Property - safe as houses

Brought to you by Australian Property Investor

Residential real estate outperformed shares on a risk-adjusted basis over the past two decades, according to a recent study. Matthew Liddy from Australian Property Investor magazine reports.

Shares or property? It’s a question nearly all investors ask themselves at some point. A report from NERA Economic Consulting and Mercer may help find the best balance for your investments.

It found that between 1982 and 2005, residential real estate performed better on a risk-adjusted basis than Australian shares, 10-year government bonds and listed property trusts. Property showed a capital return of 8.3 per cent per annum and a total return (including both capital gains and rental yields) of 14.8 per cent per annum.

The Australian Stock Exchange’s All Ordinaries index returned 16.8 per cent a year over the same period. However, once risk – or volatility – was factored in, property came out on top.

Report co-author and NERA associate director Tom Hird said the risk of investing in the various asset classes was factored in using what is known as the Sharpe ratio. The ratio is calculated by dividing the total return on an investment by the volatility of that investment (as measured by the standard deviation).

“Residential real estate has a Sharpe ratio that’s more than twice that of the All Ordinaries, suggesting that for each unit of volatility in the return, the return is two and a half times as high for residential real estate as for equities,” Hird said.
He said the study’s findings meant any smart investor should have a significant holding of residential property.

“The main finding there was that if you were to have an optimal portfolio, you would have a large proportion of residential real estate in that portfolio,” he said.

The data suggested that “if your wealth portfolio was based on the All Ordinaries, that would be a bad thing to do, that you should have a substantial proportion of that wealth in property rather than in equities”.

Another way of crunching the numbers was to choose a desired level of return and see what portfolio mix would have achieved it, while also minimising risk.

“For higher returns…the largest asset in your portfolio would be residential real estate,” Hird said.

For instance, he said an investor aiming for a 15 per cent annual return with minimal risk should have at least 60 per cent of their portfolio in residential real estate.

Hird said real estate’s lower volatility made it the perfect companion to diversify an investor’s share holdings, as shown by the property sector’s strength during the 1987 stock market crash and the 2001 technology stock correction.

“(Housing is) not strongly correlated with equities, so if you’ve got an equity portfolio you can reduce the volatility of your wealth by adding housing to it.”

Sustainable?

A critical question for investors is whether returns for the past 20 years are a good indicator of possible returns for the next 20 years. For Hird, the answer is yes.

“We see the major factors that drove those returns over the last 20 years as being the same, if not stronger, over the next 20 years,” he said.

The report identifies those factors as:

• the relatively fixed supply of real estate offering the amenities people tend to value (eg. urban housing close to employment, transport etc.);
• population growth;
• falling household size;
• growing household incomes; and
• the availability of housing finance.

Hird said these factors had driven house price increases to the point where prices as a multiple of average weekly earnings were higher than historic averages. While some analysts view this as unsustainable, Hird is not among them.

“Our message is that those things have been growing and that there are very good reasons for them to be always at historical highs, the same way you expect the equity market to keep growing,” he said.

The report concluded that Australian real estate’s performance over the past 20 years could not simply be attributed to falling interest rates. Hird said real interest rates only fell about 1.5 per cent during that timeframe.

“If you were of the view that real interest rates were going to rise substantially over the next 20 years then you would quite possibly discount the last 20 years, but I don’t hear anyone saying that that’s the case,” he said.