Some investors believe that holding a balanced property investment portfolio is the key to success, believing that you should never keep all your eggs in one basket, unless you are extremely confident about the outcome.
The logic of spreading the risk is that if property values or rents in one of your investment areas slump, good continued performance in the others will still give you an acceptable overall result. This leads to the obvious question of what constitutes a ‘balanced’ portfolio.
Some investors spread their housing investments across several states, others own a mix of houses, townhouses and apartments, while still others balance their portfolio across capital cities, regional towns and rural centres.
The purpose of balancing our investment portfolio is to mitigate risk, not to maximise our opportunities, because if we were certain where the next property boom was going to take place, it would make perfect sense to buy all our properties there and nowhere else, even despite possible downsides such as land tax or natural disasters. It’s uncertainty that urges us to diversify, not the surety of high returns. This applies to all forms of investment, so let’s look at the theory of a ‘balanced’ portfolio as it applies to investment generally.
EACH TYPE OF INVESTMENT PERFORMS DIFFERENTLY OVER TIME
Many investors split their funds more or less evenly between shares, property and cash in the bank, maybe even keeping some gold as a hedge in case things unexpectedly go wrong. They do this knowing that these assets perform quite differently from each other during booms, busts and recessions, so they reduce the risk of loss by spreading their investments around.
Bank savings, term deposits and bonds are considered low risk — not because their security is greater, but because the return is fixed, giving you a guaranteed return. Yet although bank savings and term deposits are a secure and easy form of investment, your investment portfolio should only include sufficient amounts of savings to meet unanticipated property repairs or to cover those times when properties are vacant. It is never a good idea to have more than you need in cash or savings because their value falls with inflation and income tax takes its toll.
Gold is the investment of sentiment. It provides little return in times of economic growth, but can rise dramatically in value when economic conditions deteriorate. There is not a great deal you can do with gold or cash in bank except to buy and sell at the right time, because each ounce of gold and each dollar in the bank provides exactly the same return as any other.
The profits you receive from shares and property are more complex, because some will rise in value at the same time as others are falling and your results depend on how successfully you read the market and make the best buy and sell choices.
As the complexity of each type of investment grows, so does the risk — and the potential return, but understanding the likely performance of each type of investment over different times allows us to shift funds from one to another to obtain the best returns, rather than just maintaining the same mix regardless of changing economic, financial or social circumstances.
Figure 1 shows the comparative performance of gold and Australian shares since Federation in 1901. The red circles highlight three periods in our history when shares fell dramatically in value and gold rose at the same time, each indicating a period of crisis in our nation’s past.
The first share market crash occurred during the Great Depression in the thirties, the second took place during the stagflation crisis in the early seventies and the third was the GFC in 2008. In each case, our nation suffered from economic slow-downs, even depression, coupled with social and political unrest and turmoil. During these times, share prices plunged and gold, being the investment of last resort, soared in price.
While share markets slowly recover over a few years, the price of gold usually stops its rise until the next disaster strikes, but doesn’t actually fall in value.
We have recovered from the GFC and although the mining boom is over and economic growth is slowing in Australia, there’s no real or perceived crisis waiting in the wings. Europe is still suffering a post GFC hangover and a Eurozone recession is the result, yet gold is not shooting up, because the crisis is not seen as a real threat to world-wide economic growth and financial stability.
History shows us that the mix of our investment portfolio should reflect the economic times. During economic downturns, cash reserves should be built up to cover possible increased personal financial need. Shares should be sold if necessary to protect our housing investments and increase our gold holdings as a final hedge against possible economic disaster.
During economic growth spurts we should buy shares and use their price growth to increase our capital as equity for further housing investments. At all other times, such as the present, housing investment remains the best option. Figure 1 shows that both shares and gold have been underperforming in recent years compared to their long term growth trends and the reason is that investors been putting their money in housing.
The question then is do we go for growth or cash flow?
THE BALANCE BETWEEN CASH FLOW AND CAPITAL GROWTH
The first decision that housing investors have to make is whether to go for capital growth from renovating, development or passive growth or whether to select properties for cash flow from rent. There are many personal considerations investors need to weigh up when making these choices, such as the stage of their investment journey and their capability or willingness to improve properties, but the housing market can also provide some overall indications as to the time when such options might provide a better result than others.
Figure 2 shows the performance of Australian capital city house markets from 1901 to the present and compares this to the performance of weekly asking rents.
