After the recent price declines in Sydney and Melbourne, property as an asset class has caught the attention of some astute investors. While we mainly focus on equities and would not normally invest in property directly, the sector caught our attention because of everything that is going on at present.
Coming from the stock market gives us a different way of thinking to most seasoned property investors, a factor which gives us a competitive edge. We have also helped create some new options for investing in property that we would like to share with you, in addition to discussing the merits of well-established methods to invest in the asset class.
We think shares are a better investment over the long term, a view supported by the long-term performance of both asset classes. Nevertheless, investors who do not like the volatility associated with having all their wealth in the stock market should consider property as an alternative. This is because interest rates are at all time lows in Australia, which almost eliminates fixed income and savings accounts as income producing asset classes.
To make matters worse, 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.
What’s Happening in the Property Market
The RBA’s recent interest rate cuts have stimulated the Aussie property market, with home values rising 0.8% in August. The recovery is particularly pronounced in the Sydney and Melbourne property markets, where price gains exceeded 1.2%.
This comes off the back of some much weaker growth numbers shortly after the announcement. While such an outcome seems confusing at first, it is important to remember that monetary policy changes generally have a 12-18-month time lag, after which they will start having a more tangible impact on the economy. This is why central banks have to be forward looking in outlook, making decisions based on where they think the economy will be in a bit over a year’s time.
One other factor supporting property prices is the recent election result, since it means there will not be any changes to negative gearing or capital gains tax concessions. While there has been some tightening in lending, it is easier for a lot of borrowers to obtain a loan. Further government concessions to first home buyers as well as interest rate cuts, which will often make mortgage rates lower than renting a comparable property, have spurred recent action in the market.
If you want to invest in property, residential real estate is not the only game in town. Another investment opportunity is in high quality commercial properties, which you can get access to through 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.
While most of our readers will not take issue with property price growth, since it feels good to see the value of your house go up, there are some economic side effects if prices get out of hand. If prices rise above the ability of people to pay for houses, it will increase Australia’s household debt levels. Australia has one of the highest levels of household debt in the developed world, well above where the US was in the GFC.
If people lose their jobs in a financial crisis, they are more likely to default if they have high levels of debt, pushing up mortgage arrears. As we saw in the GFC, a high level of defaults on home loans alongside high levels of negative equity can lead to bank collapses, throwing a systematically important part of the economy into chaos and causing a deep recession. Retirees would be particularly badly affected by house price declines and bank collapses, which is why it is better to prevent a bubble in house prices.
Australia’s household debt levels have been persistently rising (Credit: RBA)
A booming property market in Australia’s capitals stopped the RBA cutting rates to zero for a large part of this decade. Now that the threat of a property bubble has receded, the RBA cut interest rates by 150bps and has demonstrated a willingness to go further if necessary. Property price growth is constrained by tougher capital standards and a deteriorating economy.
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.
Despite the benefits commercial property has over residential, there are still a couple of good reasons for holding some residential property. One of them is to track the market that you wish to purchase a dwelling in, which is a perfectly legitimate reason since everyone needs a place to live. An investor with an existing property may want to get some exposure to property in the area they want to retire in, in order to ensure that their retirement dreams become a reality.
Another major consideration with property investment is how they are treated from a tax perspective. For some people, there will be an advantage to owning property directly, instead of through a REIT.
The solution we use to invest in property directly is DomaCom, a platform which allows fractional ownership in individual properties. This solution involves the owner having a direct share in the title of the relevant property and get the same tax treatment as another investor who bought a whole property.
Another major drawback to property investing is liquidity. When you buy a property, it is difficult to sell it, since the process takes time and will require spending large amounts in fees. If you are forced to sell a property because of a financial emergency and later buy another one, the costs in agent’s fees, stamp duty and other smaller expenses like expenses which add up to tens of thousands of dollars.
Through DomaCom, we have a guaranteed liquidity facility that investors can use to sell their interests in the fund. This makes the option much more attractive than syndicates and unlisted property trusts, the former of which can freeze investments for over five years in a number of cases.
Reduced volatility provides another compelling reason to purchase fractional interests in properties, instead of buying a property outright. Since A-REITs trade on the stock market, traders make them more volatile than underlying real estate. While high quality commercial assets do offer better rental yields and greater tenant stability, investors may choose to put a proportion of their assets in properties that they understand better. Because DomaCom properties are traded amongst property investors, your position will not be subject to the moves of the stock market.
DomaCom also allows investors to play trends in the property market that they wouldn’t otherwise be exposed to. One example is an investor who believes that continued property growth and a limited supply of freestanding houses on the Sydney Harbour waterfront will push the prices of those houses up. If the investor does not want to spend $20m on a house however, they are unlikely to be able to profit from holding such a view, even if those properties ultimately outperformed. DomaCom however gives investors the opportunity to buy an ownership stake in those properties, allowing the investor to maintain a level of exposure they are comfortable with, while still profiting from the underlying price moves.
Being the Lender
Most people struggle to pay for a property upfront and take a mortgage to make getting in the market a bit easier. As such, most property investors know what it’s like to pay interest. Not many of these people however have thought about being the lender who helps other investors looking to build their property empire.
Nevertheless, for every individual who curses their bank over a large interest bill, there is another investor collecting the interest on the other side of the table. Usually this is a bank or wealthy individual who supplies mortgages, but there is no longer any reason why you can’t join that group, even if you don’t have millions of dollars in cash.
This is because DomaCom allows you to invest in property loans with a small deposit, by combining the deposits of multiple investors. These amounts add up, providing the capital necessary for a property developer to finance a property purchase. Some of these loans offer an interest rate of 9%. The best part of this is that those rates are available by lending to large, trusted property developer like Mirvac and Meriton, not risky borrowers.
One example is a property development loan paying 9.56% interest at current market rates, which certainly beats the 1% you get from the banks. This is one of the loans we have on offer to finance the purchase of land for property development. Having a block of land that you can’t derive a rental income from does increase risk if the developer collapses and leaves a half-constructed building that can’t be rented, but the LVR is 60%, compared to a standard 80% on residential loans. There will always be some risk in any investment decision, but the attractive 9.56% interest rate will prove attractive for many investors.
The elephant in the room is why everyone isn’t doing these deals, if they are as attractive as they seem. One reason why is that they have so far been out of reach of all but the wealthiest investors, many of whom have been engaging in deals. Some of these wealthy investors have been getting interest rates as high as 20%p.a. lending to property developers, through higher risk loans known as mezzanine financing.
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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