Rants, Raves, Reviews

Why I Invest in Property and not in Shares

By Gary R, in , posted: 18-Apr-2007 18:38

Yesterday I blogged about my view of the economy and it seemed to be quite popular. A few of you replied that shares are a good option and that investments should be spread around to minimise the risk. I absolutely agree but I have had it with shares and now I choose to invest in property. Here is why:

Firstly the Sharemarket:

I got involved in the share market as a 19 year old in 1986 by purchasing shares in some colorful companies. Does anyone remember Equiticorp and Goldcorp? The shares kept rising and here was me not knowing if I should buy more, sell or hold. It was a dilemma that caused me quite a bit of stress. I think it is human nature that a certain amount of greed comes into the whole decision making process. You keep seeing the shares rising in price and you don't want to think about that ever stopping. Like a lot of other people I held on too long and one fateful day in October 1987 the end of the bull run arrived. I was left holding worthless pieces of paper. It wasn't a lot of money to lose by todays standards, I think all up I lost $5000 but back in those days I could have probably purchased a house in Invercargil freehold for that.

It took me quite a few years to recover from my first foray into the world of stocks. It wasn't until the mid 1990's that a merchant banking friend convinced me to try it again. This time I tried to follow some simple rules of investing:

1. Spread your risk - a few high risk, some medium risk and a lot of low risk shares
2. Know the company - do your home work and find out as much as you can about the company you are investing in
3. Don't buy all at once - spread your purchase over a number of months, the price you pay to acquire the shares will vary but overall you should aim for a return on your average share purchase price
4. If you can't afford to lose it don't invest it - very, very important. Buy shares like they are casino chips as you may never see the money again.

By following these rules I acquired shares in commercial property companies, forestry and tech. The result was that I did very well in the commercial property (well enough to recoup my 1987 loses) but very poorly in the forestry and horrifically in the tech. You see by the late 1990's the whole internet bubble thing exploded and made quite a mess of my investments. Then my forestry shares were split, bought back and diluted so many times that I lost track of where I was at in terms of the return. Overall I would definitely be down and out.

From my sharemarket experience I formed the following opinions of and reasons for no longer acquiring shares:
1. I am not a big enough investor to get in on the floats of the really good companies (such as Rakon). If the shares are oversubscribed I get bumped.
2. The whole process causes me stress and I spent far to much time analysing my investments
3. I have no control. Sure I get a vote at the AGM and on 'extraordinary' occasions but my vote is not big enough to affect the outcome I want.
4. Governments on a whim can change the playing field. Consider Telecom where Labour wiped a few billion off the value overnight
5. I am not intimate enough with or embedded enough in the companies I have invested in to understand or know the strategies that will affect the long term outcome of the share price.
6. I have worked for big corporates and seen how they waste money due to poor decisions

Sure, there are other ways to invest in the sharemarket. For example, you can buy into managed funds and unit trusts but they are not for me.

Now to housing:

Lets face it everyone needs a place to live. Sure there are rules you should adhere to such as not buying the best house in the worst street and it is all about location, location, location. So, for my rental property I treaded very carefully and spent quite a bit of time before buying. I also made sure that I was cashed up and pre-approved so I knew what my limit was and by being a cash buyer I was able to make a decision very, very quickly. Along the journey I put in offers on a couple of properties and then diligently went through the process of having a building inspection conducted. This cost me money but it also meant I didn't lose money by making a bad decision. I avoided tenders and auctions so that I was not tempted to spend beyond my means. So, in the end we manged to buy a house we really liked, in a very good area at a price that was 10% below the valuation at the time purely because we were ready and there was no mucking around.

The processes and logic around acquiring an investment property need to be totally different to those applied to the purchase of a family home.

1. Don't look at a property and think 'I wouldn't live here' because you will then never buy a property below the standards you are used to and don't forget you are never going to live there anyway.
2. Do your research on where people live and where people want to rent. For example is it near a school and public transport?
3. Think about the sorts of tenants you want. Lots of bedrooms could mean a group of young people. A few bedrooms could mean only a couple.
4. Look at the area and the movement in the property values. The end game is the capital gain so think about areas that traditionally show good potential
5. Think about the features of the property - a stand alone house is probably a better renter and is worth more than a semi-detached/detached flat especially if it has a good, private outdoor living area.
6. Think about the street and who the neighbors are. You don't want to buy a rental in an area that has the Manson Family or Black Power living next door. Remember certain areas also attract certain types of tenants.
7. Check out the rental return (median rental information is available on the internet) for the area and calculate your loss based on the purchase price, less what you are prepared to invest (capital), leaving what you need to borrow. Work out how much you will need to subsidise the mortgage by (after rent) and don't forget rates and insurance. Be careful not to financially stretch yourself.
8. Do your sums based on a 48 week year. Take the calculations you have done above and then rework it based on only having rent paid to you for 48 weeks of the year. Lets face it tenants come and go so there will be times when the house is empty. You need to be prepared and able to subsidise the whole mortgage for as long as the property stands empty.
9. Consider the condition of the house. You don't want to spend a lot of time maintaining the property. Things like painting and general maintenance are not depreciable through the LAQC so you don't want to spend a lot of time and money on upkeep. As a landlord you also have to give notice to the tenants if you want to visit so spending 2 months painting the house is not usually good for the tenants privacy or sanity.
10. Get yourself a good accountant and run the figures past them. They will soon tell you whether it is a goer or not and what the financial risks/rewards will be.

