SMSFundamentals | Oct 26 2011
(This story was originally published on 13 October, 2011. It has now been re-published to make it available to non-paying members at FNArena and to readers elsewhere).
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By Greg Peel
Property analysts and property fund managers always like to pull out a particular chart which they use as their argument for superior returns available to the longer term investor in the property market. In simple terms, it compares the past ten-year or more return on property, stocks, fixed interest and cash. The reason property people like this chart is because it usually shows property investment as the winner.
The team at ANZ Research has also prepared such a chart, setting its base at the beginning of 1987. The chart compares returns on commercial property, residential property, the ASX 200 (accumulated for dividends), government bonds and term deposits. The chart appears shortly in this article but I won't unveil it yet, because ANZ Research has only produced it as a means of comparison. Not comparison between asset classes in this case, but comparison between what is for the most part a misleading chart and the chart investors really should be looking at if they are going to arrive at a realistic conclusion about the past performance of different asset classes.
One of the problems with the first chart is that it lumps in both owner-occupied and investment property under the same “residential property” banner. Yet as we well know, there are significantly different investment implications for each from the perspective of loan cost, tax and tax deductions. Realistically, owner-occupied housing (OOH) and residential investment property should be treated as two different asset classes for comparison purposes.
Indeed, as soon as we open up the Pandora's Box of costs and taxes, we realise that every asset class is very different, thus rendering an “apples to apples” chart more of a fruit salad. On that basis, ANZ Research decided to undertake a far more comprehensive exercise and thus produce a far more “apples to apples” set of results.
The initial, simple chart ignores debt, transaction or maintenance costs or taxes. Nor does it assume cashflows from any asset are reinvested. The problem here is that you can't reinvest rent from an investment property by buying a little bit more of the same property, whereas you can reinvest dividends from stocks, for example, by buying a bit more of the stock. So instead, ANZ takes any cashflows and sticks them in an accruing term deposit. Hence “total return” comparisons can be more realistic.
For its more complex chart, ANZ maintains the same reinvestment model but now takes account of that which the simple chart does not. The analysts have accounted for maintenance costs, stamp duty and agent's fees as realistically as possible. They have included tax effects using a marginal income tax rate of 45%, and have included capital gains tax.
Whereas such changes render OOH and residential investment property now quite different, residential investment property and commercial investment property are otherwise equivalent with the exception of maintenance costs. Simple chart assessments of commercial property always assume a level of maintenance costs whereas assessments of residential do not.
ANZ has assumed a 50% level of gearing for all assets other than government bonds and term deposits. Interest costs are then taken into account and the deductability of interest costs likewise, thus to allow for negative gearing. Cashflows from property and equity investments are first used in the model to pay off debt before they are placed into the aforementioned term deposit. The analysts have not made any allowance for enhanced property value from any renovations or improvements. That's getting just too esoteric.
So thus I can now unveil two charts for easy comparison. The first is ANZ's equivalent of the simple chart many of you would have seen before in some form. The second is ANZ's more complex and thus more realistic chart, taken all noted above into consideration:
So what can we see?
Firstly, the first chart has five lines and the second has six. In the first chart, the winning brown line represents “residential property” as both OOH and investor. The same brown line in the second chart is OOH only. Given the second brown line reaches to 1700 (return index from common base) to the first brown line's 1200, we can see that OOH has proven a much better investment than residential investment property when we include all the costs and taxes.
Such a conclusion is hardly knock-me-down-with-a-feather stuff. Australian government fiscal policy has always supported home ownership as an investment. On that basis, we can separate OOH from all other investments and let's face it, the decision to buy a property to live in is a very different one from the decision as to where to invest super or other funds, even though we might include our house as part of our super portfolio. We would not, for example, decide stocks look more attractive as an investment and thus forsake a roof over our heads. We may, however, decide stocks look like a better place to invest super than investment property.
On that basis we note that the darker blue line on the second chart represents residential investment, and that even without the boost provided from OOH included in the first chart, this line still beats the orange ASX 200 line. But also note that in both graphs, the orange line arrives roughly at the same price of around 800. This is important when we consider the remaining three lines, or asset classes, of commercial property, government bonds and term deposits. In the first graph their returns all reach 400-600 but in the second graph they are clumped within 200-300 only.
This tells us that the “risk” asset classes of stocks and property have provided superior returns to the “safe haven” classes of bonds and cash.
Commercial property has been a disappointment. If you break commercial property down into its constituents of retail, industrial and office, retail has performed a lot better than the other two over the period, with office the dowdiest performer.
There are two obvious points we can bring up here. One is that we would surely expect “risk” assets to provide greater reward than “safe haven” assets over time, or otherwise what is the point of the risk? The other is that we are looking at a particular period of time. We know that the biggest victim of the 1990s recession, which is captured in these graphs, was commercial property. We know the period 2004-07 brought booms in both residential property and stocks providing annual returns that may not be seen again for a while.
Let's take the first point first. As an accompaniment to the above return graphs, ANZ Research has also compared the risk of each asset class over the period using what is known as a “value at risk” (VaR) measurement. It's a complicated statistical measurement, but let's just say it takes account of volatility over the period. The ultimate returns reached by each of the asset classes on these graphs obviously required the investor to hang in there no matter how rough the ride, whereas in reality we may have either panicked, or gone bankrupt, or been forced to dump risk assets for the sake of raising required cash at any time during the period.
No prizes for guessing which asset class has the highest VaR – we need only look for the wobbliest line. That's the ASX 200, and the second graph shows the ding-dong battle for superior returns stocks and investment property have had over the period, particularly this century.
The next graph compares VaRs, and bare in mind the nature of the stat is that the highest volatility is represented by the largest negative result.
The graph says a lot, doesn't it? First of all we expect bonds and cash to barely register, and we've already dismissed OOH as a different kind of investment decision altogether. Then we see that residential investment property has a much lower risk profile than stocks, yet referring back to the second of the two graphs above, investment property “beat” stocks on a return basis. Commercial property, by contrast, was high risk and low return.
Were history to be our guide, we'd take out whatever we had invested in stocks and put that into investment property instead, perhaps with some bonds and cash as a risk diversification measure. But is the last 25 years going to tell us anything about what's going to happen in the next 25 years?
For starters, we know that the GFC impacted on the ASX 200, to the point where 50% of value was lost by early 2009 on a price basis, whereas property prices only stumbled for about five minutes before resuming their upward trend. Yet when we add in dividends, investment property has not beaten stocks by all that much in the end. Knowing that returns on bonds and cash are going to be pretty consistent over time, we have to ask: which of the two risk assets has the most upside return potential for the next decade? There's a lot of talk that stocks are looking pretty undervalued at present, while house prices are quietly slipping after the long running boom.
Fortunately ANZ Research has applied the same sort of modelling to the future as it has to the past.
And the winner is…drum roll please…the ASX 200. With dividends. And a special nod goes to commercial property, which actually comes in ahead of investment residential property. Indeed, both beat even OOH. Note the following graph, in which all elements of costs and taxes etc are equivalent for forecasts as they are for historical measurements:
These are, of course, only forecasts. And the ANZ analysts are the first to admit they only need adjust one of the assumptions in their forecast models slightly and the outcomes become rather different. If it were all simple, nevertheless, there'd be no such thing as a risk asset.
Technical limitations
If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
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