Taking point on property

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How does property fit into a portfolio?

How does property fit into a portfolio?

Property ownership is wired into the Australian psyche with “the great Australian dream” having been passed from generation to generation. In this paper we look at the behaviour of investors in relation to property and how that fits with modern portfolio theory – investors acting rationally and considering all the available information at their disposal when making a decision about an investment – in this case property.

Interestingly, for many, where we live is not regarded as an investment so much as a home and it is seen as a ‘safe haven’. For very many people it takes most of their working life to clear their home loan and so buying a second property as an investment is either too difficult or too big a commitment.

Whilst modern portfolio theory is over 60 years old it remains a relevant concept and builds on an excellent pictorial model first published in the late 1930s – the economic clock which broadly depicts how and in what order capital markets typically rise and fall.

Whilst investment timing is always subject to fear, greed, political and other factors making it impossible to perfectly time entry and exit points, it demonstrates that investors should build a portfolio that delivers maximum return for a given level of acceptable risk. To do so requires a spread across all markets so that downturns are not affecting 100% of the portfolio and the investor is always ‘in the money’ somewhere in their portfolio.

Part of that theory is to spread risk across multiple investments in the different asset classes of cash, fixed interest, shares and property and the myriad sub classes and derivatives of these primary classes. The higher their risk tolerance potentially the higher their return could be and vice versa.

Introducing a new look for an old friend

Buying a whole asset like a property, a company or a corporate bond as a retirement nest egg can be difficult for many, if not impossible, given the high cost. Even if it is possible, it would likely be a heavy overweighting and expose the investor to a far higher risk than might be appropriate.

Of course there are mechanisms that enable access to portions of these assets via managed investment schemes, managed accounts or direct, on or off platform as administration efficiency dictates. Technology solutions have made it relatively easy to establish a spread of assets to reduce risk however some technologies and methodologies are now dated and don’t necessarily cater to the needs of modern investors. Property trusts (listed or unlisted), for example, do not offer the option of residential property; their structures are pooled and tax ineffective and investors have little or no choice (transparency) over the underlying assets.

However, through fractional ownership it is now possible to develop truly diversified property portfolios for clients which target the type and locations of properties of their choice. Such portfolio development choice allows advisers to:

  • Meet the changing needs of clients – notably Gen Y who arguably have a preference to property over shares and baby boomers who may want property exposure without debt
  • Provide them with diversification of capital and income so when other markets fluctuate they maintain a steady return
  • Protect clients from paying too much for properties with built-in sales commissions and capitalised rental guarantees
  • Protect fee based FUM from property marketeers selling to clients

Disruption in the property market

Disruption is the buzzword pervading many industries as new products and services seek to disturb traditional technologies and methodologies with greater efficiency and lower cost alternatives.

One of the most impacted could be how people own and trade residential property. This sector in Australia is worth more than $5 trillion, three times the value of the ASX.

Why will there be disruption? Because there is a problem and that is the rapidly increasing price of property.

Crowd funding organisations are slowly growing as well as new forms of ownership like shared property ownership in the UK and fractional buying and selling in Australia. These models could be applied to other asset classes as well but for the moment it is property that is the principal target for these fast growing models.

We have seen the introduction of peer-to-peer lending which cuts out the ‘middle man’ (the banks) and reduces the overall cost of borrowing through lower margins enabled by technology which effects transactions quickly and easily.

The market is changing and technology is turning its attention to the property sector and how it can be changed to make it more accessible to more people. You could call it the ‘democratisation of property ownership’ because the high cost is pushing traditional ownership of investment property out of reach for many people.

By fractions

But if investors could buy a few thousand dollars’ worth (fractions) of one or more properties, receive a share of the rental income and capital value then it becomes viable for most if not all investors.

These changes could also be a shot in the arm for the financial planning industry as the next generations appear to have greater interest in property than most other asset classes. They are concerned about equity markets and perhaps don’t necessarily understand it in the same way as they understand property. And whilst they have seen rises and falls in the equity markets in their short lives, they have not seen such dramatic falls in property.

Property resonates

We discussed fractional investing in an earlier paper and how advisers can use this model to good effect with clients while at the same time building new revenue streams for their practice.

Central to introducing property into advice delivery is to establish a good relationship with a qualified professional property adviser. A good adviser, a buyer’s agent (AKA an advocate) is essential to choose the right properties to create a diversified portfolio of property interests within a balanced asset allocation that will help insulate clients from excessive risk.

