How have homes performed as investments?
[ September 15, 2015 ]
The Real Estate Institute of Australia (REIA) says that at December 1980 the median home price in Sydney was $76,000 and the median home price in Melbourne was $43,000. In June 2015 the median home price in Sydney was nearly $930,000 and the median home price in Melbourne was $688,000 (See The true extent of Australia’s rising property prices). That’s a significant increase in value over three decades. The increases are bigger in the better suburbs. The entry price for the fashionable inner, eastern and bayside suburbs in Melbourne is now over $1,000,000, and the entry price for the fashionable Sydney suburbs has been over $1,000,000 for years now, in fact more than 100 Sydney suburbs have entry process above $1,000,000. Shares prices have gone up a lot too. The Russell Investments ASX 2015 Long-term Investing Report (We regard this is one of the most reliable and bias free reports available on the market.) says, at page 9, exhibit 7, that the 20 year average for Australian shares to 31 December 2014 was 9.5%, which is only a smidge behind residential property at 9.8%. The share market has fallen since then, and property prices have risen further.
Why are prices rising so fast?
The papers are full of theories and explanations. These best include the following elements:
- record low interest rates
- rising international interest in Sydney and Melbourne as cities, and investment centres, connected to a (true) perception of Australia as a safe haven, a stable political and economic environment where property rights are protected by the law
- population pressure. Melbourne’s population is increasing by more than 90,000 a year, every year. Most are from Asia and South East Asia and are eager to enter the property market, as home owners and investors
- negative gearing by high tax rate individuals
- SMSF gearing
- concerns that the share market is too risky. It’s been a very volatile few years. For example, the ASX fell by more than 8% in August 2015
- a sense of being left behind, ie that prices are rising and if you do not act now you will end up paying more later.
Will this trend continue?
Home values can’t go up every year. Home values are particularly sensitive to interest rate increases. For example, if a new home owner borrows say $1,000,000 at 4% pa to buy a home, they have to pay $40,000 a year interest. If interest rates rise by say 2 percentage points to 6% pa, this increases by $20,000 a year to $60,000 a year. This interest is not tax deductible, so at the 40% tax rate they have to earn an extra $33,000 in pre-tax income. (Even more when Medicare, 9.5% super, workcover and payroll tax is factored in.) In mid-September 2015 the real estate agents are saying auction clearance rates are less than they were in September 2014, and on 16 September 2015 the Australian Financial Review said that Chinese purchases of Australian property have dropped significantly in the previous month as buyers encounter new rules in China designed to stop money being moved out Home values don’t go up every year. But they do go up every decade. When you look at home values over the decades there is a significant upwards-sloping trend line.
How have our clients gone investing in their homes?
As good as these results are, we believe most of our clients have done even better. They bought better homes in better suburbs, and these homes appreciated better. Some clients have made fortunes just owning their homes. I can still remember sitting down in a Vaucluse lounge room in 1997, and almost not believing my client when she said her home was worth more than $1,000,000. It did not seem that big or that good home. It just seemed like an average home. And it was. The average home was worth more than $1,000,000. Vaucluse was the first suburb in Australia to break this price barrier. Paul Keating lived around the corner. It was the place to be. My client was already wealthy because she bought ten years earlier for less than $500,000. She is even wealthier now: the median value for Vaucluse is more than $3,500,000. That’s an excellent return on investment. Sure it’s taken three decades. That’s how long property takes to generate real returns, and it’s how long good properties should be held for.
What are future home prices expected to be?
Fifty years is a long time. But it’s how long property should be held for. Property is an intergenerational asset and over the decades and generations property will produce excellent rates of return. Obviously precise predictions of future prices are not possible. There are too many variables in the equation. Let’s stick to the basics, and look at what is expected to happen to Australia’s population over the next fifty years, and try to make an educated guess about home prices from that. The Australian Bureau of Statistics provides the following data:
|State||Population 2012||Population 2062||Increase %|
Income levels will rise too. Inflation runs at roughly 3% a year, so a $1,000,000 home in 2012 will be worth at least $4,384,000 in 2062 if it just goes up with inflation. Much of Australia’s population growth is driven by immigration. More than 220,000 arrive each year, and most are well educated, reasonably well off, and very aspirational: they want to get ahead in the Lucky Country and they work very hard to do so. Of this 220,000, nearly half arrive just in Melbourne, keeping demand for Melbourne property, particularly the fashionable inner, eastern and bayside suburbs rising and rising each decade. These aspirations are shared by older Australians too: just listen to talk back radio for a day to witness the energy and effort put in to buying and keeping a home. It’s an intrinsic part of the Australian culture and psyche, and there is a stigma attached to not owning a home. Obviously the more fashionable suburbs will be in more demand. They are privileged locations and people will fight to get there. There is no precise formula, and it’s a very simplified model, but if you combine cultural preferences (obsessions?), dramatic population increases, privileged locations and prolonged inflation you get significant home value increases across the coming generations. Vaucluse in 2015 is probably still a very good buy. One day in 2035 someone will boast she bought Vaucluse for just $3,300,000 way back in 2015.
