Should I run with the herd on property and other growth assets?

This week, we'll tackle some questions from one of our members. The issues raised are ones we are all probably grappling with in a world dominated by politicians and central bankers.

Hi Guys

A macro question, and probably more property than shares oriented. Intuitively the idea of saving your pennies and investing them wisely (i.e. according to value investing principles) has always felt 'right' to me. I've been quite proud of my contrarian 'not running with the herd' streak, especially when it came to not taking on large amounts of debt to buy expensive property. I'm originally from Ireland so I've seen the damage this can do and benefited from not getting involved.

However of late I've started to think I'm the mug. It seems like anyone I know who's bought property (I haven't), especially 3 years ago has done extremely well for very little effort. In fact the more they borrowed the more they have been rewarded. Throw in negative gearing on top and it seems like the decks are stacked in favour of borrowers.

For the last 5 years and looking into the future, because personal debt levels are so high and governments are so dependent on consumption (especially via property) to generate growth, all I can see is savers being penalised and borrowers being rewarded through ultra-low interest rates and the inevitable asset appreciation that follows.

It would seem that for savers to be rewarded and borrowers to be penalised, we would need a huge recession. That is, a situation that will bring asset prices, especially residential property, down by about 40%. Even in the event of a China blowup, this seems unlikely. Bottom line, because borrowers (public and private) are such a large and favoured proportion of the population, it looks like savers will always get shafted.

Now, probably the worst thing I could do is chase assets (especially property) when they're already expensive but I'm starting to wonder if the rules of the game have changed and aggressive investors (borrowers) will be favoured over conservative investors for the foreseeable future? I already think (barring a huge recession) I've missed the boat on property but I'm wondering if in general I need to change my basic philosophy of only buying assets when they're 'cheap' because having a significant portion of my portfolio in cash/fixed interest (45%) waiting for asset prices to fall is starting to look like a fools game when the game's rigged (in Australia and even more so in US/Europe/Japan) in favour of borrowers.

These are very interesting points that will test anyone who's trying to stick to a sensible saving and investing path (myself included). Seth Klarman, founder of Baupost group, has been through this dilemma twice in the last decade (just recently and in 2004). His views make for great reading.


Let's look at the performance question first. There might be pockets of property that have done exceptionally but most people won't have done as well out of property over the last three to five years as shares.

Over the last five years STW (the ASX 200 tracking share ETF we have in our model portfolios) has returned about 12% a year. Some international funds, like Magellan Global Fund, are north of 15% over that period (the returns get even better over three years)

Median property prices on the other hand have gone up 6% per annum (according to the ABS index), perhaps giving you 9% per annum total with some generous net rental yield assumptions. Note though that those figures don't account for stamp duty, transaction costs like real estate agent fees and renovations.

Hot markets, like inner city Sydney and Melbourne, might have done better (the ABS says 9% for Sydney) but then the hot shares have done a lot better again. Even Telstra has almost doubled over the last five years (plus made substantial distributions).

The property obsession

I tend to think the main difference with property is that everyone talks about it. Plus we watch reality TV shows highlighting the exceptional results. You rarely see a TV show focusing on the property investors who've ended up with a strata fight, concrete cancer or termites. Nor do you see TV shows about the self-funded retiree who bought Telstra instalment warrants and cleaned up.

That's not meant to be an advertising campaign for shares but simply to point out that the last five years or so of extreme monetary policy (ultra low interest rates) have been a great time to own assets generally. Property is up, Australian shares are up, international shares are up and so are bonds. When interest rates are manipulated downwards it makes everything paying a half-decent return attractive in comparison. The benefit that the non-property assets had (and why they've provided better returns) is because they suffered a proper correction post-GFC (that is, they were cheap).

Of course, one thing property does have in its favour is our cultural obsession with it. At times it feels like the entire population has a negatively geared investment property and the recent Federal budget suggests subsidising property investors is more important to the Government than the age pension.

This national obsession creates buying pressure, which creates demand for an array of borrowing products that enable people to speculate with money they don't have (and won't have for another couple of decades), leading to more buying pressure. Government policies (both negative gearing and capital gains tax concessions) and banking regulations (banks get generous capital treatment of home loans) work towards feeding the beast and driving prices north.