One of the most important things to remember is that tenants are your customers so treat them with respect. Some landlords treat tenants with a total disdain and assume all tenants are there to rip them off. This is not always the case so be nice.

Based on the above we purchased a two bedroom house in good condition, with a garage and a large section in a quite no exit street with nice neighbours. Our tenants are an older couple who love gardening and mowing lawns. They have been there now two years and have indicated that are staying for the longer term. Perfect! You couldn't ask for anything better.

From my own experiences this is why I will continue to purchase property:
1. Houses are real. You can touch them and see them.
2. People will always need a place to live
3. The property market goes in cycles. Weather the lows to gain on the highs
4. Rents do go up over time
5. I am the CEO of my own LAQC so I make the decisions that affect me
6. Your tenants are paying most of your mortgage
7. A house is a real asset that you can borrow against or pull money out of
8. When I retire my rental property could be worth 3 times (or more) what I paid for it and it will be freehold
9. It is the only investment I can think of that pays me a return for making a loss
10. I am in it for the long term - 20 year plus.

Since acquiring our rental property the market value has gone up $100K. I recently submitted a new valuation to the bank and my equity has now gone from just 13% to 40% in a couple of years. The losses claimed through the LAQC leave me close to cost neutral in terms of what I have to contribute.

Because I have a tangible asset, owning a rental property is more real to me than a piece of paper from Computershare registry saying that I own 0.0000000003% of The Mighty Big Dick Corporation.

Other related posts:
I Smell a Conspiracy
Disposal of Eco-bulbs
Welcome to Vuestar

Comment by lokinz, on 18-Apr-2007 19:05

Wow some free advertising (TMBDC)

Thanks Jama!

Comment by Grant17, on 18-Apr-2007 19:50

Awesome post Jama!

You have really done your homework I must say and it sounds like you have an ideal tenant, your equity has tripled in 2 years, good on you, the whole picture looks rosy

Investing in the sharemarket is definitely not for everybody.  I have neighbours who have lost literally millions of $ on foolish investments made during the lead-up to the 1987 crash.  Some of them lost properties that had been in their families for generations because they thought they were bullet-proof and leapt into the sharemarket, futures etc like there was no tomorrow.  The people involved are nice neighbours and it is tragic to see them still struggling financially 20 years later due to some bad decisions made when they were in their early 20s.  The winners out of all this are rich property developers who were there with cash to pick up the pieces at fire-sale prices.

Having said all that, I am a few years older than you, but I never had any money in 1987, and looking back in hindsight, it's probably just as well...

Like you, I have also had my fingers burnt during the Tech. Stock rout in early 2000.  Fortunately, I didn't have too much invested at the time (was just getting started in the sharemarket and feeling my way), so it taught me a relatively cheap lesson.

The real winners for me have been unexciting but solid companies like Contact Energy and Auckland Airport.  Having seen what happened with Telecom, I decided to bail on some Vector shares I held when the ComCom regulator did her thing.  In hindsight, I should have toughed it out and hung on in there and I would be sitting on a decent profit by now.  But, as you have pointed out so eloquently, small investors like us don't have the inside running, so we usually don't know what is around the corner.

I have pretty much followed the rules you set out regarding spreading risk, purchasing over a reasonable time period and after 7 years investing, I can now look back with some satisfaction at the results.  However, if you had asked me the same question in March 2003, at the end of the post-millennium bear market, I would have had a different view.  At the time, I toughed it out, and in fact kept putting more money into shares while prices were low in the hope of an eventual recovery.  My faith has now been well and truly justified.

Anyone who invests in the Sharemarket with a less than 10 year timeframe runs a considerable risk that they will lose money.  As time goes on, that risk lessens to the point where at 20 years, according to the historical data of world sharemarkets collected over more than 100 years, there is virtually no chance of losing money.  And, if history is any guide, they will more than likely do very well.

