The property market has outperformed the share market over the last 10 years, so why not jump straight in?
This week we look at the risks of investing in property.
What are the Risks of investing in property?
There are lots of benefits to investing in property, but make sure you understand the risks before making what is likely to be the largest investment decision of your life. Below we take a look at the key risks.
We have spoken about liquidity previously, it refers to the ability to turn assets into cash. Shares are very liquid because they can be sold on any business day. However selling a property can take some time, if the market is falling it is very hard to get out quickly. Once the market has fallen, it can take years to sell certain kinds of properties (e.g. rural / remote properties, bespoke properties, commercial buildings that no longer have tenants).
Also, when selling property it is all or nothing, you can’t just sell part of it.
Property is classed as a growth asset, not a defensive asset (which include cash and bonds) because property values are volatile. The volatility of the share market is very apparent, because the prices move all day every day, and there is clear visibility of the share price movements. The property market is also continually moving, there is just less transparency around pricing, and therefore less visibility of the movements. A study found that the standard deviation (a measure of volatility) of direct property investing over the period from 1985 to 2012 was close to 10%, compared to 20% for the stock market. This data suggests that property investing is less volatile than investing in the stock market, however volatility is still present.
One of the benefits of investing in property is the ability to borrow money to do so, which allows you to leverage you initial investment to purchase a more expensive property than you could afford without borrowing. The downside of leverage is that it introduces additional risk. If you invest $50,000 in the stock market, the most you can lose is $50,000. If you use $50,000 as a down payment and borrow $400,000, then you get an asset worth $450,000, however you now owe $400,000 to the bank and are personally liable for making sure the money gets repaid.
Lack of diversification
Due to the large cost of purchasing property, it is difficult to create a diversified portfolio by investing directly. If you own only one residential investment portfolio, you are heavily dependent on the performance of that geographic location, which means a very concentrated portfolio. This issue can be overcome by investing via a fund, however then you do not have direct ownership or control over the asset, and are unable to benefit from negative gearing.
Investing in property comes with high management costs for the owner of the asset. This includes agents fees, maintenance costs and other running costs (e.g. utilities, council rates, land tax). These fees tend to result in much higher management costs for a property portfolio than a share portfolio.
What goes up must come down
There has been a lot of talk in the press about the Australian market being over-valued. Whatever your view, it is worth remembering that market conditions change; house prices will eventually come down, and interest rates will eventually go up. Here’s a good overview of the last housing crash, including interest rates of 17.5% – yikes!
The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.