The age-old debate in Australia is whether to buy shares or property. With the ASX rising more than 20-fold since the Whitlam era and property prices coming off a six-year boom, there are stories of incredible wealth creation on both sides of the coin.
One saving grace with property is that it is much more difficult to regularly check the valuation. The same investor who professes to follow a long-term investment strategy feels compelled to check their stocks at 1.25pm, after checking their market value at 1.15pm. The investor feels no compulsion to order two different valuations for their house in such close succession. But this is silly. If both are long term investments that are expected to play out for a few years, investors should regard them in a similar fashion, maintaining a laser sharp focus on the fundamentals driving the assets. This is the philosophy behind the long-term approach with which we approach the stock market.
Another benefit of investing in the stock market is that it provides the ability for an investor to achieve a much higher level of diversification. Take Macquarie Bank (ASX: MQG) as an example; it provides diverse geographical exposure, with two thirds of its business based in the US, Europe and Asia (excluding Australia), and offers exposure to infrastructure, investment banking and asset management.
Having the bulk of your wealth tied up in three or fewer houses in similar areas, as many Australians do, gives you large, undiversified exposure to a very specific set of risks. These include investing in Australia more generally, interest rate changes, unemployment levels and the performance of the city and the desirability of the area to future buyers. Unforeseen events such as burglaries or fires can also wreak havoc on a property investment, and there are a surprising number of events where insurance policies won’t be a magic bullet solution.
Short term volatility, however, is definitely higher on the stock market. Market corrections, constituting a 10% selloff in the stock market, generally occur at least every once to two years but mostly do not cause a recession. The signs are currently only pointing to a slowdown in the global economy, which would mean defensive stocks, and companies that can maintain dividend payouts in challenging times will outperform.
Quality yield is about finding a stock that is unlikely to cut its dividend and can slowly increase its dividend yield over time through steady earnings growth. The payout ratio is a good proxy for a dividend cut; if a business is paying out more than 80% of profits, like Westpac (ASX: WBC) and CommBank (ASX: CBA), it often has a higher than average chance of needing to cut its dividend to get some cash to reinvest. Cyclical sectors such as banking and mining are also susceptible, since their earnings can swing more than normal in a downturn.
High yielding stocks tend to perform better than the market in recessions and downturns, because investors look for stable income opportunities. Not all dividend stock however will outperform, and some will badly underperform if they are in cyclical industries. US banks for instance lost an average of well over 80% of their value in the GFC, and many have either gone completely bust (Lehman being a case in point) or never recovered. This is why it’s not good enough to just search for yield, you need quality yield.
Should I Trust the Pros with Property?
One way of investing in real estate is to buy real estate investment trusts (REITs) on the ASX. REITs consist of a portfolio of real estate assets, which you can invest in by buying REIT shares on the stock exchange. Let’s assume that a REIT had a $1bn office tower and divided it up into 10,000 shares that traded for $100,000 each on the stock market. By buying 10 shares, you own $1m worth of real estate in a property that would otherwise be reserved for very wealthy investors.
Examples of REITs on the ASX include Goodman Group (ASX: GMG), Scentre Group (ASX: SCG), Dexus (ASX: DXS), Mirvac Group (ASX MGR), GPT Group (ASX: GPT), Stockland (ASX: SGP), Lendlease (ASX: LLC) and Vicinity Centres (ASX: VCX). Some investors who buy residential real estate are concerned by yield, but don’t realise that much higher yields are available in commercial real estate.
The Charter Hall Long WALE REIT has high growth commercial offices concentrated in prime, capital city locations, and still has a 4.6% yield. The REIT has a WALE of 12 years, meaning that the yield will increase year on year for over a decade. This is a far cry from residential real estate, where a tenant on a typical Sydney house will give you a yield amounting to half that of Charter Hall’s when times are good. Tenants also generally pay outgoings like taxes on commercial properties, which is not the case with residential real estate. Charter Hall’s tenant list includes Goldman Sachs, King and wood Mallesons, Moelis, Gilbert + Tobin and Nomura, blue chip names that are unlikely to even think about the negative publicity that would come from not honouring a lease.
