SMSFundamentals: Steady Income And A Hedge vs Inflation

This story features ISHARES GOVERNMENT INFLATION ETF. For more info SHARE ANALYSIS: ILB

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By JP Goldman of the Switzer Super Report

Should residential property form an important part of an investor’s superannuation portfolio? Judging by recent history, the answer would be a resounding yes.

But as the saying goes, past returns shouldn’t necessarily be taken as a guide to future returns – especially as one-off structural factors likely boosted property returns over the past two decades.

What’s more, investors should be aware there are now cheaper, simpler and more liquid investment options available should they be seeking both steady income returns and a hedge against inflation.

That said, there’s no denying property has been a terrific investment over recent years. Relative to shares, property returns have been comparably strong and enjoyed considerably lower volatility.

Of course, since the start of the Global Financial Crisis (GFC), there has been persistent fear across Australia that already lofty house prices could be set for a tumble. Indeed, there’s a core group of analysts that have long speculated that house prices would soon follow the declines seen in countries such as the United States, the United Kingdom, Spain and Ireland.

But while house prices have softened in recent years, we’ve so far avoided the spectacular collapse evident elsewhere – and they’ve held up far better than shares.

Property vs shares

According to the Australian Bureau of Statistics survey, the last peak in nationwide established house prices took place in the June quarter of 2010, and average prices have declined by 4.7% since then.

Even during the GFC – and a time when fears of recession in Australian were very real – house prices were at their lowest in the March quarter 2009, and this was still only 5.5% below their peak of a year earlier. That’s not bad compared with the 20 to 30% declines seen in the United States and parts of Europe.

Indeed, since September quarter 2007 – when the GFC began to troubled global markets – Australian house prices (as measured by the ABS) have lifted by 14% by the end of the June quarter of this year. By contrast, the S&P/ASX 200 equity index is still 37% below its September quarter 2007 peak.

That’s perhaps even more surprising considering that the property prices had just posted a decade of relatively strong gains: in the ten years to September 2007, house prices increased at a 9.8% annualised rate. Australian share prices (excluding dividends, which is fair as house prices excluded rents) increased by 9.4% annualised rate over this period.

There are several good reasons the property market has held up reasonably well. For starters, land supply and development restrictions meant that Australian developers were less able to respond to rising prices by boosting supply – thereby avoiding the speculative property gluts created elsewhere. Decent financial regulation also prevented lenders from going overboard in lending to those with poor credit risks. House prices were also supported by the fact that the rise in unemployment during the GFC was relatively limited due to the ongoing commodities boom and timely monetary and fiscal policy action.

Price outlook

But investors shouldn’t expect property prices to keep rising by 10%. A large element of earlier gains reflected a structural decline in inflation and interest rates – which meant households could afford to take on larger mortgages relative to given levels of household income. With supply restricted, that caused house prices to rise strongly relatively to household incomes. But relative to income, house prices have now likely reached their limits, barring a further large and sustained decline in mortgage rates.

Property prices are no longer cheap, but they’re not overly expensive either – after all, prices are set in the market and so must reflect the capacity to pay of the marginal buyer.

Going forward, property prices should at best largely match growth in household incomes over time – implying an annual rate of gain of 3 to 5%. And within this trend, there will be the inevitable dips and surges in line with the cycles in unemployment and interest rates.

In fact, with households now more highly leveraged, house prices are likely to show greater sensitivity to the economic cycle than in earlier decades, with returns perhaps even more correlated with the share market.

Indeed, if and when the next great recession comes, house price decline of 10% or more might be expected. Investors should be prepared to live with such volatility.

Recommendation

That’s why investors wanting greater diversification and a hedge against inflation might also consider inflation-protected government bonds readily available on the Australian Stock Exchange though an iShares listed exchange-traded fund (ETF).

The iShares UBS Government Inflation ETF ((ILB)) invests in federal and state inflation linked government bonds, which provide a yield return plus increases in capital value over time in line with consumer price inflation.
 

Peter Switzer is the founder and publisher of the Switzer Super Report, a newsletter and website that offers advice, information and education to help you grow your DIY super.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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