Mary Holm: Weighing up best place to grow nest egg

Investing in property is one way of growing your inheritance, but buying shares or putting money into a share fund are other options. Photo / Getty Images

COMMENT:

I have followed your columns for many many years and hope you can help me. I have $400,000 that has been left to me due to my beloved mother passing away.

I have paid off our house mortgage and we have no credit card debt.

Should I invest this money in a rental property or invest somewhere else? I want this money to grow and work for me but am unsure of the best vehicle to utilise.

Sad circumstances, but your Mum has given you a great opportunity to build up a substantial retirement fund.

What are your other options, besides rental property? If you want good long-term growth, you should go with individual shares or a low-fee share fund.

While you've got enough money to buy a diversified range of individual shares, a share fund is simpler and would probably suit you better.

So let's compare a share fund with a rental.

Both investments are somewhat risky, although much less so if you're happy to tie up the money for 10 years or preferably 20 or more years and promise not to bail out when things aren't looking so good.

But they're very different creatures. Let's explore the differences via letters from other correspondents in the next couple of Q&As and next week.

And given readers' tendencies to hold strong opinions on the rental versus shares issue, the conversation will probably flow into a week or two after that!

Future planning

My wife and I sold our Auckland property and moved to Whangārei about three years ago. We bought two mortgage-free properties, one of which we live in. We retired but started working part-time and have now decided to retire again.

Our rental property (bought for $350,000 but now worth around $600,000) is returning around $15,000 a year. I was wondering if you would advise selling and investing for a greater return.

We are not "good" landlords! We find it very difficult to raise the rent. Thank you in advance.

I know the feeling. I've had fairly brief periods as a landlord and couldn't bring myself to increase the rent. That's an often overlooked aspect of the rental versus share fund debate — you need to have a landlord personality!

When you're assessing total returns on your rental, you should of course include:

• The huge gain you've made — which amounts to about 20 per cent a year.
By the way, you've had a narrow escape from the bright line rules. If you had bought the property after March 29, 2018, you would have been taxed on the gain if you sold within five years.

But if you bought between October 1, 2015 and March 28, 2018 — which you may have — those rules apply only if you sell within two years, and you've already owned for longer than that. If your purchase date was before October 2015, there were no such rules.

Still, your gain might be taxed under the older rules about your intent when you bought, so discuss it with your accountant.

• The ongoing rental income, minus rates, insurance, maintenance and any other expenses — which usually include mortgage interest but not in your case. I'm assuming your $15,000 is after expenses.

But now that you've made the big gain, you're looking at what might happen from here on. The future includes a possible gain or loss from the $600,000 base, plus receiving $15,000 a year on a $600,000 investment, which is 2.5 per cent.

The gain or loss is anybody's guess, although it seems unlikely the property value will continue to rise at a rate of knots. And the rental return is low, even though you have no mortgage.

How does this compare with prospects in a share fund? It's just as hard to predict share price movements. But again, shares have done really well — both in New Zealand and internationally — over recent years, so further big jumps in the next few years would be quite surprising.

What about the ongoing income, which in share funds is dividend income? It might be similar to the 2.5 per cent after fees and tax — especially if you include international shares, which I would suggest, to get more diversification.

So where are we? It's impossible to predict which investment will do better, and the risk is probably similar — although read on for more on that. I would go with the one you would enjoy more, which in your case sounds like a share fund.

A win for shares?

I trust you saw Brian Gaynor's table in the January 26 Weekend Herald comparing property to shares over 10 years in New Zealand? Shares beat property every year, and since it is 10 years the house needs to be painted.

You raise a good point that rental properties need lots more work than shares.

But you're not quite right about Brian's table. The first thing to note is that he compared both NZ and Auckland property prices with the NZ capital and gross share market indexes.

The capital index shows just growth in share prices, while the gross one includes dividends. And when your comparison is with property prices, with no allowance for rent, the capital index is the fairer one to use.

So how did that index fare? In six of the 10 years the capital share index beat property in New Zealand, and in five of the 10 years it beat Auckland property. It all sounds pretty equal.

Over the whole period, though, shares did better. The capital index grew 105 per cent — more than doubling — from the depths of the global financial crisis in 2009 to the end of 2018. Over that same period Auckland property grew 96 per cent, and NZ property grew 70 per cent.

What about volatility? Here are the highest annual return and lowest annual return for each category:

• The capital share index: 18 per cent and minus 6 per cent.
• Auckland property: 13 per cent and minus 4 per cent.
• NZ property: 13 per cent and minus 2 per cent.