One certainty with property is that everyone has a view on it – be it to do with aesthetics, style, amenities, functionality, location or value. Unlike shares or any other asset class, property resonates with people because we all live and work in one and everyone we know does the same so it is something we associate with every day. For this reason, arguably, it’s an easier asset class to discuss with clients.

Investing behaviour

So why is it so difficult for some advisers to engage their clients in investment property? Perhaps selecting stocks and buying shares is a lot easier than selecting property to invest in. Prices, trading volumes, company announcements combined with annual and interim accounts and daily market data and news provide plenty of material with which to make judgements. Sure, everyone has a few biases but share investing is more widespread than property investing, often as a result of privatisations and de-mutualisations like Commonwealth Bank, Telstra, AMP, Medibank Private and others which have given shares, or the opportunity to buy shares, to so many people.

Market expansion

Everyone lives in a property so why is investment property so different? Of course it’s the high cost of property and the necessity to borrow large sums of money to buy it. But if you could buy property in much the same way as shares – a bit at a time – clearly it would expand the property investment market to a much greater audience.

Data for property includes price history, if over far longer periods, median area and street valuations and yields. However, more importantly property values are linked to supply and demand, local economic conditions, population movements and employment opportunities, educational, transport and other amenities. As such there is a very wide array of data to absorb in relation to a potential property investment.

Ideally you should be able to select an investment property sight-unseen simply based on the numbers stacking up. Obviously an inspection is always warranted to ensure it is not falling down, but a decision to invest or not should never be based on whether the investor likes the colour scheme.

Model property portfolio

For investors who want engagement and to know precisely where their money is invested, pooled structures like equity trusts typically hold little interest, particularly for SMSF trustees. Arguably, if they had wanted pooled investments they would stayed in industry or corporate funds.

Fund managers in these structures have discretion to run internal portfolios for a pool of investors who share the net distributions, the profits and losses, the tax breaks and liabilities. The only choice the investor has is in the fund itself, not the underlying assets.

Enter model portfolios. Here fund managers construct their portfolios to achieve higher or lower income or capital value outcomes or a combination of the two. In many model portfolios the investor is able to select or deselect specific assets according to their likes or dislikes, but broadly investors are following the portfolio manager who, it is assumed, has greater knowledge of the asset and its market sector.

If recommending an individual property(s) for client portfolios is outside an adviser’s scope or causes issues around Authorised Representative compliance or Professional Indemnity limits, then building diversified property interests via fractional investing into portfolios is a viable option.

Increasingly AFSLs can, and are, engaging property advisers to create model portfolios in the same way equity managers are engaged to create equity portfolio models.

What property markets can be accessed via fractional investing?

All forms of property can be fractionalised provided sufficient funds are committed. Here is a sampling of properties available for book builds;

Established residential – yield and growth are mixed and dependent upon location and type. May include apartments, NRAS and Defence Housing (secondary market)

New developments – house and land, apartments, NRAS and Defence Housing – yield and growth are mixed and some of these have significant tax benefits traded off against lower rental yields. Beware of added sales commissions and rental guarantees on house and land and apartments, and oversupply

Rural properties – reasonable yields in the 5%-6%+ range generally with a long lease around 5+5 years

Student accommodation – strong yields around 8%-9% + with subdued capital growth, but the sector is currently a strong export market via education (overseas students)

Commercial property – generally stronger yields up to 8%-10% with moderate capital growth potential depending upon area and usage. May also include industrial, strata car parks, fast food and other service outlets with longer term leases

And the risks?

It almost goes without saying but risks abound in all markets. Paying too much for a property affects future capital value and a lack of tenants affects cash flow and overall return. Many new developments have sales commissions and rental guarantees built-in adding tens of thousands of dollars to the price. A property advocate or buyers’ agent can help avoid these situations. They can also access off market properties and negotiate on behalf of an adviser’s clients.

It is critical to examine the risk factors in each type of property as they vary greatly. Tenancies in commercial property, whilst generally longer than residential can be more difficult to fill and student accommodation should be seen primarily for its yield rather than capital appreciation. There are also economic considerations where business premises are being considered as well as maintenance costs. Tenants usually pay council rates for commercial property and some other costs, but that’s not the case for residential tenants.

Alignment

In looking to recommend direct property for clients, by aligning with a professional property adviser, in the same way financial advisers might align their practice with professionals in other disciplines such as accounting, legal, estate planning, risk and stockbroking, risks can be substantially reduced for clients.

From there it is easy. You do what you always do – talk to your clients, understand what they want, and help them achieve their goals. In doing so you only risk growing your business and helping protect your clients.

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