Shares vs Property – an age old debate
Which is better?
There is no one hard and fast answer to this age old debate. Generally speaking, it is not about one being better than the other but rather it is one complementing the other! From our experience in advising clients, there appears to be an often incorrect perception by mum’s and dad’s investors as to what share investment is about. The mystique and self-acknowledged ignorance of this form of investing is a significant reason why mum’s and dad’s investors continue to flock to residential real estate investment.
The hype and hysteria shown by the media is also a contributing factor when markets rise and fall on a whim and adds to the perception that sharemarket investing is a form of gambling. We trust that as you read through other posts made on this site, you will be at least aware that our philosophy of a sustainable diversified investment strategy is one of logical method underpinned by extensive research and is far removed from any gambling hobby.
While the average Australian appears to be preoccupied by the real estate market, particularly the residential sector, it is fortunate that most working Australians also have sharemarket investemnts via their superannuation funds. Over the long term, which is what superannuation is designed for, investments into shares have generally provided outperformance against other asset classes.
Often, the comparison between shares and property is made by reference to the specific returns generated by a particular stock, in contrast to owning residential property in certain locations.
Reference is also made to the various factors that contribute to increasing growth in one area or another, such as a strong economy and lower interest rates.
However, if the before tax return from shares and property is the same, the better after tax result is often produced by an investment in shares.
An investment in property typically only generates moderate tax benefits in the form of depreciation and expense deductions. In contrast, the dividends received by shareholders in listed companies commonly carry franking credits, which can be used by the shareholder to reduce their tax payable.
In recent years, it has become common practice to sell new residential real estate projects based on an after tax cashflow projection. In many cases, the projections are supported by a two to three year rent guarantee. In all cases, the projections show a very healthy after tax yield due to the combined impact of interest and depreciation deductions. Such projections invariably show tax refunds as an important part of the investor’s yield.
What the projections do not show you is the prognosis for the tax profile of the investment after the first two to three years.
This is because the tax depreciation advantages associated with real estate investment diminish rapidly over time, as the table below shows.
Assume the investment property includes a depreciable air conditioner having a useful life of 6 years, a cost of $1,000 and a depreciation rate of 40%. The allowable depreciation deductions would be as follows:
| Opening Value | Depreciation Rate | Tax Deductions | |
| Year 1 | $ 1,000 | 40% | $ 400 |
| Year 2 | $ 600 | 40% | $ 240 |
| Year 3 | $ 360 | 40% | $ 144 |
| Year 4 | $ 216 | 40% | $ 86 |
Furthermore, the tax advantages of depreciation are really only in the nature of a timing advantage.
Eventually depreciated assets, such as carpets and air conditioners, need to be replaced, involving capital outlays that cannot be deducted but only depreciated.
In contrast, the tax credits attached to franked dividends are of an ‘evergreen’ nature and represent a permanent tax benefit and not only a timing advantage. As the dividend yield from a share portfolio rises, assuming it remains fully franked, the tax benefits generated by the investment automatically rise in proportion to the increasing yield.
Gearing into shares also offers far greater flexibility than direct property. It is very hard to meet a need for emergency funds by ‘selling a piece of the backyard’. When you invest in share funds you can quickly redeem a portion of your funds or reduce the size of a geared portfolio.
Direct property investment
What is Direct Property?
Direct Property is a ‘real property’ asset. Real property generally includes land and any items fixed to it – such as a house, shop, factory, or apartment building. A large amount of money is usually required to invest in direct property, putting it beyond the reach of many people. If the property is tenanted, income may be received as rental payments. Generally, the value of direct property increases over time, providing much of the return received from this asset type.
Direct property – strategic advice
It is important to note that we are only able to provide strategic advice in relation to direct property. This means that we are not able to provide you with direct property advice based on the individual features of a specific property, other than ongoing costs and income-generating characteristics. If you require advice in relation to a specific property, location, or likely value of a property you should contact a registered real estate agent that is familiar with the area or property in question.
Costs and risks of direct property
Any decision to purchase, retain, or sell a direct property asset should be carefully considered as there are specific costs and risks associated with this type of asset. We have listed below some of the main costs and risks relating to direct property assets.
Purchasing direct property
- Purchase costs: There are many purchase costs associated with direct property. These may include:
- Time and cost of searching for a suitable property
- Inspection reports (e.g. structural and/or pest inspections)
- Legal and conveyancing fees
- Loan establishment costs
- Stamp duty
- Location, location, location: The character and location of a property can have a big influence (positive or negative) on the current and future desirability of the property to purchasers and/or tenants. It is important to know the area in which a property is located, and to determine what future developments may be planned nearby which could impact on its suitability as an investment (such as a new highway, rubbish tip, high-rise development).