Should you own a home?
The above anecdotes and tables seem to be a persuasive case for home ownership, particularly in the better suburbs people like to live in. But not everyone agrees. Phil Ruthven is a well-known economics and social commentator. He argues owning a home as an investment is irrational and unlikely to produce optimum investment results. He says home ownership is nice emotionally but most will be better off renting a home that suits us now, and implementing a disciplined investment strategy based purely on rational grounds. Mr Ruthven says this is particularly once the hidden costs of home ownership are considered, such as hours and dollars spent improving the home, rates and repairs, and stamp duty, legal fees and other transaction costs when we move every seven years. There is something in what Mr Ruthven says. This is particularly if you move more than once every seven years or if your home is not in a good performing suburb. In July 2014 the Reserve Bank released a report saying that house prices need to go up by more than 2.9% a year for buying to beat renting. You can read an article by Scot Pape, of Barefoot Investor fame, published in the Herald Sun on 19 July 2014, interviewing Mr Ruthven and exploring his thesis here: Renting or buying: home truths can hurt. On balance we do not agree with Mr Ruthven. Fundamentally, the great advantage of home ownership is forced savings, and apart from super most people would not save a cent without regular home loan repayments. Most clients own homes in good performing suburbs for more than seven years (and as you know we recommend homes be owned for decades and even generations). Clients are more likely to pay off the (expensive non-deductible home) loan fast and to implement a separate disciplined investment strategy. Once again, it’s the unusual height, stability, scalability and longevity of the clients’ income coming into play: put simply, clients can afford to buy better homes, pay them off quickly and keep them as investments when they up-grade to the next home. This means homes work well as investments for clients. Over the two decades to December 2014 residential property earned 9.5% per annum. Most clients who owned properties did well, and those who own properties in the next two decades will probably do well too. On balance we expect the Reserve Bank’s 2.9% price increase to be easily beaten by Melbourne and Sydney’s better suburbs: 2.9% is barely the inflation rate, and well below the historical rates of return actually generated in these markets.
What do clients ask us?
Nearly every meeting discusses the client’s home. Questions include: Should it be sold? Should it be kept? Should it be renovated? Should it be protected? Should it be left in a will? Should it be used as security for an investment loan? Should it be used as security for a child’s home loan? For clients who do not own homes some questions include: Should I rent or buy? Should I buy something affordable for now, pay it off fast and up-grade later? Or should I buy something more than I can afford now, and work harder than ever before? Should I invest in shares instead, buying a fixed amount every month rather than paying off a home loan? Should I buy a practice first? There is some evidence that Australia’s historically high home ownership rates are falling. Home ownership rates have fallen from 71.4% to 69.5% since the 1990s, with Australian being one of only five OECD countries where home ownership rates fell during this period. This does not seem like much of a drop, particularly as the population grew strongly during this period and home prices grew even stronger. The level of home ownership, and aspiring home ownership, in the medical profession has certainly not dropped. Owning a home, and variations on the theme, is a major point of interest amongst clients of all ages, and the home remains the greatest store of wealth for most clients. Super is catching up, and may be one day will overtake home ownership as the most valuable asset. But I would not mind betting that as average super balances grow average home value will grow even faster, due to a wealth effect between these two asset classes. That is, clients (like many others) will be more willing to take on more loans to buy more home as their super balances rise.
What are the advantages of home ownership?
