Residential investment property is a sub-par way to grow your wealth – Part 2/2

Last week, I penned the first part of this wire on why residential real estate is nowhere near as good a growth investment as many investors think, and I highlighted there are three major, and often ignored, issues – the first is that costs are very rarely considered when talking financial returns.

That wire is here:

Property

Residential investment property is a sub-par way to grow your wealth – Part 1/2

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To be clear – everyone needs somewhere to live and where applicable, to raise their family. The point of this pair of wires is not to assert that investors shouldn’t buy a home to live in. It is that when investors have a marginal investment dollar, the Australian obsession with investing in residential real estate with that dollar will likely deliver a sub-par return relative to readily available options, and for many reasons. However, I’m highlighting what I think are the biggest three, and the first reason is costs.

Now to the second and third reasons.

Reason 2 - Liquidity

There are several different risks in all types of investments, but one “risk” dominates all “risks” in all investments - it’s the risk of losing value. But there are other risks, many of them in fact. In the world of residential real estate investment, often forgotten are interest rate risk, inflation risk (kind of linked), operating/management risk, Government policy risk, and maybe the dandy of them all, liquidity risk.

When you want to buy a piece of real estate, it often takes weeks or even months of research to find something you might want. Never mind that the selling campaign for that property takes at least a couple of weeks, and even if you buy it right after that, it’s often 30 days before the deal is done. Very best case, you’re up for 6 weeks but going through a 3-to-6 month process is not at all unusual. If you need to sell, remember that the same thing will happen – you’ll skip the research involved in buying a property, but you’re at least up for the campaign (which now includes prep, because you’re the seller), the sale, and then the settlement.

That’s going to be at least 2 months. At least. The point is, real estate transactions take a long time.

So, now you own a property. What if you need some cash, for any reason? Let’s say you need what would amount to 20% of the property value. You can’t sell a bedroom, or the garage.

All of what I just noted is liquidity risk. And the big problem with liquidity risk is that very often, people have applied one of two prices to liquidity - either zero, or a hundred….that’s it!! Almost always, you either don’t want or need the money at all, or you want or need the money right away with some urgency. Real estate of any kind does not even remotely cater for this eventuality. Your options are to refinance, which takes up significant time and resources, and regularly costs a lot in fees, or to sell, which takes a long time as I highlighted above. Again, you can’t sell a bedroom, or the garage. And even if you could, it won’t settle in a couple of days.

Huge problem….but there’s one more big one.

Reason 3 - Yield

In short, the yield is very often very low. Routinely, residential real estate is getting sold for investment purposes sometimes yielding in the 2s, likely in the 3s, rarely in the 4s. Remember, that’s in a world of 6%-plus mortgage rates, 5.4% inflation, 4.35% RBA cash rate, 4%-plus ASX 200 dividend yields, and 5%-plus TD rates. Part of the reason is that the assumed growth in the value of the property is built into the return profile. But also, Australia has a unique and expensive real estate market that means there are lots of investment dollars chasing not enough investment assets. Low yields are part of the mix, and have been for a long time.

Another input into how low the real yield is can be attributed to negative gearing. Introduced in the mid-80s, it was a massive benefit back then because the top tax rate was 60%, it kicked in at $35,000 of income (which is about $80,000 today), the prevailing RBA cash rate was around 12%, and these then-new reforms were quite comprehensive.

Since then though, the top tax rate has fallen to 45%, it kicks in at $180,000, interest rates are at 4.35% but have been well below that for a decade until a year ago, and there’s real risk that the provisions of negative gearing will be chipped away at, a little at least. That all adds up to negative gearing being significantly less financially beneficial than it used to be, take a look.

                                  Mid-80s        Now              Impact

Top Tax Rate            60%               45%               Smaller tax deduction

Income Level           $80,000*      $180,000     Less income getting that tax deduction

Interest Rates          12.00%           4.35%           Smaller interest deduction

* adjusted for inflation

But the allure of negative gearing has remained, and it is today a huge part of why many regular investors choose residential real estate as a growth investment vehicle. Whilst I’m aware that non-cash items are part of the puzzle (although you will have to replace the dishwasher at some point), it is amazing to me how often people forget that the only way you get a negative gearing “benefit” is by LOSING money. That’s the “negative” part. The way you lose money is that the income – the yield – is lower than the expenses. Another way to say that is, the yield is too low.

These three issues aside though, there is one unique benefit to investing in residential real estate that is offered at a level unrivalled by essentially any other asset class.

Leverage

Banks in Australia are very comfortable around 60% and 70% loan-to-value ratio (LVR) for an investment property. Leverage will enhance your returns by minimising the amount of your own capital you need to put into the asset you buy. This is the difference between ROI (return on investment), and ROE (return on equity). One measures the return on the total amount invested, ROI, and one measures the return on your piece of the amount invested, ROE. Without getting too complex, leverage will theoretically enhance your ROE but not impact your ROI.

But remember, you can do this with shares too. Most people think it’s way too risky but in that case, lever in at a lower level and voila – you’ll enhance your returns and now, residential real estate doesn’t even have the leverage advantage. Let’s look at a relatively conservative financial example. To be clear, I'm not advocating you do this - this is a direct comparison.

If you buy a piece of residential property and pay $1,000,000 for it but borrow $650,000, your equity is $350,000. We can now (crudely) calculate ROI and ROE.

Rent                  $55,000           assumption for $1,000,000 property

Value                $50,000           assume 5% per year average national growth

Agent Fee        ($2750)             assume 5% managing agent commission

Interest             ($35,750)          generous assumption of 6% interest rate

Stamp Duty     ($2500)            amortise over 20 years

Other                ($6000)           for insurance, utilities, rates, R&M

TOTAL              $58,000

The ROI is 5.80% and the ROE is 16.57%. That's not bad, right?

Now assume that I lever to just 50% (versus 65% for real estate) an all-US-equity portfolio of $1,000,000 that is 50-50 the Nasdaq and S&P 500 (see the chart above why I ignore Aussie equities in this situation). And given 2023 was so right-tail for US equity returns, let's use the 10 years to the end of 2022 as the base return data.

Income             $15,000             assumes 1% for Nasdaq and 2% for S&P 500

Value                $140,000           uses the historical annual returns noted above

Interest            ($40,000)           assumes 8% interest rate (versus 6% mortgage rate)

TOTAL             $115,000

The ROI is 11.50% and the ROE is 23.00%. Those numbers are significantly better than not bad.

I apologise to the real estate evangelists, however if you’re willing to take a similar style of risk you take in property (that is, leverage, although at a much lower LVR mind you), but instead take it in US shares, and if you’re willing to be just as diligent in paying off the debt, your long term return, apples-for-apples, is much better in liquid capital markets than it is in residential real estate.

And you’ve essentially eliminated all liquidity risk. Sounds pretty good to me….

Good luck out there.