Deconstructing property risk

For a property adviser, the most conservative starting place to demonstrate the benefits of long-term direct residential property investment is material provided by a reputable supplier of a competing investment product. We use the latest ASX Russell research report, (see May 17 2007, page 26, Table 1) which indicates.

- cash is the worst investment — no surprises;

- fixed interest is in the bottom half — no surprises;

- property beats everything else (Top 3 total return positions) — perhaps a few surprises, especially considering the report is released by the Australian Stock Exchange;

- overseas investments carry risk (property outperforms, unhedged shares underperform); and

- managed funds underperform. While managed funds provide opportunity to diversify and source investment expertise, this comes at a cost. The cost is that managed funds must underperform on average, because the only return they can generate is that of the underlying (property and equity) assets minus the fees they impose, which includes costs such as advertising, commissions, salaries and profits.

Direct property investments have at least three benefits not shared by other investments, such as equities or managed funds.

The first is security. The value of property cannot fall to zero because of poor company management (for equities), fraud, maladministration or poor judgement of a fund manager.

The second advantage is leverage. Direct property investors can obtain loans for 95 per cent or more of valuation. So a deposit of $100,000 can in theory leverage into a direct property portfolio of $2 million. With margin loans, this deposit could only allow leverage into a much smaller portfolio of equities or managed funds.

The benefit of leverage is illustrated in Table 2 using the 10-year data produced by the ASX (20-year data is not released).

This tells us that tax issues will cost an investor about 3 per cent annual growth, and 50 per cent gearing will add about 3 per cent.

There are three reasons why the residential figures should actually be considerably higher.

First, residential investment gearing can be much higher than 50 per cent, and therefore the benefit will be much higher. Why do funders and their regulators permit higher gearing for direct residential property? Because downward price volatility of residential property is very low; the very high level of Australian home ownership means that during downturns stock is withdrawn rather than sold, which supports the price, allowing a long-term leveraged investor in direct property to ride out the downturns.

Second is the cost assumptions used in the Russell ASX analysis. The report assumes the assets are bought and sold after 10 years. Because property acquisition and sale costs are much higher than those of equities, the property returns would be higher were these costs amortised over the realistic life of the property investment, which would often be longer than 10 years.

Thirdly, the borrowing cost for property is assumed to be the standard variable rate — in practice, property investors with astute advisers would pay much less.

The third benefit of direct property over other investments is control. Unlike equities and managed funds, the investor can see, touch and feel their direct property investment, and has total control over it.

Why don’t most fund managers recommend direct residential property investment?

The conventional answer is that direct property investments lack liquidity. However, while this can be a legitimate short-term concern, it is not a serious impediment for those with a long-term financial plan or adequate cash flow.

Another possible impediment to direct property investment is that they do not earn ongoing funds management fees for the large financial institutions that support most financial planners.

While independent planning groups are not subject to the approval regimes of employers with large funds management operations, in many cases they lack a framework and the necessary research to soundly assess direct property investments.

This leads to the second purpose of this article, to introduce a 10-point risk assessment framework designed to enable planners to give sound advice to their clients in regard to direct property investment (see May 17 2007, page 27, Table 3).

The 10-point risk assessment framework

Most of the items in Table 3 require assessment of the particular property under consideration.

However, timing/capital gain is driven to a large extent by general economic factors.

Therefore, sensible comment can be made in this area without knowledge of the particular property under consideration.

The importance of timing for capital gain

Long-term capital gain in direct property is assured.

Decade after decade, Australian property grows in value. The ASX Russell report suggests 12 per cent total return (after buying and selling costs). After deducting net rental returns (say 3 per cent), average capital growth is about 9 per cent per annum.

But there is considerable fluctuation around this trend. If property is acquired at the bottom of the cycle, then the returns are very much greater than the trend.

For example, Table 4 (see May 17 2007, page 27). shows that if you bought direct residential property in Sydney in 2003, you could expect to have lost money by now (although it will come good in the long run). But if you bought in Perth or Darwin, you could expect to have made 40 per cent or more.

Timing is critical and requires consideration of two things. First, the factors that drive the supply and demand for property, and second (and more difficult), how to accurately measure these factors and apply sensible weights to them.

Identifying the factors

Some factors that drive demand for property are fairly obvious. For example, demand is driven by:

- population — the more people, the greater the demand;

- demographic structure — the fewer the people in each dwelling, the more dwellings demanded;

- capacity to pay — consider the strength of the economy and employment, interest rates, the attitudes of funders, and government initiatives such as the First Home Owners Grant and tax regimes; and

- infrastructure activity — consider whether there are large projects that will increase jobs, wealth, or desirability.

Supply is basically fixed in the short-term. Residential developments take about six to 24 months for council approval, followed by another 12 to 24 months to build.

So, if demand rises, it takes a considerable time for supply to rise to meet demand and any imbalance reflects in the price of the available stock.

Supply factors include construction costs, zoning and environmental restrictions, new releases, taxes, infrastructure and transport requirements.

The less obvious thing to predict is the attitude of buyers. When a cycle is turning, it takes experience to judge the mood of the market and to predict when prices will start to rise quickly. Some leading indicators of this are discussed below.

Measuring and assessing the factors

We are all aware of statistics that show a dramatic rise or fall in the value of a suburb, that we know is nonsense. This is because normal measures take the ‘average mean’ value, or the ‘median value’.

The ‘average mean’ value adds up the value of all sales, and divides by the number of sales — this can easily be distorted, for example, if some very valuable properties sell.

The ‘median’ value is the one that has on either side of it the same number of more expensive and less expensive properties. This can also easily be distorted, for example, if the mix of properties sold does not replicate the mix in the region.

To fix this, we need a ‘hedonic’ index of property prices. This strips out variations due to factors such as land size, number of bedrooms, views, location and so on.

Hedonic property indices are being created by a new firm on the property scene, Rismark. Rismark employs five people with PhDs in mathematics, finance and econometrics to calculate their numbers. They have to be accurate, because their business is to make loans to property owners at a zero interest rate, in return for a share of the capital gain on the property (and Rismark also shares in any capital loss).

The latest Rismark Hedonic indices have been picked up by the Reserve Bank of Australia in its May Statement on monetary policy. The hedonic index shows that Sydney prices rose at an annual rate of 3 per cent during the March quarter. By contrast, the biased but more popular ‘median price series’ shows a fall of 9 per cent.

We use Rismark analysis, together with our own experience, to assess the opportunity for capital gain in various properties.

Leading indicators of price change

The key to beating the market is to move before prices start to change significantly. There are many leading indicators of when prices are about to change. These include rental vacancy rates, rental yields, the time properties are on the market before being sold, the size of any adjustment between initial asking price and final sale price, and auction clearance rates.

Putting it all together

Putting together the various indicators, measuring and assessing them accurately and then applying correct weights to them needs to be done in a systematic and rigorous manner. When cycles are turning, it is more complex, as mixed messages can be expected.

Our analysis, supported by statistical work undertaken by Rismark, provides the medium-term forecasts for Australia’s capital cities (see May 17 2007, page 27 Table 5).

A word of caution

Within a city there can still be great variations in capital growth depending on the particular suburb, the building purpose (for example, apartments, house and land, and student accommodation), and the age of each property (for example, old ‘as is’, old refurbished, and new off the plan). Even in generally flat markets there can be bargains.

Brian Boardman and Michael Shreeve are principals at Boardman & Associates.