Property and especially Australian property is an excellent investment. Not only is it much harder to lose money in property than in the stock market, but with property you also benefit both from steady capital growth and from rental income. And as rental income increases over time it protects you from inflation. At the same time you can borrow money to buy property and despite Australia’s high taxation environment, property investment can be very tax efficient.
Let’s have a look at these advantages and some more beneficial aspects of residential property investment in a bit more detail.
1. An investment market not dominated by investors
First of all, you need to realize that some seventy percent of all residential property is “owner occupied” and only thirty percent is owned by investors. That means that residential property is the only investment market not in fact dominated by investors, which means that there is a natural buffer in the market that is not available in the share market. To put it simply, if property values crash by 10%, 20% or even 40% we all still need a home to live in and so most owner occupiers will simply ride out any major crash rather then sell up and rent (compare this to the stock market where a major drop in prices can easily trigger a serious meltdown). Sure, property values can and do go down but they simply do not show the same level of volatility as the share market and property offers a much higher level of security.
And if you don’t believe me when I tell you that residential property is a safe investment, then just ask the banks. Banks have always seen residential real estate as an excellent security and that’s why they’ lend up 90% of the value of your property; they know that property values have never fallen over the long term.
2. Sustained growth
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Property prices in Australia tend to move in cycles and historically they have done well, doubling in cycles of around 7 – 12 years (which equates to about 6% to 10% annual growth). We all know that history is no guarantee for the future but combined with common sense it’s all we have. There is no reason to think that the trends in property of the last 100 years would not continue for the next few decades, but to be successful in property investment you must be prepared and capable to ride out any intermediate storms in the market, but that applies to any investment vehicle you choose.
Australia’s median house price between 1986 and 2006 as published by the Real Estate Institute of Australia (REIA) shows that back in June 1986 you would have bought an average home for $80,800. That same home would have been worth $160,500 in 1986, which is pretty much double of what you paid 10 years earlier. Another 10 years later in 2006 that average home was worth some $396,400. So between 1986 and 2006 that average home went up by nearly 400% or about 8.3% per annum.
Not bad. And quite in line with the longer term history.
In fact, as Michael Keating points out in his blog on 24th January 2008 (Why Melbourne’s properties will keep rising), it is actually on the low side compared to the historical average. Australia’s property prices have been tracked for something like the last 120 years and on average they have risen 10.4% per year. Just in case you might believe that had to do with Australia being a newly found colony, and don’t believe this would be sustainable in the long term, consider this. In the UK records of property sales go back till 1088 and analysis of the data shows that in those 920 years UK property on average has gone up by 10.2% per year.
3. Buy It With Other Peoples Money (OPM)
Now just in case the above has not been enough to convince of the value of residential property investment, let me tell you one of the great secrets of creating wealth, which also applies to investing in property. The secret is OPM. Other Peoples Money.
Secret? No – that’s just marketing hype you see on the web, but the power of Other People’s Money or more common referred to as leverage or gearing is absolutely critical to building wealth. And, in the case of property the leverage you can apply is substantial. As I mentioned above, banks love residential property as security and therefore will easily lend you 80% or 90% of the value.
It was Archimedes who said, ‘Give me a lever and I’ll move the earth’. Well, as an investor you don’t want to move the Earth, you just want to buy as much of it as we can! When you use leverage you substantially increase your ability to make profit on your property investments and, importantly, it allows you to purchase a significantly larger investment than you would normally be able to.
Let’s have a look at how this works. Imagine there are five investors each with $50,000 to invest. Say they all buy an investment that achieves 10% growth per annum and has a rental yield (or return) of 5% per annum. Investor A borrows 90% of the value of his investment property (Loan to Value Ratio or LVR of 90%) and investors B, C and D borrow 80%, 50% and 20% respectively. Investor E doesn’t borrow at all and goes for an all cash transaction.
Let’s start with cashflow, which is here simplified to rental income minus interest paid. Investor A, who geared 90%, has a negative cashflow of $15,500 for the year whilst Investor E who borrowed no money at all has a positive cashflow of $2,500. But that’s not the whole picture because each of the properties increased in capital value and once we include that the picture changes significantly, Investor A has a net worth increase of $34,500 whilst Investor E who didn’t gear increased his net worth by only $7,500. In terms of return on investment Investor A achieved a 69% return on his initial $50,000 whilst investor E achieved a return of 15%.
That’s pretty impressive for one year. And if the investors let their properties grow one or two full cycles we’re talking about serious wealth creation. And once the investors have enough equity in their investment property they can use that to fund a second purchase which after a few years growth will allow the purchase of a third and we’re on our way to wealth! That is, those investors who geared as Investor E is not going anywhere fast.
However, it is not all that easy. As you saw Investor A incurred a negative cashflow in his first year and would continue to do so for a few years until the rental income had grown sufficiently to pay his interest. He has to fund this annual shortfall from his salary. And this is called negative gearing – you borrow money to generate capital growth in your property but incur an annual shortfall in the near term. For most investors this means there will come a limit on how many properties they can buy with negative gearing, as they don’t have too much spare income. If you look in our strategy sections you can read more about negative gearing and techniques to avoid paying the shortfall out of your own pocket. We also address cashflow positive properties.
But let’s get back on topic and have a look at some more compelling reasons to invest in Australian residential property.
4. Income That Grows
We’ve discussed that Australian residential property vestment is safe, with long term growth prospects and combined with the right level of leverage can create significant wealth. We also briefly touched on the fact that it generates a rental income. The good thing is, that over the years the rental income received from property investments has increased and this increase has outpaced inflation. In fact the last few years have shown tremendous increases rents – I know because the rent on my investment properties has been booming. Still is actually.
Ok, but are rents likely to keep growing? Well, statistics show that the level of home ownership is slowly decreasing in Australia. There are a number of reasons for this like demographic trends but, in particular, as property prices keep rising, fewer people are able to afford their dream homes. The latest Australian Bureau of Statistics figures confirm that more and more Australians are renting and many industry commentators are suggesting that the percentage of Australian who will be tenants in the near future will go up to 40%. So demand is growing. We also know that supply of good quality rental properties is limited (very low vacancy rates across all of Australia) and the government is having difficulty providing public housing. So all in all, it is very likely that rents will continue to grow at a pace faster than inflation – good news if you intend to become a property investor!