The high yields and potential cap rate compression across the commercial and high-quality retail and industrial REIT space remain drawcards to the sector. Additionally, even a property investor with five properties acquired over a couple of decades is unlikely to be able to compete with a real estate fund manager who manages tens of billions of dollars of real estate day in and day out.
Additionally, the most profitable real estate investors over the long term have consistently been those who engage in property development. Harry Triguboff, for instance, is the second richest person in Australia, has been a property developer for well over 50 years and has built over 75,000 apartments. By choosing to invest in real estate yourself instead of in Triguboff’s company, Meriton, you are making a bet that you can outperform the most profitable developer in the country. Beating a record such as this one or arguing that a house in the suburbs will outperform a prime-CBD office tower with double the yield is a tough ask. This is why we use the stock market as the primary vehicle through which we get exposure to real estate.
Figure 1: Cap rate compression across Australian REITS (Credit: Deloitte)
This reporting season, REITs were mostly little changed on their results, as the market shrugged off profit declines that were primarily linked to short term revaluation losses. We remain confident that a moderate slowdown, along with further cuts in interest rates from the RBA, will drive up REIT prices through cap rate compression. As alluded to previously though, only investing in real estate, even if you diversify from residential into commercial, will still fail to produce a balanced portfolio.
Are shares riskier?
While shares do generally exhibit more volatility than property, this argument confuses price and value while paying no attention to the average amount of debt people use when purchasing real estate. Let us suppose that for some reason the price of your house dropped to $100k every 10 years and traded at a reasonable value for the rest of the time. This does not make the house a riskier investment than previously; the intrinsic value remains constant and your enjoyment of the house should not change because other people suddenly value it at a lower amount for a short period of time.
The same is true of a stock. A company that has great management, strong industry fundamentals and a quality dividend yield is not less valuable just because the market price is lower for a few months. The risk that is important is business risk – the risk that the company will not be as strong two, three or five years from now.
For an investor with a diversified portfolio, what matters most is the ability to make money from an asset class over the long term. In this way, shares have still outperformed property since 1926. This is not our opinion; the outperformance is taken directly from a property journal which would have a natural inclination to favour the real estate market.
Real estate prices vs shares since 1926 (Credit: Australian Property Journal)
Another factor that you will need to consider in real estate is the tendency for prices to move in long cycles. Sudden growth spurts, like what Sydney saw between 2012 and 2017, are generally accompanied by several years of weak price growth, as shown in the chart below. You will have to consider whether you are happy with the likely prospect of several years of very low capital growth in real estate, along with a lacklustre yield unlikely to cover your mortgage.
Real estate prices vs shares since 1926 (Credit: CoreLogic, ABS, RBA, Deutsche Bank)
Will we go into Recession?
Figure 2: 2s10s inversion has been a timely recession indicator (Credit: St Louis Fed)
One indicator that is used to see whether the economy will go into recession is the 2s10s spread. When investors worry about the economic cycle, they prefer to buy long term bonds since they go up more than short term bonds. To illustrate why, suppose you held a $1,000 bond paying a $50 a year in interest for the next 10 years. Imagine interest rates suddenly fell by 5%, and new bonds that sold for $1000 now paid a 0% interest rate. Investors will clearly pay a lot more for the first one since it makes more money, pushing the price of the initial bond up.
This is why investors like longer term bonds as much as shorter term ones when they think the economy will contract. Bond markets have, in the last four market cycles, predicted contractions far earlier than the stock market. The difficulty is that the stock market generally rallies 13% over a few quarters after the first yield curve inversion. If history is any guide, now is not the time to exit the markets completely, especially since most other indicators do not point to a recession in the next year, but it is the time to invest more defensively.