All of this suggests that shares tend to bring somewhat higher returns but are also a bit more volatile. And data over the decades confirm that.

However — and this is important — most people who invest in rental property need a mortgage to do so, while very few people borrow to invest in shares or a share fund these days.

Borrowing to invest is sometimes called gearing. And, as I've said many times, gearing makes a good investment better but it makes a bad investment worse.

If the value of the property — or any other geared investment — rises, you get the gain, not just on your money, but also on the bank's money. Nice. But if you're forced to sell when the value of the investment has fallen, the proceeds of the sale might be less than your loan. You can end up with a debt to the bank and nothing to show for it — something that just can't happen with an ungeared investment.

The people most likely to find themselves in this predicament are those with big mortgages on their rentals who have to regularly contribute extra money because the rental income doesn't cover all expenses. If you're in that situation and you lose your job or other source of income, you might find yourself having to sell the property, even at a loss.

Once we take gearing into account, then, a typical investment in a rental property is probably somewhat higher risk than a share fund, but with somewhat higher average returns.

Enjoy your money

We are a couple in our late 70s and realise that our remaining years on this planet are becoming limited. We live in a freehold home.

We agree with your advice in the Herald recently to "stick with sharemarket ups and downs".

However, we consider that this strategy may be more applicable to younger and/or wealthy investors.

We have a "mixed" international share portfolio administered by a financial adviser.

Current value is reduced to $260,000 following a recent market meltdown. We have experienced a rollercoaster "ride" over many years with growth in some years, being discounted by loss in other years.

Given our age and limited resources, we would be grateful if you could advise if we should:

• Hang in and persevere until we are 80 or a longer time period or
• Instruct our adviser to sell down the portfolio and thereafter invest the capital in a less risky and more secure option.

I'm a bit concerned about the motivation of your adviser. I hope he or she has at least suggested you sell some of your shares and enjoy the money. But I fear it might be in the adviser's best interests to keep you investing.

Please don't feel embarrassed discussing that with your adviser. It's your money. Perhaps take this Q&A with you if it would make it easier.

However, I might be doing the adviser an injustice. Perhaps you've said you don't need the money, at least for 10 years.

The basic rule — regardless of your age — is that you should invest in shares and share funds only money you expect to spend in 10 years or more. That gives your investment a chance to recover from a major downturn.

So if this is money you'll spend in your nineties, you could leave it where it is. But if you — or possibly your heirs — expect to spend it earlier than that, I suggest you move to lower risk.

Put the money you plan to spend in, say, the next three years in bank term deposits or a cash fund. A good place for the three-to-10-year money is a bond fund.

One more thing: I was startled to read of a market "meltdown". The international sharemarket was volatile last year but it hasn't dropped all that much. Over the year ending February 12, the MSCI world share index fell just 1.5 per cent, and over the three years it rose 11.2 per cent a year.

If your shares dropped lots more than that, once again I would have a chat with your adviser.

Mortgage focus

I feel that there are more considerations to take into account than interest when discussing the merits of saving with KiwiSaver versus paying down a mortgage.

It is, of course, important to save for retirement, but it is more important surely to reach retirement age without significant debt. Even before retirement age anything can happen, for example redundancy or health problems.

I believe that increasing principal repayments by as much as you can afford for as long as possible is a strategy that can't be overstated.

Several years ago I took a contributions holiday from my KiwiSaver (keeping up monthly payments to qualify for the tax credit) and put the whole amount into increasing my fortnightly mortgage repayments without changing the agreed term of the loan.

The loan was paid off early, and then I was able to not only recommence my KiwiSaver contributions but also increase them — and I had a freehold home should my circumstances change.

The counter argument is that you've had less money in KiwiSaver over a long period. And as it happens, most KiwiSaver funds performed really well in recent years.

What's more, if you're an employee you probably missed out on employer contributions, which is a pity.

Still, you're right that paying off a mortgage gives you lots of security.

I think that's enough now on KiwiSaver versus mortgage repayments.

- Mary Holm is a freelance journalist, a director of the Financial Markets Authority and Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. Her website is www.maryholm.com. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary's advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it. Send questions to mary@maryholm.com. Letters should not exceed 200 words. We won't publish your name. Please provide a (preferably daytime) phone number. Sorry, but Mary cannot answer all questions, correspond directly with readers, or give financial advice.