Financial Planning as a profession has taken a lot of knocks in recent years. The Global Financial Crisis (“GFC”) was only the start of a litany of financial disasters and ‘unprecedented’ impacts on areas once considered ‘safe’. In the midst of this, Financial Planners attempt to balance the likely outcomes against the likely risks in an effort to provide some guidance on potential impacts of one strategy versus another. Yet the last few years have seen much of this guidance brought into question. Here we look at just one point – residential property in Perth, Western Australia.

Financial Planning – The Role of Property

This is one of the most contentious issues in financial planning circles, Australia wide. However, the relevance is even greater in Perth, owing to the astounding fact that Perth residential property prices have failed to spiral downwards as some have suggested it should. This makes any comparison of residential property with other investments fraught with difficulty – as facts are confused with commonly held myths amid claims of bias and conflicts of interest.

Disclosure of Bias – The business of which i am a shareholder (WSP Financial Services Pty Ltd) earns income from being noted as the “dealer” associated with various investment, managed funds and superannuation accounts. I charge fees to discuss residential property just as i would charge fees to discuss superannuation, investment, cashflows, estate planning or anything else. However, you could say that my part-ownership of the business biases me against residential property investment, as WSPFS is not a licensed real estate firm. Therefore, make sure you do your own research, and check any figures or points that i may raise, to assure yourself that this has not impacted on the content of this note. That’s about the best i can do, i am afraid. i may think that this is an unbiased report (which i do) but bias is often just an expression of ‘preference’, and that will often impact on our discussions, even if we think that it does not. So take my comments as just that – commentary – in the same way that i would hope you take any other non-personal financial discussion…. as just one input out of many that should be canvassed before taking any large financial decisions.

Back to financial planning, and the peculiarity of Perth property.

Financial Planning as it is applied to the investment world is a balance of the potential for returns against the potential risks that may get in the way of that return being achieved. Financial Planning 101 training starts from the assumption of ‘diversification’ – more commonly referred to as ‘not having all of your eggs in one basket’. This means financial planners measure a portfolio to identify any glaring exposures, and where appropriate, aim to reduce those exposures to the outcomes of any one ‘area’ against others that may be available. We can cover this in more detail as a separate note but the idea is that there is no way of predicting which area will do better or worse in the future, and therefore having a little bit of exposure to a lot of areas is one way of reducing reliance on any one particular investment or section of the economy. This is a basic precept of financial planning but it almost by definition, means that there will always be somewhere doing better and most likely, somewhere doing worse. As i said, this is financial planning 101.

However, the world does not operate according to a preset plan in this regard – just ask any central bank Governor. This has especially been the case post-GFC. There have been managed funds that are hugely diversified in their respective fields, and yet they have shown abysmal returns or even shown massive losses.

This is a rather long post – if you are too time constrained or bored to read the entire note, please make sure you have a quick look at the charts shown further on – even if only to validate the time it takes me to keep these figures current. I do think you will find them interesting.

Financial Planning – Property versus ‘Other’ Options

One of the most difficult, yet fundamental, choices that financial planners must confront when looking at options with their clients, is that between ‘managed investments’ and residential property. Why is this so? It is a result of the fact that residential property is a ‘default’ investment for most people. That is, once cash has been built up, debts are gone or under control, and there is a surplus of income or assets over what is perceived as ‘necessary’, most people will accumulate cash to the point where they begin to look around at what properties may be available for investment.

From a financial planning point of view, this will not always be the logical course of action – for a myriad of possible reasons, some of which are listed here:

• Lack of diversification – Most people do not have enough money to buy more than one property. Perth property especially, has reached stratospheric levels when considered from the point of view of a cash purchase. This means that the bulk of people who consider investing into property would only be able to buy one property. Even when there may be the chance of buying two, most people want to buy in the more sought after areas, which tend to be more expensive, thereby encouraging even less diversification.
• Concentration within a sector – A component of diversification but an important one from a financial planner’s point of view. If you have decided on gaining exposure to property then residential property will usually involve a direct asset purchase (although this may change over time as institutions become more involved in residential property projects), which means buying one property on one side of one street, in one suburb in one area of one city in one state’s economic environment. That is a lot of concentration of risk that can impact on that single investments’ returns over time.
• Gearing – Again, most people do not have $500,000 in cash (which is the average Perth residential property price, give or take an overseas holiday or two). Most people don’t even have $300,000 in cash for that matter, so even the lowest price properties will involve some level of borrowing or gearing.
• Cost – Financial planning is often seen as costly – especially when fees are charged for investment into managed funds or superannuation, where the perception of value for that investment can be difficult to see. However, the bulk of the community has been immunised from the impact of residential property costs simply because ‘it has always been that way’. In other words, there is an expectation that costs of around 5% of the purchase price are going to be encountered when buying a property. Now just think about that for a moment… $25,000 for the average Perth property (i know i am being rough with figures here… there are many websites that will estimate your up-front costs for a given property purchase – i am simply using a broad average estimate). And you have not paid for any advice at this point in time, you are paying for the transaction. And when you sell, there will be further costs – probably another 3% ($15,000)? In a decade of flat returns, this would be an expensive asset to buy, maintain and sell.
• Maintenance – Properties are big, lumpy investments – and maintaining or renovating can be an expensive, complex task. At the least, there are rates and taxes, insurances, utilities and day-to-day maintenance. There is also the need to monitor your expensive asset, to make sure it is being looked after properly by your tenants. You may do this yourself or you may pay a property agency – either way there is a cost in money and time.
• Income – Tenants can be good or tenants can be bad. The evening current affairs programs gleefully report instances where tenants abuse properties or fail to pay their rent. These are a minority of cases but there is the potential for bad outcomes. For many people, that is an emotional issue even more than it is a financial issue. When a tenant moves on there will be periods in which no rent is received. This may be ok – but gearing will usually make this a far more important issue than it seems when starting on the residential property pathway. Fortunately for most landlords in Perth, properties are in demand, and vacancy periods are not usually a big deal – but that does not stop vacancy from being a factor in the decision process.
• Opportunity Cost – If all or most of your money is tied up in one asset, does that leave you unable to take advantage of other opportunities that may turn up? If you are borrowing to make the purchase, how long does this restrict your cashflows (assuming it does), and what conditions are required to reduce that impact?
• Superannuation – Would it be better to simply boost your exposure to superannuation? This is a starting point for most analysis, as super offers a tax concessional environment that is hard to match. Again, this is an area that is evolving, as it is now possible to purchase property in a super fund using borrowings – don’t get me started on how terrifying this is for the community generally, ’cause it’s a soapbox of mine, in the same way that the First Home Owners grant for purchases of established houses gets on my financial gall…
• Lumpiness – i know, there is no such word… but there is now because i have made it valid. It refers to the need to treat the entire investment as one entity. You cannot usually sell part of a property if you need a bit of money, and you therefore need to make very large financial decisions should you require cash out of your investment, other than that provided by the rental yield. And so we come to the last point…
• Yield – Simply put, rents are too low and have been for some time. You could argue that prices are too high but that is a different road altogether. It would be nice for a $500,000 property to provide a solid rental return after costs and expenses. However, most of the analyses that we do suggest that the likely after costs return is going to equate to 2% to 3.5% of income a year. That is not a lot, and is often below the income levels required when a full analysis is performed for the average salary earner.

That is the financial planning version of life. The non-financial planning world has a different perspective, which could be broadly listed in the following way:

• God isn’t making any more land – i first heard this many years ago, and it sticks in my mind as a great selling point. You don’t need to be a theologian to understand the idea behind this one. There is only so much land that is available in areas convenient to schools, transport, employment centres and leisure spots. That means the most sought after areas should achieve a consistent level of demand, underpinning prices even in the face of changing economic conditions.
• Safe as bricks and mortar – Usually meant from the point of view that you can see it, touch it and walk around it. You own that piece of territory and its improvements, and there are very strong property laws in place to protect your interests in it. This contrasts with shares or managed funds, where you only receive a piece of paper (if the company gets your address correct) and you never really know where your money is or whether someone is about to run away with it. It’s easier to commit fraud with a bank account than it is to load up a house on the back of a truck and shift it into a warehouse to pawn later on.
• Property prices don’t go down – It’s amazing how strong a hold this idea has on the general community. However, it is a perception that exists, and one that makes many people feel very comfortable owning a residential investment property. If pushed, most people will agree that it is possible for prices to plateau for a while but the general trend is seen as up.
• Tax savings are huge! – This is a favourite of mine. Aside from any borrowing costs, the predominant tax deductions are just costs that you must meet out of cashflow. The rental income has been proportionately low in recent years, leading to more negative negative-gearing, and a bolster for tax returns. In fact, the ATO is a little bemused by the fact that they don’t seem to earn any income tax out of the entire sum of residential rent paid in Australia today. It appears that the focus is on the ‘negative’ aspect of cashflows! Depreciation can provide good taxation benefits – which is great if you buy and sell without having to actually do wear-and-tear renovation work but it is really just an acknowledgement by the ATO of the need to continuously put new money into a property to keep it in spic and span condition.
• You can borrow 100% – Now that is a very genuine advantage of residential property. Banks are happy to lend on residential property as security, and will generally lend to a higher percentage and at a lower rate, with less monitoring of outcomes than they will with any other form of lending. This brings a lot of the benefits of leverage, with a lot of the negatives of leverage already taken care of under current banking procedures.
• Control – It’s your asset, and you own it (jointly with the bank if there is a mortgage). This gives more control than people feel they have over managed funds or superannuation. Superannuation is especially annoying for many people. The government is seen to have tinkered with and continuously changed the rules of superannuation to the point where many people simply don’t trust super funds. There are no tax concession caps on property, and you don’t generally need a physics degree to work out the figures for your annual tax return.

