Secrets of Wise Investing (Part 3)

AUTHOR: The Professional Trustee Team

POSTED: 29 August 2011

In this last part of the series of Secrets of Wise Investing, we are going to look at what type of investment delivers the highest returns. Is it paper or bricks and mortar?

A debate has raged for years as to what type of investment provides the best returns. The discussion is frequently fuelled by bias, data being skewed and mis-information.

If you asked Donald Trump and Warren Buffett what asset produces better returns, you can bet one of your last dollars Trump would say property and Buffett would cite shares. But remember, each of these men is an expert in their respective fields. For my part in this debate, I thought I'd show you both sides of the same coin. To give you a balanced view, I've held discussions with an Authorised Financial Adviser.

I've always held the view that over the long term, well located properties and shares provide about the same returns. Other people, however, think this isn't correct. Rather, they will point to graphs which show shares out do property in the long run. The proponents of this school of belief hold that if property did indeed out perform shares, companies would simply invest in property rather than making their own products because those companies would make more money from bricks and mortar than they would running their businesses. Interesting point to ponder.

Irrespective of what school of thought you subscribe to, comparing the returns does not just involve looking at data and forming an opinion. You need to consider risk, leverage and human behaviour.

When thinking about risk, I've historically believed and still believe good residential property is not as volatile as shares. As such, I don't think property is as susceptible to risk as what shares are. My reasoning for this view is several fold.

First, the property market comprises a mixture of individuals, being home owners and pure investors. Consequently, if a downturn in the residential property market occurred, only a portion of individuals (frequently investors) would leave the property market. Ultimately the people who stayed in the residential property market would enjoy a level of safety as to the value of their investment because the market wouldn't completely collapse. I don't believe the same can necessarily be said of the share market. Those in the share market camp, however, raise opposition to my belief. They correctly state two of the largest investors in the share market are superannuation funds and other companies. Super funds won't leave the share market. They are generally mandated to have funds in it. They also have a very long timeframe perspective, effectively forever, so they tend to hold onto their investments rather than exiting the market. Accordingly, share market advocates believe the prices of shares wouldn't plummet because super funds and other companies wouldn't exit the market if there was a down turn. This is undoubtedly a convincing perspective.

There is a second reason why I believe shares tend to be more susceptible to risk than property. When there is a downturn in the economy, investors often cash in their shares. Investors have no emotional tie to their shares, like people do to homes, so feel little compunction about cashing up. This selling off can have a negative effect on the price of the share. In other words, there is little safety netting in share prices and the share market unlike what I believe there is in property. Others would argue, however, that even if investors did exit the market, companies would buy other companies' shares if the share prices drops too much. Thus companies would replace private investors on the basis that it is easier, quicker and most importantly cheaper, for a company to buy a rival company rather than starting a new operation or expanding organically. In other words, there will be a buyer around to buy the shares, and hence there is somewhat of a safety break on the share price falling. There could be some merit in this argument as well.

The third reason I believe property is less volatile than shares is because individual companies (being the issuer of shares) can come and go. Housing, on the other hand, is an essential need for humans. As such, there will always be some demand for housing as a necessary economic good, whereas share investing is not an essential to sustaining human life.

Conversely, however, I know that companies are essential to sustaining human life. They employ people and produce the goods and services we need. Without companies, who would supply life's essentials? Who would pay people's wages? For example, the three absolute essentials (Maslow Hierarchical Pyramid of Needs) of life are food, clothing and shelter. Where would we buy our food from if Woolworths and Foodstuffs didn't exist? Where would we get our milk from if Fonterra wasn't around? Who would supply our clothing if Hallensteins, Glasson, Kathmandu, The Warehouse, etc weren't on the planet? Where would the raw materials to build our houses come from (e.g. cement, plasterboard and other building products) if Fletchers didn't exist? Who would run our phone services if Telecom and Vodafone didn't dominate our world space? And what about internet services? Can you even imagine a world without Microsoft and Google? Finally, where would our shops live if AMP and Westfield didn't build shopping malls for us to visit and buy life's essentials?

