It’s all about gearing, not property

It is often debated which is a better investment, property or shares.

It is my thesis that property is an okay investment, but not as good as shares.

However, when you factor in gearing (the ability to borrow to invest), property becomes a wonderful investment – better than shares.

Property versus shares

The main advantages of shares (compared to property) include:

• You can outsource the management of a share portfolio to an advisor. However, as a property investor, you may need to spend time working with your managing agent to deal with tenant issues and/or property maintenance/repairs.
• Shares can generate a stable level of income with no (or few) related expenses. For example, the ASX200 index has yielded circa 4.5% p.a. for a long time.
• Shares are liquid and have low entry and exit costs e.g., no stamp duty, real estate agent fees, etc. This means you can invest and divest in small increments.

The main advantages of property include:

• Most investors feel comfortable borrowing to invest in property, which means you don’t need to make a large upfront cash contribution to be able to invest.
• The assets' tangibility can make investors feel more comfortable.
• You don’t need ongoing financial advice after you have purchased the property.
• The investment-grade property provides most of its return in capital growth in return for less income, which is tax effective.

We can debate the pros and cons of shares and property until we are blue in the face, but I think it’s a meaningless debate.

It’s like debating which golf club is better.

They are all different and you need more than one club to play well.

How do returns compare?

My thesis is that it’s not property that makes property investing so effective.

It’s the gearing that does a lot of the heavy lifting.

Therefore, an investor's decision is not whether to invest in property or shares.

Their decision is whether to borrow to invest or not.

If it is appropriate to borrow, and they can do so safely, then borrowing to invest in property will likely generate the highest return.

I financially modelled borrowing to invest in a property, holding the property for 25 years, and selling it to realise the cash proceeds after repaying the loan and paying for capital gains tax (my assumptions are in the footnote).

Whilst the investor doesn’t need to make a cash contribution (as they borrow the entire cost of the property), they do have to pay for the holding costs i.e., the shortfall between net rental income and mortgage interest.

The internal rate of return calculates what return you generate from paying for these holding costs in return for making a capital gain in 25 years’ time.

I calculated the internal rate of return to be 13.96% p.a. which is very attractive (see chart below).

How much does gearing help?

The return from borrowing to invest in property is so high because of the impact of gearing.

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That is, an investor's cash contribution (i.e., holding costs) is relatively small compared to the capital gains, after tax.

If I eliminated the impact of gearing, the investor's internal rate of return falls to 7.41% p.a., because the investor must contribute a huge sum of cash at the beginning.

Therefore, gearing adds 6.55% towards the total return as depicted below.

If we compare that to investing in shares i.e., invest over $1m into the share market in one hit, hold it for 25 years and then sell the whole portfolio, the investor's internal rate of return would be 10.29% p.a., which is much better (almost 3% p.a.) than an ungeared property investment.

However, most investors (rightly) wouldn’t feel comfortable investing a large amount in one hit, as shares are twice as volatile as property.

Therefore, if you invested the $1 million equally over 25 years (i.e., $40k p.a.), an investor's internal rate of return would be 7.98% p.a., which is similar to an ungeared property.

It’s not a property or shares question…

Often, people have trouble deciding whether they should invest in property or shares.

Instead, I propose that they first consider whether they should borrow to invest or not.

If the answer is yes, then they should invest in property.

If not, then shares are probably more suitable.

When contemplating whether it’s appropriate for you to borrow, you should consider:

• Whether the banks will lend you money i.e., do you qualify for a loan;
• Whether your borrowing capacity is enough to buy quality (investment-grade) property;
• Your level of existing borrowings;
• The value of your net asset base e.g., if you have a low asset base, then you probably should borrow to invest if you can do that safely.
• How close you are to retirement and/or the desire to reduce working hours/income;
• The mixture of existing assets i.e., the value of property and shares you already own; and
• Your appetite for risk.

Shares and property are not mutually exclusive

It is possible to build substantial wealth through investing in property or shares.

If implemented correctly, either asset class will generate enough returns to become financially independent.

However, often, the best approach is to invest in both property and shares to balance out the pros and cons at a portfolio level.

That’s why it’s important to work with an advisor that has deep knowledge and experience in these two major growth asset classes.

Footnote: Assumptions: Investors borrowed the full cost of a $1m property including stamp duty and buyers’ agent fees. Rental yield of 3% p.a. less 25% of gross rent for expenses. Capital growth rate of 7% p.a. Mortgage interest rate of 6% p.a. which implies a long-term RBA cash rate of 3.25% p.a. Investors marginal tax rate of 39%.