Of course when things go bad, sheer number of voters speculating on property prices means the Government of the day is always going to have a strong incentive to subsidise them, or bail them out, at the expense of the savers. So I can certainly understand the doubts about trying to play it smart and at times it can feel like the Government and central bankers primary role in life is to try to screw over non-speculators.

But a few things I try to remind myself are:

1. Monetary policy is a blunt instrument. Property prices are absurdly expensive in most markets, which constrains their returns. But loose monetary policy also finds its way into the price of other assets, which often aren't as expensive. Telstra returned more than hot properties over the last five years because it was cheaper to start with. Investing in better value assets puts you on the same side as property speculators when it comes to the central bankers, but with lots more upside if things pan out. More importantly, better value means less downside if they don't.

2. How do you value a property?  Residential property valuations are nonsensical, like internet stocks in the late 90s and 2000s, Dutch tulips and the rest. An official property valuation is a comparison to other expensive properties. It seems to me that residential property (especially in capital cities) is a hybrid bet on a combination of factors including Chinese demand, immigration, supply constraints, banking regulation, monetary policy and taxpayer subsidies. I honestly don't know how you value such a bet, or how you assess your downside risk. Again, I think it's better to look for the things that are priced on fundamentals (like how much income they'll make you each year).

3. Property performance statistics are often rubbish. Our Aggressive Portfolio has returned about 15% over the last year and the median Sydney property about the same, with some rental income included. But the median Sydney property has council rates, repairs and maintenance, management fees and possibly also renovations and land tax. Plus, to buy it took a lot of running around to inspections and auctions and, to sell, a lot of preparation. The median Sydney property owner also paid stamp duty and transaction costs on the way in and a selling agent's fee (plus more transaction costs) on the way out. All these costs affect the actual returns people experience from property and it's only actual returns that you can spend.

4. It's a long game. One of the difficulties with investing is that the long-term timeframes involved are much greater than the 'long-term' we apply to our lives generally. Doing a university degree takes three to five years, many jobs last less than five years, yet investing requires you to have a decade plus horizon. Plus, the major events affecting our investments are unpredictable. The next financial crisis will happen, it's just a question of whether it's a year or two, or a decade, from now. The danger with following an overly aggressive path (especially when leverage is involved) is that you take the risk that a crisis wipes you out. Sensible investing eliminates that risk.

Emotional aspects of investing

I can't help but think Australian residential property is one of the greatest examples we'll see of the Fairstar principle. It's had so many wins (and publicity) over the last couple of decades (magnified by leverage into very large wins in some cases) that it starts to feel like that's the way it's destined to be.

But equilibrium only needs to be restored once and leveraged property investors (and probably all leveraged, overly aggressive investors for that matter) will be crushed. We saw in the United States that property prices can easily fall 20% in a property downturn, enough to wipe out the equity of many property owners.

Remember that our Government doesn't have the firepower to bail out the property market (and the banks) in a true property downturn, especially as a recession would probably occur at the same time (either because it's the cause, or as a result). Plus there's a limit to what they can do politically. The Government can reduce aged pensions to keep negative gearing, but I don't think they'd be able to cut the aged pension completely to introduce larger taxpayer subsidies of loss-making real estate.

As an investor, it's important that you're in a position to survive a recession. Many leveraged property investors won't.

The other emotional aspect that's tough for sensible investors (whether they're conservative, or sensibly aggressive) is that the 'winners' in the investment game are always going to be those who take the most risk, not those with the best strategy. So a sensible investor has to accept the proposition that they'll never be first.

To use a hypothetical example, imagine you're one of a group of one hundred investors. The other ninety nine are going to make leveraged investments in highly speculative ventures, but you've come up with an investment strategy that guarantees you'll have the tenth best returns, year in, year out.

Locking in that result, with such certainty, would require investing genius. But even as a genius, you'll never get the best results. Year in, year out, nine others (some of whose investments might be downright crazy) will beat you.

The trick here is that, at the start of the year, the genius knows he'll be in the top 10%. The others don't know if they're going to be number one, or broke, like the investors who come 70th through 100th.

The investors who take on the most risk will always be the ones you see at the extremes when it comes to performance. Think of it as the 'Nathan Tinkler principle'. Tinkler didn't get rich because he was a great investor (and that's not to say he was bad either). He grew rich by taking on massive amounts of risk and being one of the ones for whom it paid off (for a while, at least).

There's probably others who took on just as much risk at around the same time, who went broke. But we'll never hear about them.

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