Investors are often interested in the relative performance of residential property compared to shares. This is especially relevant in New Zealand due to our high levels of investment in residential property compared to international norms.
According to RBNZ data, the total value of household investment in residential property (excluding vacant land), was $838 billion at 31 December 2018. Residential property serves a dual function as both a place to live and as a vehicle for savings and investment. Either way the value to New Zealanders of this asset class is significantly higher than the amount that households invest in New Zealand and Overseas listed shares. At 31 December 2018 households had invested only $112 billion in this asset class.
The graph below shows the comparative returns on the New Zealand Stock Exchange NZX 50 index and its predecessor NZX 40 index for the 27 years from 1 January 1992 to 31 December 2018. Prior to June 1991 the headline index for the NZX was the All Shares index.
The NZX 50 and NZX 40 indices are gross indices and they measure the total return to shareholders comprising dividends and capital gain.
The New Zealand Residential Housing data is drawn from the RBNZ House Price Index for which data is available since December 1990. This index does not include net rental income from rented property but it gives a good indicator of capital gain in residential property over the 27-year period.
Gross returns on the NZX versus Capital Returns on the New Zealand Residential Housing Market since 1991
The data tells us that:
· The annual compound gross return on the NZX 50 was 9.49% p.a. over the 27 years, with a total return over the period of 1,056%.
· The average compound capital return on New Zealand residential housing was 6.44% p.a. with a total capital return of 439%.
· However returns on the NZX were more volatile ranging from negative 32.80% in 2008 to plus 47.8% in 1993. In comparison the range for residential housing was a negative 8.9% for 2008 with a high of 24.9% in 2003.
· The NZX incurred losses in 6 of the 27 years as follows:
o 1994 (7.2%)
o 1998 (4.4%)
o 2000 (8.0%)
o 2007 (0.3%)
o 2008 (32.8%)
o 2011 (1.0%)
· The residential housing market incurred capital losses in 4 of the 27 years:
o 1998 (3.6%)
o 2000 (1.2%)
o 2008 (8.9%)
o 2010 (1.6%)
These dates indicate a degree of correlation between the two asset classes.
The following graph shows the growth of $10,000 invested in each asset class on 1 January 1992 through to December 2018.
Growth of $10,000 Invested in the NZX and Residential Property over 27 Years
Assuming reinvested dividends, $10,000 invested in the NZX would have grown to $115,600 by 31 December 2018 (1,056% growth). $10,000 invested in residential property would have grown in value to $53,890 over the same period (growth of 439%).
It is interesting that over the full holding period, NZX investors were able to maintain a relative advantage to residential property despite the more volatile sharemarket returns as measured annually.
The main risk for individual investors occurs when their holding period is short and they become forced or reluctant sellers in a down year. The 2008 year being a great case in point due to the onset of the Global Financial Crisis. The graph shows that investors that held their nerve over this period were amply rewarding over the following decade with NZX returns of 229% compared to residential property of 80%.
Of course these figures are composite figures and individual investors may have earned better or worse returns depending on the mix of individual investments they make.
Property investors frequently make additional investments to improve their properties, for example landscaping, insulation, adding extra rooms, decks, utility sheds and garaging. These additional investments find their way into the Housing Indices when properties are sold. Ideally this additional investment should be backed out of the Indices so as to give a true measure of the capital growth enjoyed by investors, however the extent of this additional investment is not reported in the RBNZ Housing Index and therefore this index overstates capital growth by including the value of improvements or renovations.
In contrast, the NZX 50 is adjusted for rights issues so that capital growth from newly introduced capital is excluded.
Net Rental Income
The graphs exclude net rental income (yield), earned from rental property. Of course this income stream can be significant for rental property investors, but it is not relevant for owner/occupiers. If New Zealand residential rental property investors earned a running net yield of 3.05% p.a. on the capital growth of their properties they would have matched the NZX return. This is calculated as the difference in the annual gross return on the NZX and the capital return on residential property i.e. 9.49% - 6.44% = 3.05% per annum.
Based on median 3 bedroom house prices and rents as at April 2019 as reported by REINZ and the Department of Housing and Building, the national average rental yield is 4.05%.
From this we should deduct annual maintenance, insurance, rates, real estate management fees and other costs which I assume will take-up 1.5% of the yield.
When tax is taken into account at say 33% (see below), the net yield reduces to 1.7%. It is clear that residential property investors are counting on future capital gains for the lion’s share of their returns going forward.
By comparison at June 2019, the NZX 50 gross dividend yield was 3.88%. The net yield for taxpayers on 33% would be 3.69% if the dividend is fully imputed at the company tax rate of 28%.
Tax
Gross NZX returns are calculated after tax at the company level. The individual is given credit for income tax paid by the company. Most NZX listed companies pay fully imputed dividends at the company tax rate of 28% and therefore an individual on the highest marginal tax rate is only required to pay an additional 5% on the dividends they receive.
