Key takeaways
Every asset class comes with its own set of advantages and disadvantages, and property investment is no exception.
I often highlight the many benefits of investing in property and offer strategies to become a successful property investor.
However, it’s equally crucial to recognise the downsides that come with property investment and think about how to minimise their impact.
In this article I highlight six drawbacks from investing in property and ways to mitigate them.
Every asset class comes with its own set of advantages and disadvantages, and property investment is no exception.
I often highlight the many benefits of investing in property and offer strategies to become a successful property investor.
However, it’s equally crucial to recognise the downsides that come with property investment and think about how to minimise their impact.
It is important to note that you won’t be able to eliminate these drawbacks in full, which is why I believe most investors should invest in a variety of asset classes.
1. You may need to wait 30 years to be happy with the returns
Fully understanding the concept of compounding returns is crucial.
For instance, if you invest $100 and achieve a 7.5% after-tax return, your investment will double approximately every 10 years.
What’s remarkable is how the dollar value grows exponentially over time due to compounding.
By the third decade, the return will be 4.5 times higher than what it was in the first decade, as illustrated in the chart below.
Compounding rewards patient investors.
If you happen to invest in a property just before a flat cycle, you will need to hold onto the property for an extended period to see satisfactory growth.
I previously wrote about the importance of considering property market cycles a few months ago here.
Whilst all asset classes benefit from compounding returns, this effect is particularly important for investment-grade property as most of your overall return comes from capital growth, with relatively less from rental income after expenses. Therefore, holding onto property for 30 years or more is essential to fully capture the substantial benefits of compounding capital growth.
Mitigant: make sure you have other investments such as shares and super that you can rely on to fund the initial period of retirement, allowing you to retain your investment property/s for an additional decade or more.
2. It can be a hands-on investment
I don’t want to exaggerate the amount of time that it takes to manage a property investment, but it is important to realise that is does take some time.
In contrast, other asset classes such as shares require very little time.
You might worry about wasting hours of your time dealing with nightmare tenants.
However, in my experience, this is very rare if you (1) invest in investment-grade properties that attract quality tenants and (2) hire an effective and experienced property manager.
However, there are times when you’ll need to invest your time in tasks like renovations or repairs.
Based on my personal and professional experience, these situations arise sporadically, perhaps every 5 years.
It’s important to anticipate these occurrences and be prepared to dedicate a few hours each year to managing your investment.
Property is not a completely hands-off investment.
Mitigant: selecting the right property and the right property manager should greatly reduce the amount of time you need to spend managing your investment.
3. Low and potentially unreliable income in retirement
Typically, investment property yields vary from 2% to 5% depending on location and the type of dwelling.
However, as I recently discussed here, associated costs often amount to about 35% of gross rental income.
Therefore, annual net rental yields after expenses typically range from 1.3% to 3.3% of a property’s value.
Additionally, land tax further reduces your investment returns.
As such, residential property is a comparatively lazy asset from an income perspective.
Moreover, spasmodic, and unforeseen, once-off repair expenses can arise from time to time, making rental income somewhat unpredictable.
In contrast, historically, the ASX200 has reliably yielded over 6% per annum, including imputation credits.
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Mitigant: invest in property almost exclusively for growth. Do not place too much reliance on its income. As such, you must have other assets such as shares and super.
4. It’s illiquid
With property, it’s all or nothing.
Unlike other assets like shares and bonds that can be sold gradually, selling an investment property doesn’t offer much flexibility to minimise your Capital Gains Tax (CGT) liability.
In addition, it may be faced with the challenging decision of how to reinvest a large amount of cash proceeds.
Mitigant: rather than repaying associated loans, consider accumulating cash in a linked offset account.
This approach not only helps minimise interest expenses but also provides access to funds in case of emergencies.
Additionally, if your investment strategy involves potentially selling a property in the future, carefully consider its ownership structure.
Choose a structure that optimises your tax position, including minimising CGT.
5. Subject to legislation and tax changes
While all investments involve legislative risk, property is notably vulnerable to changes in taxation and law because some states derive nearly half of their tax revenue from it.
For example, in recent years, most states have tightened tenancy laws and imposed new and increased taxes on landlords. In contrast, other asset classes typically don’t subject investors to similar risks.
In the long term, state and federal governments depend on private investors to supply an adequate amount of rental accommodation.
Without it, economies cannot thrive.
Therefore, although governments may implement short-term changes that negatively impact landlords, ultimately, they have a vested interest in ensuring they foster a healthy private rental accommodation market for long-term economic prosperity.
Mitigant: there’s little investors can do to directly mitigate their investment risk. Of course, you can help advocate for sensible and balanced legislation.
6. It is a very large financial commitment
To buy a blue-chip, investment-grade property in Australia, investors typically need a financial budget exceeding $1 million.
That means would-be investors need to make friends with borrowing a lot of money and agreeing to the substantial ongoing commitment of servicing that loan i.e., covering the cash flow gap between the property’s net income and loan obligations.
Such a significant financial commitment does have its advantages.
It compels investors to invest a substantial amount upfront.
Assuming they choose the right property and hold onto it for many decades, they will benefit from compounding growth and accumulate considerable equity.
However, the reality is that investing in property entails a fixed and substantial financial commitment.
Other than selling the property, there are limited options to adjust this commitment if an investor’s circumstances change.
Mitigant: other than being conservative with your borrowing capacity, the only way to mitigate this downside is by reducing your budget, but I wouldn’t recommend doing so if it means investing in a poor-quality asset.
While this blog has highlighted the drawbacks associated with investing in residential property, it’s important to note that there are plenty of positives, such as the power of leverage.
Many Australians have built substantial wealth through property, as evidenced by a quick look at the AFR Rich List.
Every investment carries risk.
Diversifying across asset classes, including property and shares, can help mitigate some of the negatives discussed above.
However, it’s impossible to eliminate risk entirely, so understanding and accepting an investment’s potential shortcomings is essential.
