourably compared to the total returns experienced by other asset classes. Indeed, total residential real estate returns exceeded those of all other major asset classes bar Australian equities and listed property trusts over the period.”

Er, sure, but there were only two other classes given: cash and 10-year bonds '” hardly a stretch. In reality, residential real estate came third out of five behind shares and listed property trusts.

Should I go on? Yes, let me. Aside from acts of omission, there appear to be factual errors in the report’s fine print that undermine confidence in it. On page six, it implies the Australian Bureau of Statistics forecasts that Australia’s population will grow to 26.365 million people in 2026, but if you take the effort to go to the quoted source ABS document, you’ll find that the bureau specifically doesn’t “forecast” any such thing, it just provides various projections of outcomes from a range of different possibilities. There’s a big difference.

The risk weighting is all about volatility; yes, share prices move more than housing prices. So what? For the long-term investor, that is ironed out by time. It’s something Peter Thornhill understands well. For the short-term investor, the residential real estate transaction costs are a formidable hurdle except during once-a-decade boom-times.

I wish I could believe the report as I am long residential real estate, including the inevitable investment unit, but I can’t. Any time you’re offered any report, overlook your own prejudices and first check on the aims of whoever commissioned the thing.

Michael Pascoe: We’ve spoken to you before (click here) about the dangers of holding money in cash as an investment. You’re also no fan of that great Australian love affair with bricks and mortar are you?

Peter Thornhill: From where I sit it is a huge waste of the productive capital of this country. Money is being sunk into monuments to bad taste. Industry in Australia goes begging for capital and a lot of the capital comes from foreign interests.

From the individual investor’s point of view, lots of Australians still like to be landlords.

Yes but I think that’s a mistake that people make. The comfort with property comes from familiarity, definitely not expertise. Everybody has a story to tell, a good one, about property but that’s a story from the past. It was largely inflation-related and is not going to be of any benefit to the current crop of would-be property investors. The sad thing is that many people believe that property is a far better investment than shares for all sorts of emotional reasons but I have three questions for them to consider:

• If you can make more money owning physical property than running a business why does anybody go into business?

• Second, if you could become a multi-millionaire by simply borrowing vast amounts of money and buying more and more residential property, why wasn’t Kerry Packer, Rupert Murdoch and every other corporate giant doing precisely that?

• Third, if I am to believe that property is a far better investment than shares it begs one question in my mind: is it not therefore irresponsible of the management of Australian companies investing shareholders’ funds in their businesses? Should they not be shutting their businesses down and buying residential property on behalf of shareholders? Let’s have Woolworths and Coles Myer close their supermarkets and buy residential property. Let’s have the banks close down their banking networks and buy residential property. In fact here’s a thought: why do the banks lend money to Joe Public to buy property? Why don’t the banks buy it themselves.

You’re not even very keen on property trusts, listed property trusts, and they’ve done very well over the past decade.

Listed property trusts have done well over the past decade. The comparison I find a little misleading is always with the All Ordinaries index. If you compare the Listed Property Trust index with the All Industrials index it’s not a patch on it because you have the resources pulling back the results of industrials to give you a very ordinary All Ords result. The other thing that’s important is if you compare the same chart as we had with term deposits and industrial shares, if you do the same with listed property trusts over the 25 years, they haven’t come within coo-ee of the industrials result.

One of the things that’s attractive is this yield argument yet again because you’ve always been able to get far higher yields out of listed property trusts than you’ve been able to get out of industrial shares, but if you look at the actual quantum of the dollars there is a huge gulf between the two. The reason listed property trusts do not show attractive yields is because the price performance of listed property trusts over 25 years is pretty pathetic.

Some listed property trusts, particularly the industrial property sector, had been offering high yields and done reasonably well on capital appreciation as well.

Yes, the comparison between the industrial shares and listed property trusts '” and I acknowledge the industrial sector of the property trust industry has done particularly well '” but the reason the yield on Listed Property Trusts is high is because the capital performance of property trusts generally is modest and when you divide that into again a modest income performance, you get a much higher yield. The problem with industrial shares is that both capital and income are performing very well, and when you divide one into the other you get the inevitable low yield but in dollar terms industrial shares have far outstripped listed property trusts over 25 years.

So you have no property trusts in your portfolio?

I have by default, as a shareholder in Westfield Holdings. I enjoyed owning the management company rather than the property, Westfield Trust. As a shareholder in Macquarie Goodman management, I enjoyed owning the management company and not Macquarie Goodman Industrial Property Trust. Regrettably, both those companies have stapled their securities. I now have the lead back in the saddlebags.

On the other hand a lot of individuals just feel more comfortable owning residential real estate instead of shares.

I acknowledge the comfort factor and a lot of that has to do with the fact that they can feel it, touch it, paint it, kiss it, pat it, and all the other disgusting things they do. The hard part is people feeling any sense of tangibility in relationship to shares. For some strange reason they don’t equate shopping in Coles or Woolworths with part-ownership of the supermarket or a bank and yet everybody does these things every day but for some reason there is no connection or tangibility as there is with property.

You don’t have too many upkeep costs on your share portfolio.

No, that’s very true. In fact, the upkeep costs are quite low. Costs of ownership of property are extremely high but people tend to turn a blind eye to it. Everybody has a good luck story with property and how they have “done well”. Whenever it arises, I toss my “done well”, or one of my “done well” stories back. Commonwealth Bank floated in 1991 and the first tranche was floated at $5.40 a share. The first full year’s dividend was 40¢, the last full year’s dividend was over $1.90.

Now the moral of the story pans out as follows: The dividends paid by Commonwealth Bank since the float have repaid the original purchase price of the share over three times. Second, the shares are now worth more than eight times the original purchase price. Now my question to property owners is: hands up those of you who have a residential investment property held from roughly 1990-91 that is now worth eight times the original purchase price, number one. Number two: the rent you have received has repaid the original purchase price of that property, in total, over three times fully franked; and, number three, you’ve not spent one dollar on your property since you’ve bought it in 1990.