However net rental income is fully assessable to the investor at their marginal tax rate.
Capital gains are generally not payable on New Zealand shares or property unless the investor purchased the investment with the dominant intention of making a profit on sale or is in the business of trading in shares or property.
However in the case of residential property there is a bright line test whereby from 29 March 2018, anyone who sells a house in New Zealand within five years of buying it must pay income tax on any gains, unless it's their main home or another exception applies.
Leverage
Probably the primary advantage the residential property investor has is the ability to borrow more aggressively to fund their property portfolio. Banks are very willing to lend heavily against housing – in the absence of regulation they will typically lend to 90% of valuation, although they may be less willing to be so aggressive on investment property. Normally therefore property investors can control a larger property asset base per dollar of capital with the balance being funded by bank debt. The result is that they can juice up their return on capital beyond the composite 6.44% p.a. return calculated by the RBNZ for this asset class. Of course higher leverage will result in greater losses if the property investor is forced to sell in a downturn. As shown above, there have been four negative years in the 27-year review period.
Companies also borrow in order to maximize their returns. Given that share prices are more volatile than residential property, most share-market investors avoid borrowing to fund their share portfolios. If they do borrow to fund their share portfolios they should be wary of doubling down on debt because both they and the companies in which they invest will have borrowed against the same underlying business.
Banks will generally not lend more than 50% to 65% of a share portfolio to investors and the lending will be subject to margin calls if prices fall.
In preparing their income tax returns, investors can deduct interest expense on their investment properties or share portfolios. However from 1 April 2019 any tax losses arising from residential rental property (typically interest cost is the main reason for these losses), is to be ring-fenced and cannot be offset against income from other sources such as salaries and wages. The aim of this law change is to level the playing field as between owner/occupiers and property investors.
Diversification
In order to reduce risk it is highly advisable to diversify investments. In the case of the New Zealand sharemarket this can be easily achieved by investing in smaller parcels of shares issued by a wide variety of companies.
Alternatively investors can make a single investment in a diversified managed fund or an Exchange Traded Fund (EFT). As an example, an investment in the Smartshares NZX Top 50 EFT is an investment in a basket of securities that represents the NZX 50 index. The EFT’s value is based on the net asset value of the underlying shares making up the index, but it trades as a single security on the stock exchange. This type of investment therefore makes it very easy to achieve diversification across all 50 companies in the index and in the underlying industries in which they are engaged, and to replicate the composite return available on the New Zealand sharemarket.
It is very difficult to achieve an equivalent level of diversification in residential property because individual properties are expensive and it is difficult to buy partial ownership. In addition investors are wholly exposed to this single market segment and its demand and supply characteristics.
Liquidity
Property investments are not considered to be ‘liquid’ because the investor can’t withdraw their investment quickly. To get money out they need to sell the property or increase the mortgage. It is much more difficult to sell a part share of the property than it is to sell a parcel of shares. In addition it may not be easy to increase the mortgage in a downturn when Banks may tighten their lending criteria – and there can be extra costs such as valuation and real estate agent fees.
In contrast shares of NZX listed companies can be sold either fully or partially within minutes using an on-line trading platform or by a phone call to your broker. Typically for the larger top 50 companies daily turnover is very high, therefore investors do not need to search for a willing buyer and don’t need to contemplate discounting in order to sell.
Sharemarket investors also have an advantage when buying because they can buy small parcels of shares on a regular basis, say monthly, and they are not therefore exposed to the consequences of a single large poor timed investment.
Sharemarkets are the most liquid of the various asset classes and this means they are the first port of call for investors wanting to cash up during periods of market turmoil, and this characteristic increases the overall volatility of this asset class.
Real Assets
Many investors in residential property take real pride in owning a tangible asset over which they have full control and decision making powers. They also gain a strong measure of comfort knowing that except in the worst event of a natural calamity, the land will still be there and they are unlikely to suffer a total loss. These characteristics do not apply to share investments where control is vested in boards and executives who do not always act in the best interests of investors and where in the worst event there can be a total loss of value due to factors that can’t be predicted such as technological change.
Many property investors enjoy being able to evaluate and maintain property as this asset class lends itself to a hands-on approach and seemingly does not require specialist research skills. Unsophisticated share market investors can acquire research skills via managed funds, however this will incur management fees that eat into returns.
So Which is the Better Investment
Both asset classes are excellent investments and they should be part of most investors’ portfolios. The two asset classes have different profiles relating to growth, return, risk, income, tax, leverage, diversification, liquidity, control and research.
So the answer is to invest in the right mix of each asset class that best suits the individual requirements of the investor. This mix will change over time and it will depend on the relative attractiveness of the particular investment at the time funds are available to invest. In this respect please read my post dated 17 February 2019 – Housing Affordability – has the housing bubble run out of steam?
If you need help identifying the mix that best suits your needs please don’t hesitate to contact me.