Isn’t Cash Better than Either Asset Class in a Recession?
While share prices, dividends and property may both go down in a recession, the trouble with holding cash now is that you won’t make an income in the meantime. Let us assume for a moment that the safe dividend stock you choose declines 25% in a recession. Assume that you also call a recession correctly, the economy starts to turn two years after you call it and the recession occurs two years after the downturn begins. Within that time, you have made the 25% back through a growing dividend yield, while making next to no income in bank deposits, with the RBA’s cash rate sitting at 1%.
While interest rates are at record lows in Australia, the success of quantitative easing (QE) across the US and Europe and the possibility of a recession all combine to indicate interest rates can go a lot lower. The RBA cut interest rates by 425bps in the GFC, and they would have less than a quarter of that room today before interest rates went negative.
This makes negative rates a real possibility if there was a recession today. It would be almost unprecedented for a central bank not to cut interest rates by more than 1% in a recession where inflation was running below the central bank’s target range. This would mean that you would not only not get interest at all on bank deposits, you would be billed for keeping cash there.
Sounds crazy? Then check out these advanced economies which have already cut rates to negative territory, even before a recession:
There are already $15tn in negative world bonds worldwide, meaning that investors accept a guaranteed loss on investment if the securities are held to maturity. While Phillip Lowe said that he hoped” to avoid negative interest rates, he is from ruling them out. If a moderate to severe recession was on the cards for Australia, negative rates are more likely than most people realise.
Figure 3: Major advanced economies already have negative interest rates
Are you really happy facing the real prospect of a guaranteed loss on your investment?
We’re not, and why would we when we can get over 8% though safe, high quality international equities?
Is There a More Set and Forget Way to Balance Real Estate and Dividend Stocks?
Our international high dividend Vue, a selected list of international stocks with attracts no management or performance fees, pays an 8-9% dividend yield. For investors who also want to not tie all their assets to the health of the Aussie economy, an 8-9% dividend yield beats 1% in local banks. This is one of the many options that investors have, if they want to boost their income and get out of the trap of declining interest rates that has defined term deposits over the past few years.
One of the securities we hold in the Vue is Gaming and Leisure Properties Inc. This is a Real Estate Investment Trust (REIT) covering high quality properties in the United States. While gaming is a cyclical business, the beauty of the REIT is that it only controls the underlying real estate, not gaming businesses like casinos. Their properties are leased to experienced operators in triple net lease arrangements, which means that they will get a steady income stream for years. Their clients are large, safe and experienced gaming operators, which are very unlikely to go bankrupt. The attractive 7.11% yield significantly outpaces Aussie REITS, which typically yield 3-5% for properties of a similar quality.
We also hold a top 3 Global private equity firm, which manages over US$220 billion in AUM. PE firms run investment funds that buy out entire businesses, improve efficiency and profitability as they transform the operations of those companies, sell them at a profit. After this, the PE firm will close its fund an receive a large component of its performance fees.
This creates a volatile earnings stream, given the company is paid for their performance after a few years. For this reason, private equity as an industry tends to be poorly understood by investors. In a market obsessed with quarterly earnings, the great 20%p.a. long-term growth rate of a brilliant business with sustainable competitive advantages is completely ignored by the market. This creates a great opportunity for us to use our long-term investment mindset to our advantage, and lock in a 7.81% yield at 7.6x earnings.
The importance of quality yield explains why we still recommend stocks paying a 4-5% dividend locally, despite being able to easily find stocks paying much more. We would rather a 4-5% dividend that could sustainably grow to over 10% of the initial investment over a few years, than a 10% dividend for a company in terminal decline.
This article has been prepared by the Australian Stock Report Pty Ltd (AFSL: 301 682. ABN: 94 106 863 978)
(“ASR”). ASR is part of Amalgamated Australian Investment Group Limited (AAIG) (ABN: 81 140 208 288 Level 13, 130 Pitt Street, Sydney NSW 2000).
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