Yes I have to concede. Companies are essential to our living and as such, the share market is also essential because the share market enables capital to be raised by those companies which in turn, enables them to supply us with the daily goods and services we need to live a reasonably hassle free life. Without the share market and companies, we would be living off the land, leading a subsistence life. Impossible for this girl for sure. So maybe my argument the property market is absolutely essential for life and the share market isn't, might not be as water tight as I initially thought.

So what about leverage and human behaviour? Do these factors influence whether returns from property are better than those one can gain from investing in shares?

Turning our minds to leveraging, it seems that in this country at least, individuals are more comfortable with borrowing to purchase property than they are shares. Likewise, banks are more comfortable with lending on property and more reluctant to facilitate borrowings on shares.

As I've noted in Part I of this series, the magic of leveraging is all about borrowing money to increase the returns on your investment.

To demonstrate, let's assume you purchase a property for $100,000. You contribute $20,000 of your own money to the purchase price and you borrow the remaining $80,000. This means your debt to asset ratio is 80%. Within 7 years, the property has increased in value by 25% so it is now worth $125,000. This means you have made $25,000 on your initial investment of $20,000. Another way of looking at it is you've just made a 125% return on your initial capital investment. On the basis that you now have an asset now worth $125,000 and a liability (money owing to the bank) of $80,000 your debt to asset ratio has decreased down to 64%.

Taking this to the next level, at this point in time, if you are a property investor, you would approach the bank and request to borrow further funds to purchase another property and you would then start the process over again. However, remember you are in a much better starting position than you were previously. When you bought your first property, your debt to asset ratio was 80%. Now it's 64%. This means you have more equity when you approach the bank to fund your second property purchase. This increase in equity will mean the bank is more amenable to lending you the funds to complete this second property investment.

On the basis that you purchase correctly and structure your borrowing and tax right, you can continually increase your equity and investments via leveraging.

To take full advantage of this process, you should only ever put down a minimum amount of cash on a property and the property must be purchased at the right value and in the right location. You need to ensure you do not buy dubious property as this can destroy your returns and overall decrease the value of your investments.

So the secret wise property investors know is that leveraging is best to engage in when the property market is on the rise. They also only leverage on properties situated in areas which they are sure are going to increase in value and they build in their own safety nets.

Overall, leveraging is about investing very little of your own money, using other peoples money, knowing your market, enjoying price increases, clearing your borrowings and stashing your gold away.

To be fair, you need to be aware of the downsides to leveraging. This practice only works in a rising market. If the property market falls (as it has done in USA) and you have borrowed heavily, your debt to asset ratio will rise. You may also have difficulty in selling the property which means you can be left with no assets, large debts and migraine headaches. Lastly, you should remember that you need to have some cash in the bank in case your tenant walks out owing you rent or you lose your job. Loss of a tenant or your employment doesn't stop the bank demanding their monthly mortgage payments.

I also need to make a disclosure at this junction. My above examples and associated ratios, assume the rental income that would be received, would be equivalent to the rates, insurance, maintenance and mortgage interest that would be incurred. In other words, there is no net cash flow going outwards. This is not always the case.

Standing back and looking at the initial arguments, I don't think we've been able to establish property returns outperform the returns shares can and do deliver. Nor have we been able to determine shares outrun property.

What we have been able to identify, however, is that people feel more at ease borrowing to purchase property than they do shares. When we borrow to purchase property, we are no longer comparing apples with apples. Rather, we are comparing the returns an apple orchard can generate with one single tree. Clearly that's not fair because the bases that we are then computing the returns on, aren't exactly the same.

Overall, it's my personal view that a little of everything is a good thing. Stash some cash, buy some shares in strong companies, and purchase some property at sharp prices, with the fundamentals of real estate in mind. That way, all bases are covered.

Regardless of what vehicle you use to build your wealth, one thing's for sure – investing takes time and patience. It involves well thought out goals and strategies and a diligent pursuit of financial objectives. It starts with obtaining great advice and carefully constructing a money plan. At GRA we can help you with a property plan and setting up the right structures for your investments.

Until I meet you, I wish you short spendings and long earnings as the Russian Money Barons say.