Profit is ‘the return to risk’ but ‘bricks & mortar’ as an asset class is a relatively predictable, safe, reliable and attractive option.
“Australian residential property outperformed all asset classes for the 10 and 20 years to 31 December 2017”
1. Inflation favours tangible assets – inflation is a sustained general increase in the prices of goods and services over time. Unlike real assets such as property and land, the value of bank deposits can diminish over time due to inflation. Not only do the dollars in the bank potentially buy less than when you put them in but the interest earned may not compensate for the higher prices over time.
The ‘real interest rate’ = interest minus inflation.
Think of something you bought from your childhood, perhaps at the school canteen, what did it cost? What would it cost now?
An example of the ‘time value of money’ is seen when lottery winners are persuaded to accept regular monthly payments ‘for life’ (read 20 years) rather than a lump sum now, which is usually a bit smaller. For example, what would you rather have? $4.5 M now or $4.8 M ($25 K per month for $20 years)?
Take the money NOW! The $25,000 will buy you less in 20 years than it does now.
2.Low volatility over time – records have been kept in Australia since the 1890s. During that time, the overall trend for house prices has been upwards, despite variations around around the trend.
3. Real estate ranks between fixed income and equities on the risk return scale – housing doesn’t carry the lowest risk but it also doesn’t carry the highest.
4.The ‘power of leverage’– Being able to borrow a large proportion of the funds required to invest means that lenders are comfortable with property as an investment and you use other people’s money!
Property makes your money work harder.
$30,000 invested in the bank at 5% pa = $1500 capital gain (which is then taxed)
$30,000 deposit on a $300,000 house at 5% pa = $15,000 capital gain (and costs of ownership reduce your taxable income and CGT can be deferred for years)
That’s the power of leverage!
5. Legislation allows limited recourse borrowing within a Self Managed Super Fund for property. This is an endorsement of the strategy as a safeguard against the sudden erosion of retirement funds.
6. Favourable tax treatment. Back in the first Lesson, ‘market failure’ was mentioned as an important concept to understand. In a free market economy such as Australia, goods and services are produced according to demand and the ability of supply to respond to that demand, in other words, via market forces. The market is efficient but it is not always equitable.
Government, modifies the free market by compensating for its ‘failures’. It provides some goods and services that the market can’t or won’t and restricts the supply of some that it would if it could, such as illicit drugs.
Rather than ‘crowd out’ more efficient private sector activity, government provides tax incentives for individuals to invest, thereby increasing the supply of available housing. New product in particular is encouraged because of the multiplier effect on the economy and employment specifically. Building new properties has a ripple effect on consumption that is hard to replicate.
The public sector is not typically as efficient as the private sector. Resources are wasted (not allocated efficiently) by big bureaucracy that has social welfare as its agenda rather self interest. Consequently, there are some goods and services that government outsources to the private sector to provide. It also provides incentives to others to do what they cannot do in sufficient numbers or with optimal efficiency – a prime example is housing!
7.Tax breaks in the form of Negative Gearing and Capital Gains Tax Discounts are strong incentives for investors to enter the housing market. Negative Gearing allows investors to claim all the costs of property ownership against their taxable income and provided the property is held for at least 12 months, the CGT payable is discounted by 50%.
Concessions like these promote entrepreneurial spirit, the building block of the market system, and are an incentive for individuals to create wealth for their retirements thereby reducing the burden on future generations of taxpayers.
(Remember the ideas about building a business for the future)
8. Tax on any capital gain is deferred until the asset is sold.
9. Rental income is reliable, it isn’t subject to ‘management performance’, the returns are contracted in a tenancy agreement and are protected by Landlord Insurance.
10. Interest rate rises usually mean less people buy their own homes and therefore demand for rental properties rise. All things being equal this should translate into higher rents.
Interest rates are defined as ‘the cost of credit’, in other words it’s the price we pay for using other people’s money.
Monetary Policy is Reserve Bank action designed to influence both the availability and cost of finance in the economy. Interest rates are pushed up to slow the economy and limit inflation and they are eased to encourage spending and activity and therefore employment. So, as economic circumstances change so will the prevailing cost of credit.
The upside of a rate increase is that your tax deductions increase and more people may delay buying their own home and continue to rent and put upward pressure on rents.Remember, ‘profit is the return to risk’ so you do have to take some risks if you are to build wealth for the future but make it a calculated risk.
In really low interest rate environments, retirees with assets dependent on bank earnings are adversely affected. When interest rates (and particularly real interest rates) are almost negligible, as they are currently, earning your retirement income from rent, even in part, is a very appealing alternative.
11. Investment in property is socially beneficial. Private sector activity is encouraged through negative gearing and results in a more efficient allocation of resources.
12. Risks can be mitigated further through insurances