Brent Sheather: Property v shares - argument far from over

Remember when George W. Bush gave his "mission accomplished" speech on the deck of aircraft carrier Abraham Lincoln? It was vintage Dubya - he declared, on May 1, 2003, that the war in Iraq had been won and combat operations were "done and dusted".

We all know what happened next: six or so more years of bitter fighting and lots of death and misery.

In Greek this sort of embarrassing faux pas is "hubris", defined by Wikipedia as "extreme haughtiness, pride or arrogance ... often indicates being out of touch with reality and overstating one's competence".

The NZX had a minor hubristic moment in a stock exchange release on April 7. The company's head of finance and strategy grandly declared, on the occasion of the release of some long-term performance statistics prepared by NZX subsidiary FundSource, that New Zealand shares had outperformed residential property over 20 years.

She went on to say that "information such as this is hugely powerful because it gives investors the facts about the performance of different types of investment so they can make genuinely informed decisions".

In other words, thanks to FundSource's expert analysis, it was another case of mission accomplished: those investors who favoured residential property had got it wrong.

The fact is the NZX data is plain wrong. So wrong, in fact, are the NZX's numbers that residential property has actually outperformed shares over 20 years, making the NZX's grand conclusion wrong also. So a G.W. Bush hubris award to the NZX head of finance and strategy.

FundSource, the NZX division responsible for the research, has repeated a mistake that fund managers used to employ to make their unit trusts look good relative to a benchmark back in the 1980s.

The FundSource report suggests that over the past 20 years to June 2010 residential property has returned 5.9 per cent a year, whereas New Zealand shares have returned 7.3 per cent, NZ government bonds have returned 8.3 per cent and cash has returned 6.7 per cent.

Now this was all going along very nicely for me until I looked at the "investment computation methodology" used, which said all of the asset classes include income produced by the asset - except for residential property.

So share returns included dividends and the returns for bonds and cash included interest income.

But when it came to residential property, rents were ignored, a hugely significant error, with rent minus costs likely to have averaged 2 to 3 per cent a year.

Adding 2 per cent to the 5.9 per cent return on residential property gives 7.9 per cent, which is higher than the 7.3 per cent return FundSource arrived at for New Zealand shares.

The editors of business newspapers such as the Financial Times are always on the lookout for this sort of "analysis", where a gross index is incorrectly compared with a capital index. One, remarking on the practice, noted "it is easy to look tall if you stand by a short person".

I spoke to the NZX and gently floated the idea that maybe its subsidiary had made a mistake. But NZX argued that FundSource had got it right because mum and dad residential property owners don't actually rent them out.

I pointed out the obvious: that if they didn't own the house they would have to rent a house, therefore the main economic benefit of owning a house was that you didn't have to rent another house.

Therefore the rent you would otherwise have had to pay is a benefit accruing to owning a house. But the conversation ended with the NZX having none of that.

It would be interesting to hear the views of the Property Investors Association on this topic as my guess is that the prime reason to own residential property is to get the rent, given the value of an investment asset is the present value of the cash flow it produces. If I was in charge of the NZX I would be keeping a close eye on FundSource in the future.

My firm has been calculating the return on residential property the right way, including rents less costs as part of total return, with the help of Gareth Kiernan, managing director of Wellington economic consulting group Infometrics, since 2006.

Using this data the return on residential property, inclusive of the net cash flow generated by it pre-tax in the 20 years to June 2010, was around 8.5 per cent a year, comfortably ahead of Fundsource's 7.3 per cent a year for New Zealand shares.

So that is the historical record clarified and put to rights. What of the future? The legislators force fund managers to qualify historic return numbers with a statement to the effect that "past performance is no indication of the future", but that is not quite right.

In fact, it is not right at all, if the truth be told. If markets in the recent past have become more expensive - that is, the price of the asset rises more quickly than the earnings and dividends of the assets - this will inevitably constrain future performance sooner or later. Economics has a simple model which lets us see this:

Return = dividend yield plus growth rate of dividend

If an asset class gets expensive relative to its earnings and dividend, the dividend yield (d) in the equation falls. Thus, all other things being equal, the return will be lower.

Today (d) on residential property, after costs, probably averages something like 2 to 4 per cent in New Zealand. But (d) for the stockmarket is about 6 per cent and (d) for the listed property market is 9 to 10 per cent.

In the long run growth (g) is reasonably constant at around the rate of inflation plus or minus 1 to 2 per cent. So the difference in future returns between residential property and other asset classes is likely to be heavily impacted by the difference in (d), and here it is quite obvious that (d) for the stock market and listed property is well above (d) for residential.

There will always be disagreements over whether residential property is a better deal than owning shares but a betting man would, given the yield differential, put his money on shares and listed property outperforming residential in the next 20 years. The FundSource analysis, however, adds nothing to the debate.

Disclosure: Brent Sheather owns shares in NZX.

Brent Sheather is an Auckland-based authorised financial adviser and his adviser/disclosure statement is available on request and free of charge.