Gearing up works both ways

By MARY HOLM

Q. I have been following with interest the debate between investment property versus alternative investments, particularly shares.

While I understand that most people recommend some diversification in investment and can see that historically the sharemarket does provide good returns, I have seen no mention of one point that seems crucial to me.

I borrowed $1 million from the bank to invest in property, by putting up $100,000 of my own money. Over the past five years the property has almost doubled in value, thus returning almost $1 million on paper.

If I had invested my $100,000 in shares the profit would be what? About $100,000 at best, I would guess.

Is it not true that if you can access 10 times as much money via the bank, that over a long period of time, say 20 years, property is always the winner because your gains increase tenfold?

Consumer magazine (March 2004, page 17) says "the average New Zealand house price has grown at over 8 per cent per year over the past 25 years".

Please explain how alternative investments can ever match this return over a long period of time.

I have done my research and concluded that if historical price patterns are to be trusted, then property cannot be beaten over time, if you are using 90 per cent of the bank's money and 10 per cent of your own.

A. You're quite right that borrowing to invest - known as gearing - makes a good investment better. And property is usually a good investment.

But borrowing can do the same for shares, a share fund or any other investment - if you can raise the money.

It's true that banks are much happier to lend for property than other investments. In fact, I've had two recent letters bewailing that.

In one, which I will run soon, the reader wants to borrow for his software business. In the other, which you can read below, the reader wants to borrow to invest in shares.

As long as this reader can raise a loan, he might do even better than you. While house prices have risen 8 per cent a year since the late 1970s, international shares have risen 14 per cent and New Zealand shares 15 per cent a year, on average.

Over 25 years, those higher returns have a huge impact. If you invested $10,000 at 8 per cent 25 years ago, it would have grown to about $68,500 now. At 14 per cent it would be $264,500, and at 15 per cent, $329,000.

If you add gearing to all these investments - let's say you put in your own $10,000 and borrowed $90,000 - all the numbers would be 10 times as big.

Note though, that the next sentence in the Consumer article you quote says, "While future growth is likely to be lower".

Most experts predict lower growth in all investments, including shares and property.

I do need to acknowledge, too, that shares are more volatile than property, so borrowing to invest in them is riskier. More on that below.

Nevertheless, what you're doing is also far from risk-free. There are two issues here:

* It's possible the average return on your property, in future, will be lower than your mortgage interest rate. If that happens, borrowing will make you worse off. You'll pay more in interest than you get back.

Even if the return is one or two percentage points higher than the mortgage, you won't have gained much for your trouble.

* While gearing makes a good investment better, it also makes a bad investment worse.

If you have to sell for less than your purchase price, you can lose your deposit and may still owe the lender money.

That happened to some New Zealander rental property owners in the late 1990s. And people in other countries have fared much worse.

To your credit, you have emphasised long-term investment. And there's pretty much no chance property values will fall over 20 or 25 years.

But it's surprising how many people have to get out of investments earlier than they expected - perhaps because of a job loss, poor health, family needs or business troubles.

Quite often that happens when the economy is floundering, at just the time property values are low.

In short, then, you're right that geared long-term investment in property can do really well. But, like any high-return investment, it does come with risk.

As Stephen Musaphia of NZIJ Investment Services said in a recent article: "Some commentators would have you believe there's a formula out there that achieves safe investing and high returns. They just haven't found it yet. Give them time though. They've only been looking for around 2000 years." I suspect it's longer than that.

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Q. I have read the debate about shares v property in your interesting and informative column. It seems to me that most people who write in are in the position of having a bucket of cash with a choice of where to invest.

With the bank's money, I have found that the only investment option is with property.

All the banks are bending over backwards to let the general public tie up their excess home equity for loans to purchase rental properties. The future rent is used in the risk assessment, and the banks have some good history with the home owner.

For tax reasons, I have been able to raise 100 per cent loans for rental property investments and, without the burden of capital gains tax, I can at least provide for my retirement. And I will be able to possibly help my two boys eventually when I have departed.

The scenario might be different 20 years from now when the properties are all mortgage-free, and I can invest with that bucket of cash if I decide to sell.

But the banks are not too willing to part with large amounts of cash for me to invest in the great balanced portfolio that you speak of now. I will purchase property again and become terribly over-invested in property.

I do respect the view from the bank as they have a vast experience with financial risk assessments.

Some stats of my finances: married with two boys, age 43, no cash, $80,000 per year in salary, one house and two rentals. I have $290,000 in total equity, with three mortgages totalling $450,000.

I break even on the rentals, and I have not had to subsidise the rent. I have a good relationship with the tenants.

Any suggestions as to how I could prise the money out of the bank to invest in shares would be appreciated.

Of course, a loan for the shares would need to be at an interest rate lower than the gain in value of the shares, and the dividends would need to be as reliable as what I get in the rent.

A. Have you really tried to borrow against your $290,000 in equity - in other words, increase your mortgage?

I would have thought you could. And then you could spend that money on shares if you want to. As long as the bank has your home or a rental property as security, and they are satisfied that you are in a position to repay the loan, they generally don't care what you do with the money.

But if for some reason you can't do that, or you want to use the shares themselves as security on your loan, banks are more reluctant, perhaps too reluctant.

While shares are more likely to drop in value than property, a diversified portfolio of shares is unlikely to drop by more than, say, half.

And, if you hang in there, it will almost certainly rise again.

So why don't banks lend, say, a third or half the value of a portfolio? I suspect some are still smarting from what happened after the 1987 share crash.

There's another option, though. Some stockbrokers will do what is called margin lending, letting you borrow money to buy shares or units in managed funds.

How much they lend depends on how risky your shares are, but often it's 50 to 70 per cent of the share value. You can reinvest dividends, which should go a long way towards covering your interest.

If the value of the shares falls by more than a little, the broker will make a margin call, asking you to deposit money with them or sell some shares.

And that's one of the beauties of a geared share investment. If things get tight, you can always sell a portion of the investment. That's not so easy with property.

Some people do really well with margin lending. But because shares are volatile, you must be a risk taker, and be prepared to hang in there, and meet margin calls, through down markets.

Many experts feel the worry is not worth the reward.

One last comment on your last comment: any share investment should be in a wide range of shares or a share fund.

That means that while the dividend income would vary, it would usually be much more reliable than rent on a single property, which can drop to zero for several weeks.

Even with your two properties, your rental income can halve suddenly.

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