Putting property investment losses into perspective

“Since FY 2000, at the macro level, rents have not been able to cover costs (mortgage, maintenance, rates) and policy has produced a country of loss-making landlords who rely upon negative gearing.” Chief Economist of a large international financial organisaton.

The above statement echoes a common perception about the merits of property investment in Australia. Similar views are shared by many prominent and respectable social, economic and finance commentators and hance, get a lot of circulation in the media. Since media has big influence on public opinion, such views get absorbed by wide sectors of the community without much scrutiny as to their merit. The result is that we end up in a situation where there is a widespread misunderstanding about residential property investment.

Let me try to clarify this misunderstanding by explaining how income losses originate in the early years of residential real estate investments and what implications it has for the returns on such investments. In other words, why “losses” and “profits” can go hand in hand in property investment - and why it is not a misnomer as you may expect at first…

 

1. Property investors are price takers and, as individuals, have minimal impact on the market.

As much as investors would like to buy cheap to make big profits from day one, they are not the only buyers in the market. Hence, they have to pay prices that the market dictates. Investors also compete for tenants so, incomes from letting of residential properties are influenced by prevailing rental market conditions.

To illustrate the point, imagine you could buy a property for $500K, pay 5% in interest on 100% of the value of the property plus $5K in oncosts (i.e. $30K p.a. in total) and rent it for $40K p.a. (8% gross yield) to make a profit before tax of $10K. That property would also grow in value by 3% p.a.

So $0, nil, zip, zilch, nothing invested up front (apart from a promise to the lender to repay debts in due course or if something goes wrong) and a starting profit of $25K (comprising $10K cash and $15K in capital). There is only one question to ask - how many such properties would you like? You could probably stop working with 10, make most of your dreams come through with 20, and live a multimillionaire lifestyle with 30…

Let’s introduce a twist to this scenario and say, your cousin would like to do the same… and other members of your family, and your friends, and their family and friends… Suddenly, there would be a little bit more competition for the properties you intend to buy. So, how much such investment would be worth to you? Would you pay $600K for the property to earn “only” $20K p.a. (i.e. paying $35K p.a. in total costs and earning $5K net from rent and $15K in capital gains on original value of $500K)? Or maybe $700K would still be a good deal?

And let’s consider this case from a renter’s perspective. If it costs $40K p.a. to rent, would it be worth to buy the place for $600K and pay $35K p.a. in total costs and having an opportunity of making extra $15K p.a. in capital gains? Would paying $700K for the property be still a good deal?

The point is that prices at which properties change hands are the outcome of a complex set of circumstances, leading to individual decisions of buyers and sellers - the participants in the process, who collectively make the market. By default, since there can be only one buyer per property (whether a single person or a team), the price is usually the highest offer from all interested parties and is inevitably influenced by the cost of renting of comparable premises.

The following section explains how paying market prices works out for investors in the long run…

 

2. Long term returns on non-leveraged property investments match returns on share portfolios

Exhibit 5,7 &8

If you accept conclusions of studies on returns from shares and non-leveraged residential property, both these investment classes deliver comparable results over a long term. As an example, according to RP Data, on average, property delivered gross rental yields of 3.6 to 7.8% p.a. (based on 1996 to 2013 data series) and capital appreciation of anywhere between 4 to 13% p.a. (2001-2011 data series) - results vary by State and type of property. These are quite respectable returns and reflect relatively low risk of this investment class.

In other words, investors who bought properties with cash, or who paid off the initial loan, are consistently generating positive returns form their investments. So, labelling property investors “loss making landlords” is rather unfair generalisation.

The next section explains implications of a prospect of stable long term returns for the risk appetite of property investors…

 

 


3. Low volatility creates opportunities for higher leverage

Since cash purchases of residential real estate are very rare, due to sums involved and difficulties in acquiring fractional ownership of a property, such investments are usually made with borrowed money. Buying an asset with borrowed money is called leverage, or gearing, and both owner occupiers and investors can take advantage of it.

Volatility in property prices is relatively low, especially on the down side. So, it is quite common for investors to buy residential properties with loans of up to 100% of purchase price plus full cost of purchase expenses (in such cases lenders take additional security over other unencumbered assets of the investor). The last six decades of persistent growth in property prices created expectations that this upward trend will continue in the future which gives borrowers and lenders confidence to enter into arrangements that are otherwise considered very risky (e.g. for share portfolios).

By applying maximum leverage to investments that already deliver positive returns investors have the opportunity to turn respectable profits into more substantial ones. However, the leverage comes at a cost in the initial stages of the investment when interest payments are not fully covered by income from rent. As borrowed money is paid off and/or rental incomes grow, those losses are eliminated.

The next section explains how those small losses can deliver big returns over time…

 

4.  Losses are actually additional capital injections that make leverage possible

Explanation of this step requires applying unconventional approach to account for profits. In short, the logic goes like this: the loan is required to secure possession of an income producing asset and it has an annual cost which initially is not covered by income from that asset (the reasons are explained in point 1 above). The annual operating loss (regardless whether reduced by negative gearing or not) and/ or investor’s contribution to the purchase price are considered capital outlays for the investment - not the purchase price of the asset. It therefore follows that these real cash outlays are what should be used in calculations of investor’s true returns.

To illustrate, a $500K apartment bought last year in Sydney with 100% loan (so, no cash outlay) that increased in value by say, 10% over the last 12 months (so, $50K gain) but generated $10K after-tax loss (i.e. which is actual cash invested), delivered in reality 500% return to the investor (of course net returns will be less due to capital gains tax and other costs if property is sold).

And it works in a very similarly way for owner occupiers. For example, a property purchased with 10% deposit that doubles in value (i.e. 100% return on purchase price) in reality is a 1,000% gross return on the original cash investment (for net return figure all costs of owning that property over the period would have to be deducted).

Of course, it is needless to say that the less leverage applied, the more those returns will approximate normal returns (as outlined in point 2 above). Also, that both property owners and investors can lose equally big if their bet on rising property prices goes the other way and properties decrease in value over time.

I am first to admit that this method of accounting for profits is controversial and can be criticised on a number of grounds. More importantly, this information taken out of context and in hands of unscrupulous peddles of “make zillions in property” seminars can be outright dangerous. However, it does not change the fact that for home owners and investors alike it is the real, hard cash that counts at the end of the day, not paper profits calculated for tax or other accounting purposes.  This method has its merits as it shows true net cash position after disposal costs, relevant taxes and debts are accounted for. It also demonstrates that even small increase in property prices can lead to substantial returns for property owners. There is no “black magic” or “secret formula” involved – this is simply how leverage works.

And to conclude…

 

5. Government or taxation policies have nothing to do with it

As I explained in my previous article Negative Gearing: The three facts that will challenge your assumptions, there is very little about negative gearing that would allow drawing a conclusion that landlords in Australia have to rely on it exclusively to make their property investments viable. There are no other government policies that would directly contribute to the viability of property investing either. Residential property as an investment class has its own merits - for owner occupiers as well as investors, with or without negative gearing, with or without leverage.

Majority of Australians already participate in this class of investment, either as owner occupiers and/or investors. We are not a nation of gullible property speculators, sinking money into dubious assets - but it takes some financial acumen to understand it. Off-the-caff comments, sensationalising selective aspects of property ownership or investing, without explaining the context, will not help those who are unable to participate in the Australian Dream. Promoting basic financial education is more pragmatic and would be more considerate...

 

 



 

Arek Drozda is an independent analyst who has worked in the public and private sectors for over 20 years in business development, data analysis and in building geographic information systems.

 


Community Discussion

Be the first one to comment on this article
What would you like to say about this project?