- Timeframe: Direct property should be viewed as a long-term investment. This is due to the potential short-term volatility that the direct property market (and/or specific locations) may experience. There are also significant purchase, ongoing and sale costs associated with investing in property which may take time to recoup.
- Opportunity cost: When investing into direct property, you forego the opportunity to use that money to invest into other assets which may be more appropriate to helping you achieve your goals and objectives.
That is, after taking into account the estimated costs, risks and returns that apply to each of the major asset types, is direct property more likely to provide the best net return?
Owning direct property
- Risk vs return: The return on direct property is impacted by various risks: those affecting income and those affecting growth. The income you receive will be a matter of the demand for property in the area in which the property is located. In regard to capital growth or loss, this is again a matter of location and condition of the property. Location may be broken into city, town or even more so by suburb. Also, income will generally be influenced by the condition of the property.
One of the key factors that can influence or effect returns is that of interest rates. - Lack of diversification: By not diversifying there is a much greater risk that your investment will be ineffective. No one type of security, assets class, or investment strategy provides the best performance over all time periods. Having all or a high percentage of your investable funds in direct property may not give you the best return for your money – like the old saying “all your eggs in one basket”.
- Lack of liquidity: Unlike many other investment types, it is generally not possible to sell a part of a direct property if you find yourself short of cash. As a result, direct property is an inflexible asset. If you were to decide to sell a property, there is usually a lengthy time-delay between making the decision to sell and actually receiving the sale proceeds.
- Problems with tenants: There are likely to be periods where a rental property is untenanted, meaning that no rental income is received for that period. Tenants may also damage the property, and may pay the rent late or not at all.
- Ongoing costs: There are many ongoing costs associated with direct property. These may include:
- Maintenance and repair of existing structures and fittings, both internal and external
- Body corporate fees, and the time required to attend body corporate meetings (if applicable)
- Agent fees (where an agent is used to secure a tenant and/or manage the property)
- Time devoted to managing the property. Even when paying an agent to take on some of the day-to-day responsibilities, the owner still needs to be involved in many aspects of managing the property
- Council rates, land tax, other taxes (where applicable)
- Loan interest, repayments and fees
- Insurance
- Improvements: Often capital improvements to a property are necessary (such as the replacement of an oven or air conditioner). Such capital outlays can be costly and unplanned. Other costs may include building or renovation work, or subdivision costs.
- Legislative risk: The taxation rules relating to investment properties currently allow the claiming of certain deductions and depreciation which may make property investment more attractive to some investors. There is no certainty that these potential tax benefits will continue into the future, as the relevant legislation may change over time.
- International property: Where international property is being held or considered, it is important to be aware of any applicable international tax laws, residency issues and currency risks before you proceed with this advice.
Selling direct property
- Sale costs: There are many sale costs associated with direct property. These may include.
- Time needed to select an agent to manage the sale
- Advertising the sale
- Time spent preparing and vacating the property for inspections
- Legal and conveyancing fees
- Agent fees
- Capital gains tax (CGT): Unless the property is your home, you may have to pay CGT on some or all of any gain in the value of the property (i.e. the difference between the price you bought and sold it for). This could significantly reduce the net sale proceeds available to you once the property is sold.
- Sale date uncertainty: Unlike some other asset types, it may take months or even years to sell a direct property. This could be due to the property’s location and desirability (or lack of), the asking price, and/or the length of the settlement period. Generally it takes at least 2 months from the time you decide to when you receive the sale proceeds.
Property never fails ?
The perception that direct property significantly outperfoms other asset classes, or worse still never goes down is a very dangerous assumption to make. We need only venture as far as our local Rockhampton Morning Bulletin for articles detailing recent decline in prices. Whilst not devastating, this price momvement definitely has had an effect on the balance sheets of many. These median prices publicised also do not take into account any ‘added value’ the owners may have contributed to a property prior to sale for example renovations and improvements. Factors such as these can add stability to price movements , plus the fact that the average Australian typically holds onto their home for 7 plus years.
Summary
The Australian culture of owning your own home is a sound one. It provides a disciplined methodology of investing … regardless of whether you would be better off renting or buying property, it does provide a secure means of forced savings.
If you are considering an investment property at least look before you leap and seek some advice regarding risks of direct property investment. There may be other options more appropriate to your own risk profile, goals and objectives.
Our final comment is that you must consider diversification of your assets. The property spruikers that promote 3,4 or more investment properties (7 seems to be the magic number) are not doing you any favours when the residential property markets take a turn for the worse and even moreso when retirement income is taken into account and you have the majority of your assets and income outside the highly tax advantaged area of superannuation.
If you would like us to help you with your strategic investment property purchase or alternatively are having cashflow difficulties with your existing investment property, please feel invited to seek our advice.
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