Residential Property

Property Musings

A few brief observations today which I’m preparing ahead of a trip to Hong Kong – its my first time to Hong Kong and I’m excited to experience the most unaffordable housing market in the world… even more unaffordable than Sydney!

I’m going to start by being a little patronising. Bear with me – there’s a few points I’m working towards…

Why do we invest? Seems a simple enough question… To create wealth right? Grow our assets.

Okay so how do we invest? Well that’s also something we surely know. But just indulge me for a moment…

We’d often start with an assessment of our risk profile. Where are we at in life? When will we need our money back? What’s our investment horizon? What’s our investment objectives – do we need regular income distributions to provide for living costs, or are we happy if the bulk of our returns are in the form of capital growth?

We’d then overlay this with some research on prospective risk and return. Liquidity and transaction costs. What are our investment options? What are the prospective returns and risk for each option?

We can then begin to construct a portfolio of investments that will deliver an acceptable return (hopefully) in an acceptable form (income/capital growth) whilst having an acceptable level of risk (“risk” being simplistically defined as a potential level of return that doesn’t meet our expectations – whether to the upside or downside).

We can magnify our prospective returns via leverage. In the simplest sense, if our expected rate of return is greater than our cost of funds, we should keep leveraging until the bank manager balks. But of course leverage will also magnify our risk so we need to be careful.

Now, I want to focus on just one investment option – residential property.

Nationally, residential property has had a stellar 20 years – average returns in terms of capital growth have been around 10% p.a. plus there has been some yield along the way. But if we look at a longer-term perspective, returns have been more modest.

The chart above also highlights the times where prices fell 5% or more year-on-year. The chart isn’t up to date – with prices now down somewhere around 10-15% in Sydney or Melbourne over the past 12 to 18 months, this is now well on the way to being the biggest housing correction in the last 60 years!

There’s a few more observations we can make here:

If we follow the median prices line, prices didn’t move far at all from the mid-‘70’s to the mid- ‘90’s. There’s various property investment axioms along the lines of “prices traditionally double every 7 to 10 years”. Well, that clearly depends on the period in time you care to look at.

We can reasonably observe that volatility in interest rates through the ‘70’s and ‘80’s resulted in meaningful swings in prices. Periods of stable interest rates have seen more stable prices.

We also know that the ‘80’s is remembered as a period of quite high inflation – represented by the high interest rates seen in the chart below during the mid ‘70’s to around 1990. It’s therefore interesting to observe that median prices didn’t shift all that much during this inflationary period – clearly “inflation” didn’t spill over into asset price inflation (at least residential housing).

Another observation is that median prices have really taken off since around 1995 when interest rates came down. Maybe it was related to a stronger economy during this time? Lower inflation giving people greater confidence? Cost of money being lower enabling people to borrow more.

There’s of course no specific answer; it’s a combination. There was however something else that took off during this period: Debt.

I’ve talked about this repeatedly now for several years. Australia sits right up the top on the global leader-board when it comes to household debt to GDP. In fact, only Switzerland is beating us with around 128%. (It matters a lot that Switzerland has a massive current account surplus – currently around 10% of GDP… but I won’t digress into that today.)

The key point is that during this last 20-year period where we’ve witnessed annual property price gains of around 10% we’ve also witnessed a massive increase in debt, to a level that’s basically unprecedented on a global basis. Trust me, it’s not just a coincidence that property prices have had a strong run whilst debt has been piled on. There is a direct correlation.

My hypothesis for several years now is that we might be nearing a point where debt simply can’t increase any more. It’s very improbable that debt will keep growing the way it has – we’re nearing the point where the nation’s debt servicing capacity is maxed out. And it’s very improbable that property prices will be able to keep growing in the face of a decline in debt.

The downturn is being blamed on the banking Royal Commission and a tightening of lending standards. I don’t disagree that these have had an influence, however ,I feel that these are more a symptom of the larger issue – being that debt has reached saturation point.

Circling back to where I began, when it comes to residential property, my belief is that investors need to think a lot harder about what they want to use as an “expected return” number in their investment analysis.

Since prices took off and investment loan repayments began totally outstripping rental incomes, capital grown has really been the name of the game for residential property investing. And why not – prices have been rising at 10…11…12 percent per year in recent years!

I want to raise something else that I know will be controversial…

Sorry, but I don’t view “tax deduction” as a particularly valid input into an investment analysis. It’s not a legitimate return – hell, if you want to include that then the higher the price you pay the better! Higher price = bigger loan = higher repayments = bigger loss = bigger tax deduction! And sadly, I’m sure that some investors have been suckered in to property with that precise logic in recent years.

Although Andy and I disagree on whether the Labour party’s proposal to end “negative gearing” is an overall positive or not, it will certainly bring some greater rationality into investment decisions. Prospective returns will need to be assessed more objectively with less focus on a tax deduction and more focus on critical investment criteria.

Given this stance, it really distresses me to witness a huge crowd of real estate insiders acting in a way I can only perceive to be extreme self-interest. Lobbying very actively against Labour’s proposed reforms during this election campaign period – making out that the world will basically end if Labour’s proposals are introduced.

If you’re a Sydney or Melbourne-based real estate agent with an investment portfolio full of Sydney or Melbourne-based property – with leverage – you’re right to be very concerned. You’re “all-in” – you’re reliant on transactions to provide you income and your wealth is tied to prices. But I’m sorry I don’t have a lot of sympathy for concentrated risk – diversification is a necessary piece of any investment strategy, as are considerations such as liquidity and gearing (leverage). A perpetual bull market isn’t your right. In fact, all professional investors understand that every market has its ups and downs.

Would the end of negative gearing hurt property prices? Maybe. I don’t know – nobody knows. It partly depends on how much prices drop before changes are introduced. It probably will add some downward pressure to prices but I’m afraid I still believe it’s in Australia’s interest overall. Property prices may be offset by financing restrictions that support or increase rental returns due to demand. The system will eventually balance itself out, where risk and return equate to an arms-length buyer and seller agreeing a price.

As a final note, and speaking of diversification, let me mention Aviator’s latest investment offer – the Aviator Cannon Hill fund. This is the fifth REIT opportunity we’re pleased to be able to offer investors. The investment in question is an A-Grade commercial office building in Cannon Hill, QLD. We should point out that commercial property is a different asset class to residential property and has different characteristics, performance and market forces. In the current low interest rate environment we think it will perform very well.

The investment is targeting an initial net cash distribution of 9% p.a. paid monthly. In our humble opinion the risk versus reward profile on the offering is very attractive when we survey the current investment landscape and interest rate outlook. And it would add some much-needed diversification to a lot of portfolios.

Be sure to read the Information Memorandum for all the important information and note that the offer is only open to Wholesale Clients. If you’re interested please get in touch with

Andy at:
Andy.Glen@AvCap.com.au
Tel: 1300 55 88 58