What Ends Up In Your Pocket
There’s no point debating shares vs. property, or any other asset class for that matter. All you care about is what ends up in your pocket! Endless data available can be manipulated to support whatever argument someone wants to push… as I have no doubt some accuse me of.
The question needing careful consideration is, after tax and all other costs, how does my return stack up when taking my investment of time and money into account? Basic numbers can be quite deceptive; you have to dig deeper to discover your real returns.
I really enjoyed Nick’s article of a few weeks ago he called “The Myth Surrounding Positive Cash Flow Property”. He demonstrated the massive impact compounding has on returns over time. Today I will build on that important truth.
NB: If you missed Nick’s be sure to read it >>>here.
Important But Often Missed
Often overlooked by those comparing investment option are:
- Always measure like with like
- Personal Taxation and it’s impact on your investment bottom line
Median Price Of Property
With such a wide range of property types and varying sales patterns from month to month and quarter to quarter, it’s impossible to make accurate comparisons. Expensive listings sold one month followed by less expensive sales the next will show up as a drop in median prices… even if they didn’t.
Big picture statistics help but they are not definitive. Let me share an example…
A recent article using suburb data to support their claim wrote that property had dropped by 10% . The very same data showed that there were many suburbs where a result was not possible due to insufficient data. That same report also listed one suburb as having dropped in value by 27%, with its neighbouring suburb rising by 54%. It’s too easy for those looking for a story to manipulate data to support whatever arguement it is they are pushing.
How Are Medians Calculated
It’s the top end of the property market that has taken the biggest hit. When I hear stories of a property that was bought for $13m having just sold for $9m only 18 months later (as has been the case on a number of occasions in recent years) I know the median price is about to take an unfair hit. You see, it’s not just effect of the property sold for less than the vendor had paid that pulls the median down… but it is also the impact of all those that defer selling in a buyers market.
Katrina and I sold our first home back in about 1989. Paul Keating was the treasurer and Australia was heading into recession. The property market was actually very strong at the entry level and we sold our home quickly and for more than we were expecting. Meanwhile the mid to top range was shocking and those selling had to accept low offers. This pulled down the overall median (which means middle) price but was not a reflection of what we were experiencing. Again, big picture numbers can be helpful… but equally they can mislead. Equally, a cash flow analysis we prepare for a client must have the data relevant to that property and that client or the result would be misleading; so it is with property.
NICK’S HERE!!!!!!!!!!!!!!!!!
The top end of the market has taken a big hit and there are examples of properties being sold for less than $9m by people who paid $15m to buy just a handful of years ago. This is not the case in the median priced market that mrd promotes. Yes prices have softened a little but in light of how most other investments have performed in recent years, this market has proven to be remarkably resilient. This is in fact why Nick has been telling investors for over a decade to steer clear of ‘the executive market’ and ‘stay statistically safe by buying in the mid rage where most people live’.
Never underestimate the medium term impact our ever increasing population and chronic lack of new property construction will have on rents property values.
The current softer market means buying opportunity not some catastrophic capitulation, as some in the media would have you believe.
Share Market Indices
The other asset class, shares is measured by either the ASX200 or the All Ordinaries Index. The ASX 200 is the top 200 stocks in the market by capitalisation. The All Ordinaries Index represents the 500 largest companies listed on the Australian Stock Exchange by capitalisation. As companies falter they will drop out of these indices and be replaced with other, stronger companies (remember X, Y & Z?).
This form of measurement will give a skewed view of the market as only the largest and strongest are measured. As the companies making up the index are constantly changing it is difficult to get a consistent measure of the market as a whole. There are approximately 1,700 companies on the Australian stock exchange so you can see how measuring just 200 or 500 of them will not give you a true picture of the market as a whole.
If you then try to compare these two asset classes using these constantly changing measurements you are going to get erratic results.
You are measuring the top stocks with the average or median property. A fairer comparison would be to measure the top 200 suburbs each month with the ASX200 or perhaps the performance of the average of the entire stock market with the average property price. I am sure the result would be different if more comparable measurements were used.
Then overlaying this constantly changing measurement is the chosen timeframe. In a recent report Russell investments quoted the gross returns from residential property for the 20 years to December 2009 to be 9.8% per annum. Over the same period they quoted 9.7% for Australian shares. John Lindemen of Residex stated that the property market has increased by an average of 10% per annum since federation in 1901. This figure does not include rent received.
Other sources have quoted for the ten years to December 2007 Australian shares returned 13.3% per annum. For the twenty year period the return was 12.5% p.a. Long term, over the 109 year history to 2007 the average return from the Price Index was 7.48% with the accumulation index, providing a return of 12.42% including dividends.
As you can see the numbers can be manipulated very easily to support an argument either way. In my opinion and observations these two asset classes have similar gross returns over time. It is the drivers of wealth that makes residential property investment my first choice of asset class.
Tax and the effect on returns.
Once you get past the plethora of data you then need to consider the tax implications of your investments. In the earlier example I asked would you prefer an investment that returned 8% or 10%. Let’s look deeper and find that the 8% return is after tax. If you are on a 30% tax bracket then the 8% investment is the better for you, assuming the risk is similar across both investments. 10% less your 30% tax rate means you end up with only 7% in your pocket. If you were on a lower tax bracket then perhaps the 10$ investment may be better fro you.
A factor that few take into consideration is the taxation effect on compounding. We can see the effect on the annual net return but did you know that not only how much tax you pay but when you pay the tax can have an enormous effect on the end result. In Nick’s article last week he showed the example of the difference between an investment returning 5% and one returning 6% over a longer time period.
What I will now look at is the effect of taxation on not only the annual net return but on the compounding.
Let’s assume that we are looking at 2 investments that for the sake of the example grow at 10% per annum over the next 21 years. One we will call property and the other we will call shares. Historically residential property is held on average 7 years. During those 7 years no Capital Gains Tax is due. Therefore the full 10% is compounded to the following year. There are also CGT discounts when the asset is held longer than 12 months.
As outlined in the graphs below the average holding period for shares is now under 1 year meaning that tax is paid in each financial year. I found another source that quoted the average holding time of shares as 22 seconds.
If we invest $100,000 and assume a 30% tax bracket then out of the 10% annual return you are only able to compound 7%, the remaining 3% being lost each year to tax.
For the sake of the example we will be taxing the returns at years 7, 14 and 21 for the property taking the 50% CGT discount into effect. The shares we will tax each financial year. (Often within managed funds the shares are turned over regularly and the tax taken off the total returns thereby not being obvious to the client.)
In this example the result over 21 years is $386,968 for the shares taxed each year compared to property which returned $574,306 after tax. The difference is $187,338 or 48% more than the investment that paid tax each year.
Even though the returns of the two asset classes are identical the end result is very, very different. Yes you can choose to hold shares longer than 12 months but then it is also an option to hold the property for the full 21 years. It would be unusual for a parcel of shares to be held for 21 years.
As you can see there is much more to the numbers than just a numeral on a page. When making comparisons you have many, many factors to consider coming to the resulting question; How much do I get to put in my pocket and walk away with once everyone else is paid?
You may not have watched the “State Of Origin” on Wednesday night (shame on you)… but regardless of what sport you prefer to watch, you would agree that winning requires a game plan. As with a sporting team, the most common “Investor Mistake“ is to start a game/journey without a clearly defined goal or outcome in mind.
Don’t Get Stung!