OK. So there we have some of the many arguments flowing around the position of residential property in a financial planning based investment portfolio. How about looking at some results from the past?

Residential Property Returns

This is an incredibly difficult area to deal with in an fair and even-handed manner. By definition, the ‘average’ or ‘median’ house price will rarely have much to do with the specific returns obtained by an investor, as their individual outcomes will be determined by property position, presentation, specific rental potential, development potential and position in the demographic demand trends of the moment. However, median price is pretty much the only statistically consistent tool that is generally available to the public. So let’s consider the returns of residential property in Perth against an equivalent investment into the Australian Sharemarket.

We’ll use the assumption of buying a house in Perth for $75,000 in 1986 and compare that with buying a similar parcel of shares through the Australian All Ordinaries Index (which currently measures the top 500 companies listed on the Australian Stock Exchange). For the sake of simplicity, we are going to ignore rental income, as well as any dividends from the shares. In effect, we are assuming that you plonk down your $’s and then spend whatever income comes your way year to year. It’s not precise but it is the easiest way to prepare a robust set of data.  We have also excluded property costs and share costs.

Disclaimer : Here’s the chart i prepared earlier. Please keep in mind that these are my figures, distilled from IRESS ASX market data and ABS property reports, so any errors in figures or process are mine. This also means you must not use this data as a basis for a financial decision. It is not personal advice, and past results are no guarantee of future returns.

If you click on the chart, you will open a PDF file for greater clarity. You can see that we have not yet received the end of September 2011 quarter figures for property, so the chart simply assumes a continuation of the June figures.

Financial Planning was Wrong on Residential Property

Looking at this data, it is very easy to see why previous ideas and perceptions of property would have been strengthened in the last 10 or 15 years. Most of the time, the income from shares is ignored or forgotten, and so the differences seem particularly stark in times such as these, where the sharemarket is in a definite ‘slump’.

Anyone who has forgone an investment into residential property in say, 2002, has missed out on a massive increase in value – only to see an equivalent sharemarket based investment provide a humble return in the face of huge volatility. With the benefit if hindsight, financial planners who recommended avoiding residential property because of the points mentioned earlier, were wrong.

The real point though, is what is going to happen from here? The problem with financial planning is, and has always been, that the future is an unwritten book (theological ponderings aside). At any given point in time, a recommendation can only be made on the basis of information available at the time. This is why so many billions of dollars are spent, and wasted, in the pursuit of more information or more up-to-date data. There is always the hope that someone will have the answers. Problem is that they don’t. So all you can do is analyse the current data in the face of your current position, expectations, preferences and needs, and hope that your chosen course of action will turn out ok. That sounds awfully uncertain, and way too random for most people. Most people want to hear that their chosen course of action is going to be spot on the money – that they will get the highest returns, with the least risk, at the lowest cost, and save tax in the process!

If we look at the challenge of residential investment property moving forward, the earlier financial planning points remain valid – even if they don’t seem to be.

The strengths of residential property are highlighted in the latest Australian Bureau of Statistics (www.abs.gov.au) figures for transfers of Perth residential property. If you look at the data, you can see that prices have stabilised. If you look at volumes of transfers, you can see that it is probably more a case of most people holding on to what they already have, and few people being prepared to make the jump into the market right now. You’d have to assume that the RBA being keen to raise interest rates would be a factor in amongst these decision trees. Here’s the chart of my figures taken from the ABS releases for Perth established homes (ie, NOT apartments or units or the like).

Time stops me from analysing this data against the various First Home Buyer grants but it is likely that you will find these large lumps of money helped support prices at a difficult time in world markets, and quite possibly helped Australia avoid some of the pain experienced by other countries during and following the GFC. We will come back to these points another time but it is also likely that Australia’s impressive employment record was a major factor, as was the relative strength of our banks when competing in global markets for funding.

This is only a superficial look at some of the points regarding residential property as it stands in financial planning. We have not even touched on the arguably more important issue of residential property in a retirement income portfolio – but maybe that’s something for another day.

Feel free to comment, critique or criticise – and remember that these are simply my figures based on my research – you must not rely on them for personal financial decision making as they do not constitute personal advice.