The advantages of home ownership can be more psychological than financial. It’s all about the nesting instinct and territoriality: this is your home, and your home is your castle. Home ownership provides a sense of permanence and control that is important to overall psychological happiness. Residential properties, and the loans used to buy them, are a great way to save. Many people, clients included, would not save a cent if it was not for the principal component of their home loan repayments. Later, when the home is paid off, the owners save the rent. The family home, including improvements, is usually free of capital gains tax. The principal place of residence is excluded from the CGT net by dint of social policy and political survival. Improvements to the home are CGT-free, so if a $100,000 improvement creates $150,000 of value, that extra $50,000 is tax-free. For older people, the home is outside the assets and income test for the age pension. Pensions are usually not an issue for clients. But sometimes they are. Increasingly older clients without significant investments are using reverse mortgages to access the equity in their home without having to sell it. Reverse mortgages turn homes into tax-free reservoirs of wealth. Individuals can smooth consumption over their expected lifespan by building up the reservoir during their working years and running it down in retirement. The Australian Master Financial Planning Guide 2013-14 (Walters Kluwers) recognizes other advantages as including:
- Provides security since the alternative, renting, may involve the owner selling the property;
- Avoids the stigma that some feel may attached to not owning a home;
- Lifestyle choice where wealth creation is not the primary objective;
- Paying off the home loan is a form of personal saving; and
- Freedom to make personal changes to the
What are the disadvantages of home ownership?
Property can be expensive to buy and hold. Acquisition costs include stamp duty (work on 5% of the cost), bank fees, solicitors’ fees and titles office costs. Holding costs include council and water rates interest, land tax, maintenance and repairs, and real estate agent’s fees. These can be significant and are often ignored when people calculate the gains made on their homes. Critics also list the opportunity cost on foregone investments and a lack of diversification, which means higher risk. But historically neither has held true. Property is a top performing asset class: the ASX Report for 2013 says property averaged 9.5% in the two decades to December 2013, just behind Australian shares at 9.8%, so there is no significant opportunity cost. Any lack of diversification is to the homeowners’ advantage – who wants to diversify into a lower-earning asset class? Critics say residential property is not a liquid asset. This has been even less of a problem in the past 10 years because equity access loans (debt facilities linked to the value of the home) allow clients to cash out some of the value of their home, whether for consumption, investment or business purposes. Illiquidity is not a problem for most property owners The Australian Master Financial Planning Guide 2013-14 (Walters Kluwers) recognizes other potential disadvantages as including:
- property prices can go down, as well as up
- demand for property may be lower in the future due to:
- Less immigration, which means lower population growth (this appears incorrect)
- Low inflation, which reduces the potential for high capital gains
- Increasing unemployment rates
- The global financial crisis and continued global financial instability
- the high costs of buying and selling property, including legal fees and stamp duty
- the opportunity cost on missing out on other better performing investments
- lack of diversification
- property not being suited to investment
- miss out on other tax concessions, even though homes are CGT free and
- homes are illiquid, ie hard to convert to
What do we say to clients? Is there a bubble about to burst?
Historically we have said clients should own as much home as the bank will let them as soon as they can, and then pay off the loan as fast as they can. Clients who followed this advice have done well so far. But we confess to having second thoughts. The rapid rise in home prices raises questions about sustainability. Some say there is a bubble, and it’s going to burst. Interest rate rises are likely to be the trigger, particularly if unemployment grows and mortgage stress sets it. Rose Powell, a journalist with the Sydney Morning Herald, summarized the concerns in her article on 1 July 2015 captioned House prices in a bubble- but what will make them pop? Others who see a bursting bubble include the RBA, well known property advocates and academic economists. The field is surveyed and summarized by Larissa ham in an article published in the New Daily on 16 August 2015 which can be read here: How to deal with the threat of a housing bubble. The OECD is perhaps the most revered body warning of a possible price collapse: The OECD has warned Australia’s housing market could collapse (www.news.com.au on 4 June 2014) We confess to second thoughts, and these thoughts are expressed here: McMasters’ Youtube explanation: In summary, our traditional advice that clients should “own as much home as the bank will lend them: has changed, and we believe it’s a time to be cautious with residential property purchases.
