KEY POINTS:
Sharemarkets have generally produced higher investment returns than residential property over the long term. Theoretically, if you rent a property and invest your money in quality shares you should be wealthier than those paying off their homes.
However, the discipline of meeting regular mortgage payments and gradually taking
ownership of a tangible asset means homeowners usually do better financially than those who rent.
Beware though: a strong preference for property can lead to over-investment and low diversification.
New Zealanders have more than 75 per cent of their assets tied up in relatively illiquid property, including their homes and investment properties. Investing in residential property other than your family home is likely to result in higher risk and lower returns than investing in quality shares.
Over recent years, the Kiwi dream of owning a home has led to a financial windfall for many people.
Spicers' Quarterly Household Savings Indicators report shows house prices from late 2001 have delivered an improvement in net worth of more than $188,000 per household over that period.
However, this impressive performance has given some blurred vision.
The past five years have mistakenly led many to believe rapid gains from housing have always been the norm. In fact they have been the exception and, in the chase for capital gain, the risks have been downplayed.
While property often delivers adequate, real returns over the long term, this is not always the case.
There have been prolonged periods where house prices have stagnated and even declined.
House prices declined in real terms during the 20 years spanning the 1960s and 1970s. The next 10 years brought us back to positive territory, but only just. During the 30 years ending 1991, national house prices delivered an average real annual gain of only 0.4 per cent per year.
After seven years of booming prices, the property cycle is once again heading down. Housing sales turnover is running significantly below levels of the previous year and prices have started to fall. Ordinary homeowners and prospective homebuyers are feeling the effects of higher mortgage interest rates and a tightening in lending standards.
People who jumped into the hyped-up market with little or no deposit, scared they may be unable to afford a home if they waited, have stretched their debt servicing capabilities to their full limit, leaving little buffer for the unexpected. People needing to sell are selling below expectations. It's therefore no surprise that a new trend of investing in shares over property is emerging among Generation Y, people born in the early 1980s to late 1990s.
The main reason is they have been priced out of the housing market.
Historically, depending on the market, shares have outperformed property by an average of around 3-5 per cent annually. On average, the risks of investing in property are understated and returns from property overstated. As a result, investors pour too much money into residential property, forcing prices higher than if they accounted fully for the potential risks and returns for investors.
So, why are property risks understated? Behavioural theory provides some useful insights. The main reason is property is tangible and seems easy to understand, so investors have a perception of control. The truth is property is able to elicit an emotional response, unlike shares or bonds which lack the same sense of substance and permanence.
The pricing of residential property is infrequent and informal. Property investors never see red ink on a statement unless it is on the day of the sale. And most property investors never formally evaluate the performance of their investments at all.
Returns from property are also generally overstated, which has the effect of further narrowing the risk/return trade-off for the asset. Indices measuring property market performance generally capture only the increase in sale price of existing dwellings but fail to take into account major developments in a nation's housing stock.
Share investors can effectively "buy the market" and participate in its long-term performance because of the ready availability of broadly-based share funds, including those designed to track the market index. But investors can't "buy" the return of the residential property market as a whole. The indices purporting to track the market tend to grossly overstate the returns because they do not adjust for the costs of maintaining and renovating property over time, nor for the improved quality and cost of new developments.
The one main advantage of investing in residential property is individual investors with time on their hands have a greater ability to add value to their investment.
For many, buying a family home is their one means of saving. But for the amateur investor, investing in a residential property is likely to be expensive and riskier than investing in a well-run, diversified share portfolio. And it will probably yield a lower return, too.
Investment myths
*Property values are not as volatile as share prices.
*Property prices never fall.
*Property prices might fall occasionally but never as far as share prices.
*Property prices rise with the cost of living, so investment in property always keeps you ahead of inflation.
*The only way to lose money on property is to buy in a declining population centre or a house on the main road.
Arun Abey is executive chairman of financial planning firm Ipac, head of strategy for AXA in the Asia Pacific and a director and advisory board member of Spicers Portfolio Management. He is also the author of "How Much is Enough?"