Nothing is certain in this world though, and it would be a foolish person who invested borrowed money in the sharemarket, especially over a short time frame.  Back in early 2000 when world markets were going ballistic, I remember reading about someone who invested into the sharemarket a large sum of money that was earmarked for building a house a few months later.  Then the tech. stock crash happened and took most of the world's markets with it.  Needless to say, that person rued their decision and was unable to build their house without borrowing to make up the shortfall.

As Jama said so well:  "If you can't afford to lose it don't invest it"

I guess my point in making this post is to say that I am worried about the outlook for the property market when I read statements like this in the papers:

"Economist Gareth Morgan (father of Sam Morgan of TradeMe fame) believes the Reserve Bank will move on interest rates twice within the next quarter.

The kiwi dollar is trading at around the US74c, breaking records set over two years ago. Morgan said the Reserve Bank has no choice but to raise rates, as the economy has run too hot for too long, and the central bank now has to make up for lost time.


He is convinced the probability of a housing market crash is rising by the month, and said a government dereliction of duty in policy setting is firmly to blame."

I also read somewhere in the last few days (and I can't find the reference just now) that consideration is being given to "Ring Fencing" the losses from Investment Property meaning that the tax deductions enjoyed by LAQC owners such as yourself, would no longer be available.

As you've said, you are in it for the long haul, 20 years plus, and that's great.  If all property investors in NZ were like you, the market wouldn't be overheated.

Nevertheless, if the Government changes the rules significantly regarding deductibility of losses on rental properties, it would have a snowball effect which would kill any capital gains for an extended period.  That could have the effect of making your overall return much more modest, to the point where you would have been better with your money in the bank.

Today, I just put a substantial sum into a 3-month term deposit earning 7.9% at Rabobank.  Why only 3 months?  Because, chances are, in 3 months, the rates will be higher again when I reinvest the money next time.  With returns like this on offer at virtually no risk, and chances being that rates are going to get higher still, it would be a brave person indeed who invested in rental property at the moment.

You have had a good run, and for your sake I hope that it continues, but it could also be that you have already seen the best returns you will get from your investment.

Then again, Gareth Morgan and I could be barking up the wrong tree, and you may be laughing all the way to the bank in 20 years time!

Time alone will tell I guess...

Comment by NadNailer, on 19-Apr-2007 15:56

Another good post, nice one! :)

I cant help thinking though that *now* is not a time to be making *new* investments in property. The time to be making them was 5-6 years ago when the property market was depressed. I sold my house back in 2001 to go do my OE. The market was so crap that you'd be thankful if even one person turned up to your open home.

When I got back to NZ in 2003, the great NZ property bull market was on. Thankfully we bought a new place when we got back! We honestly were concerned that we were buying near the top. Normally, property bull markets are short and sharp. This one's gone on and on and on ...

Now it seems every Tom, Dick and Harriette is trying to get in on the action. Rental yields on property are now lower than interest rates. So anyone making *new* investments is speculating on capital gains continuing. I use the word 'speculating' because while rental yields will continue as long as you have tenants, capital gains are based on the 'greater fool' theory. That is to say, there will always be someone else willing to pay more than you did for a property. That's not investing, that's speculating.

The problem is that the music wont keep playing forever. House price inflation is much much higher than wage inflation. The proof of this is that house affordability fallen to the worst ever. In fact I think it's currently the worst in the developed world.

Theoretically, rental yields should be higher than the inflation adjusted risk free rates of return. The reasoning is that cash value is destroyed by inflation, so a portion of interest yield should be fed back into the base of cash to ensure that the inflation adjusted real value of the capital remains constant.

Rental yields don't need this adjustment, because rental yields will increase at least in line with inflation.

So why do rental yields need to be higher than the 'real' risk free rate of return? Because property has risk - bad/no tenants, maintenance, fire, supply/demand etc. You get higher returns on property because you need to be compensated for the risk.

For this reason, shares are riskier than property, and hence also have a higher long term return. Don't believe me? Look at the real returns of property vs shares over time and you'll see that dollar for dollar, shares outperform property. The big difference between the two in NZ is that you can apply a lot more leverage (10:1, or 90% mortgages) to property, but only 2:1 to shares, and with property you get tax rebates for running the property at a loss.

This has created an uneven (and slightly perverse) playing field. The trouble is that property encourages us to become ladden with debt. Why bother saving when you can leverage yourself and get rewarded for it!

So, there's the next biggest risk. If things get too lopsided and out of whack in the property market, I'd expect the IRD to get serious about charging capital gains on property, OR, for the IRD to ring fence property losses.

If that happens, the only investors that will truly lose out are those who are highly negatively geared.

All IMHO :)

Comment by business insurance, on 2-May-2007 22:00

Do you find more reliability in investing in properties than shares?

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