The next ten years
We are not sure what will happen to home prices over the next five years. Home prices could easily fall between now and 2020. There is every prospect that share prices will do much better than housing prices over the next five years and perhaps even the next ten years. We believe the historical rates of return attached to residential property will probably not be able to be repeated in the period 2015 to 2025. They may be, but the odds are against it. This means clients should consider other strategies as alternatives to traditional home ownership. In September 2015 we ran webinars for the General Practice Registrars Association that identified “other strategies” including:
- maximum concessional super contributions every year ($30,000 up to age 50 and $35,000 over age 50)
- extra non-concessional super contributions every year (maximum $180,000)
- buy a property to rent out to a tenant and live cheaply elsewhere, perhaps with friends or family, after living in it briefly to set it up as your CGT free principal place of residence, under the 6 year rule
- the stepping stone approach, ie buy something small and low cost now, perhaps a small town house, pay it off as fast as possible using an interest offset account, and then draw your equity out to buy a new bigger and better home and keep the old home as a (very) negatively geared investment
- arrange a loan facility and buy say $500,000 of shares rather than $500,000 of home, and pay the same amount into it as you would pay on to your home loan, and reinvest all the (after tax) net dividends or
- a combination of the above.
For the record, we doubt a bubble will burst in the sense of a sudden significant drop/collapse in property prices. It will be more moderate than that; minor drops followed by a prolonged period of nothing much happening here, and real (ie inflation adjusted) prices falling a bit each year until affordability resumes.
The next twenty years
Our thoughts and expectations change as we cast our minds further into the future. The twenty year forecast is much better than the ten year forecast. Well located homes in good suburbs will cost a lot more in 2035 than they do in 2015. Clients should be fattening their residential property portfolios and buying a home, or up-grading to a better home, is one way of doing this. The disadvantages of home ownership set out above are all valid and relevant. But we believe the advantages outweigh the disadvantages once you move out beyond a ten year time frame. In particular, the strong population growth over the next few decades dominates our thinking and means home values will rise significantly in the popular suburbs, particularly Melbourne, Brisbane and Sydney. We therefore routinely recommend clients buy good quality well located premises in these areas, with a holding period of two decades, both as homes and as investments.
Homes for children
Investing over the decades and the generations mean children and even grandchildren are very much in our mind. If you have children over the age of 18 should encourage their children to buy their first home, with the next 20 years in mind, and fully aware that some of the alternatives may be better particularly in the next ten years. A loan, or a bank guarantee, from mum and dad means the next generation can enter the property market much earlier than otherwise, and can buy properties at 2015 prices rather than 2035 prices. And if the children stay at home and rent the property the tenant and the tax benefits pay most of the costs, really accelerating the wealth creation process. It’s a great way to create a permanent financial advantage for your children. Property is an inter-generational asset. You have to think that far ahead. The only real down side is the risk that the property may fall in value and the parents become exposed under the guarantee. This is a manageable risk, and one most parents should prepared to take on: I have never seen a parental property guarantee called in. Exercise some basic common sense and everything will be fine.
Don’t invest in apartments unless it is on the secondary market (ie not off the plan) and has perpetual views that can never be bought out. There is an over-supply of apartments in both Melbourne and Sydney so the capital gain prospects just aren’t there. Sure, some apartments will be OK investments. But most won’t be. It’s better to be safe than sorry. On 2 April 2014 the Age newspaper quoted Robert Mellor, managing director of real estate researcher BIS Shrapnel, as saying there could be 2,000 apartments in excess to demand in Melbourne alone, and Louis Christopher, the managing director of property researcher SQM Research, as indicating that the Sydney apartment market was over-supplied too, with higher planning approvals, low rental yields and rising vacancy rates forcing values down. Some apartment developers are offering up to 20% commission to financial planners to get them to flog their stuff. If an apartment needs a 20% commission to be sold you can be sure it’s never going to be a good investment.
Don’t invest in tourist accommodation either. There is an over-supply and the capital gain prospects just aren’t there either. In 2011 a client made the classic mistake of buying a Gold Coast apartment for $400,000 while on holidays. It seemed a good idea at the time. The rent was good, $30,000 a year, which meant the interest of $22,000 a year is more than covered. The problem is management fees of $15,000 a year and cleaning costs of $6,000 a year. Throw in rates and water and total outgoings are more $45,000 a year. The cash shortfall is more than $15,000 a year. The apartment is worth less now than it was in 2011, and brand new apartment blocks are springing up all the time. Any capital gain is decades away. Holding costs of $15,000 a year means the family’s week in Surfers each May costs more than $2,000 a day, and he has missed out on nearly $80,000 of capital gain. That’s what we call an expensive holiday. In summary, tourist accommodation is too risky. The Australian dollar has made overseas holidays cheaper and virtually killed in bound tourism. There are too many apartments and too few genuine buyers, and you are at the mercy of the apartment managers.