The historical data shows us that there have been four times in our history when rents rose rapidly compared to housing prices and so we can analyse the causes and predict the conditions under which a boom in rents might take place again. Not surprisingly, each of these rent booms occurred when our population was rising rapidly from overseas migration, such as the two post war population booms of the early twenties and early fifties, as well as the more recent booms during the mid seventies and mid noughties. The reason that rents rose rapidly during these events is that overseas arrivals generally must rent for some years before they are settled enough to buy their own home and because they tend to live in established ethnically friendly suburbs while they rent, the result is an explosion in weekly asking rents.
Figure 2 also shows that the gap between asking rents and house prices is currently widening and this is leading to a fall in rental yields.
The two causes of this divergence between prices and rents are a consistent and prolonged fall in interest rates, which is encouraging purchases rather than rentals and the boom in inner urban high rise unit development of our major cities which is creating surpluses of investor owned stock. With neither of these dynamics showing any change in direction, inner urban unit rentals are unlikely to rise in the foreseeable future and declines could occur.
This indicates that investors should not rely on rental guarantees or other incentives unless they are certain that there will be real demand from renters, rather than more investors in areas where they are planning to invest.
THE BALANCE BETWEEN CAPITAL CITY AND COUNTRY PROPERTIES
Our growing urbanisation generates ever growing demand for housing in already heavily populated and over developed coastal areas and creates more or less continuous housing shortages in most of our capital cities.
Figure 3 shows that this was not always the case, and in fact around the time of Federation in 1901 the price of regional and country housing was equal to and in some areas greater than the cost of equivalent city properties.
Since then there has been an almost continuous drain of people from rural areas to the cities, but a far more dramatic influence has been the arrival of overseas migrants, especially since the end of the Second World War who have overwhelmingly preferred to live in cities, especially Sydney and Melbourne. Over time, this has resulted in city house prices being higher than those in country towns with country and regional housing prices declining to around 60% of capital city equivalents. This is unlikely to change in coming years, with no significant or serious decentralised housing initiatives forthcoming from governments at any level.
It does not mean that country prices are falling in real terms, but that their rate of growth is less than that of capital city housing markets. The annual average growth rate of capital city housing markets is around 2% more than country areas on average, which means that investors seeking a balanced portfolio should only invest in capital cities, unless there is strong evidence that a particular regional or rural market is about to boom.
THE BALANCE BETWEEN UNITS AND HOUSES
While country housing markets have fallen behind their city counterparts it has been the opposite with regard to units compared to houses. As the price of houses in our major capital cities pushes them out of reach of most home buyers, units are becoming more attractive to both investors and owner occupiers.
The introduction of Strata Title for unit owners in the late sixties made them more attractive to investors, and Figure 4 shows that home unit prices have steadily risen since the thirties from 60% of median house prices to around 90% at present.
The current price differential is less than 10% and is reducing as units become a more attractive dwelling option for increasing numbers of households. Not only have the quality and fittings of units improved over time, they provide occupiers with the opportunity of living in areas where house prices make them virtually unobtainable, such as beachside, bayside and riverside locations, near shops and transport and many have views which far exceed those of nearby houses.
Many modern units are becoming the preferred type of accommodation for both young professionals and retirees, being far less work to maintain than a house.
THE BALANCE BETWEEN TYPES OF HOUSING MARKETS
Irrespective of whether we decide to balance our properties between city or country dwellings and units or houses, we need to consider the single most important fact about housing investment. Housing is about people, not places and the best investments will always be where the demand for housing is so great that it leads to housing shortages.
This demand will then translate into rent or price rises. We can safely ignore other dynamics, such as past performance because the dynamics which led to high price growth in the past may not continue. Figure 5 shows the extremely high long term price growth that took place in some regional towns in the ten years leading up to the end of 2011.
The causes of this growth were housing shortages for rental accommodation generated by workers in the coal and iron ore mining booms associated with these towns. It was the subsequent competition between investors seeking a piece of the action which then led to dramatic rises in house prices. Although it seemed to some experts that the house price boom would last forever, it was not to be and the slowing of the mining boom led to the equally dramatic falls in prices shown in Figure 6 as investors now competed with each other to sell their vacant properties.
If you are not certain about your ability to correctly pick those areas where price growth is most probable, then it is best to balance your portfolio amongst the best types of markets where growth is most likely. In our current housing market environment these include outer urban unit markets where further development potential is exhausted, but there are also excellent locations in regional areas.
The key is that must there growth potential such as in potential retiree coastal destinations about an hour or two drive from major cities and overseas tourism boom towns. Achieving a sensible balance means that while all of your investments may prosper, it is highly unlikely that none of them will, because the dynamics of each of these markets is different and they all have good potential.
Housing data provided by APM Australian Demographic Statistics 3101.0, ABS Australian National Library on line Trove facility Mitchell Library archives Capital City House Price Indexes, 6416.0, ABS