Investing directly in property is very popular in New Zealand and Australia. Many (most?) people think that investing in property in this way is the best way to build wealth. And there are certainly plenty of people who have generated a significant amount of their wealth through property.
One thing that concerns me is that while property can – and has – generated wealth, it’s also possible for property to destroy wealth. Or, less drastically, to generate a return that is less than other forms of investment, such as investing in a diversified basket of listed shares.
In particular, property has three qualities that can result in it being riskier than other types of investments.
If a financial adviser was to recommend a financial product (such as an interest in a particular company) that had these three qualities, it would be difficult for them to show that their advice was appropriate and in the best interests of their client. They’d need to go a long way to demonstrating the suitability of such an investment, and have ample documentation showing that they drew the client’s attention to the risks involved.
- Property is illiquid
Let’s say you own a property. For whatever reason, you want to sell it. Maybe you need the money because your financial circumstances are not as good as you expected. Or maybe you have an investment opportunity that you can’t turn down.
Can you sell the property to release the funds you need immediately? No. You need to put it on the market. There’s a great deal of uncertainty about how long it will take to sell the property and what you’ll get for it. And there are various transaction costs associated with the property.
If you have money in the bank, on the other hand, you can access that money immediately. If you hold publicly listed shares, you can generally sell these on NZX or ASX in a matter of days. In this sense, money in the bank is liquid, publicly listed shares are liquid (but less liquid than money in the bank), and property is illiquid.
All else being equal, it’s best for assets to be liquid. There are exceptions to this, and for many people, liquidity isn’t an issue. But it’s something that should be kept in mind.
- Property is undiversified
If you invest in a property, you’re putting a lot of your eggs in one basket. You’re totally exposed to unique risks to the property and the local property market.
If there’s any downside in the property market, you have to wear it. If the property is untenanted for a period of time, you have to suck up the lost income while still servicing the costs associated with the property.
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That’s a lot of risk to bear.
As a general rule, the more you diversify your investment portfolio the better. Another way of putting it is that rather than putting your eggs in one basket, you should put them in lots of baskets. This means that if one of your investments goes badly, it’s unlikely for all of your investments to go badly, so that your loss is minimised.
(You could argue that by diversifying you’re limiting the potential return, but there are complicated mathematical formulas that show that if you invest in assets that aren’t correlated – ie, don’t go up and down in identical ways – you can reduce your risk for a given level of expected return. If you’re interested, you can read about “modern portfolio theory” and “efficient portfolios” or “efficient frontiers”.)
(It’s possible to invest in property in a diversified way. Financial products called real estate investment trusts are professionally managed trusts where a number of people pool their money together, and purchase a large number of properties. If one property is untenanted, the other tenanted properties offset this to some extent so income is still generated. If one property incurs significant expenses or suffers a significant decrease in value, then the other properties aren’t likely to have the same issues, smoothing the risk. Real estate investment trusts address many of the risks in this article, but this article is not intended to focus on these types of investments. The only additional comment I’ll make is that it’s rare for such a vehicle to invest heavily in residential property. If professional money managers don’t invest in residential property, does this tell us anything?)
- Property is often geared
When most people invest in property, they are borrowing money to do so.
Let’s use a simplified example. Say you put down a deposit of 10% of $50,000 towards a $500,000 investment property, meaning you borrow the remaining $450,000.
If your investment property increases in value by 10%, then it’s now worth $550,000, which after factoring in the $450,000 debt, puts your net position in the investment at $100,000. $50,000 to $100,000 – you’ve doubled your investment!
If the property decreases in value by the same amount, however? It’s now worth $450,000, which is the same as the debt you owe against it. Your net position is now $0. Your $50,000 deposit has gone.
Gearing can magnify gains. It can also magnify losses.
If you purchased the property but didn’t borrow against it, an increase or decrease of $50,000 only represents a 10% return, compared with the example above of 200% or -100%.
It means your returns or losses are really sensitive to changes in value. Don’t get me wrong – you can make a lot of money doing things this way. Many people have.
But you need to recognise that there’s significant risk here. And many people have lost money like this as well. For some reason, however, the “losers” are less inclined to talk about their experience than the “winners”. I wonder why that is?
I need to stress that I’m not against property investment per se. Certainly, I have reservations, including:
- the cultural bullishness towards property in New Zealand and Australia and even some of the policy settings that favour property;
- the general sense that “property always increases in value” – it doesn’t; and
- the fact that there are many powerful people and organisations with an interest in promoting property as an investment (for example, sellers and financiers of property), while there are very few people with an incentive to do the opposite.
But my key point isn’t that direct property investment is bad. Just that, like any investment, it has risks, and it’s important to be informed about them.