nottheaverageactuary

Actuarial news and views from Cape Town and beyond

Property vs Equity

8 Comments

Hopefully many of us will soon be making choices about what we will invest in. While we are still far from retirement, two asset classes are likely to dominate this choice – equities and property. These two classes are said to yield high returns that exceed inflation, making them the obvious choice over the more secure, but lower-yielding options, for investors with a long time-horizon. But of the two, which is more attractive?

By asking this question, I don’t mean to imply than only one should be chosen. It’s likely to be better to include both in your portfolio, so as to benefit from diversification. Nevertheless, I was interested to find out more about how these two classes compare, and what kinds of proportions each should constitute in a typical portfolio.

Joshua Kennon gives an answer that we should expect by now – it depends on the investor.

He goes on to list pros and cons of both asset classes that may have varying degrees of importance to different investors. Some of the points he makes should be familiar by now – e.g. equities are more liquid, but have greater short-term variability.

Interestingly, he mentions one of the advantages of investing in property to be that it is tangible. For some people, he says, being able to point at property and declare “I own that!” can be important psychologically. Our Act Ed notes also mention that property investments can result in extra utility to the investor. This will ring true to you if you know anyone who enjoys renovating, or who loves being able to say, “I built that!” Although these sorts of returns aren’t financial, they shouldn’t be ignored.

Another interesting point he makes is that it is more difficult to be defrauded when investing in property, since you can perform physical inspections. Given the number of stories I’ve heard of people who’ve uncovered undesirable features of properties only after renting or purchasing, I’m not sure how true this is, but it’s an interesting point nonetheless.

It’s not all good for property though. In his words, “buying stocks, reinvesting the dividends, and holding them for long periods of time has been the greatest wealth creator in the history of the world.” In contrast, in this article he argues that property values don’t even keep up with inflation. He does say that many investors are too emotional or undisciplined to take advantage of the high returns on equities, but the fact remains that higher returns are generally expected on shares than property. There are also higher management costs, and possibly even hands-on work required for property investments.

Despite this, property could be very appealing because it is generally much easier to use leverage to invest in property than other asset classes, as Ann Wilson points out. You can take out a mortgage to invest in property, but it is more difficult to borrow to invest in shares or other financial instruments. As a result of using leverage, the absolute amount earned on the investment can be larger for property even if the rate of the return on the investment is smaller.

An important consideration for property investment is that there may be periods where no rent is collected. In this article, a rule of thumb is suggested of never directly owning more property than you can maintain without receiving rental income, due to this risk.

Indirect investment in property does avoid some of the disadvantages that I’ve discussed here, but it is still recommended that the proportion of risky assets invested indirectly in property should not be too large, as the recent crisis showed that there is a large amount of undiversifiable risk in the property market.

Overall, I think that there are some great points in favour of both property and equities. That said, my view on this is that there may perhaps often be more room in a portfolio for equities, given the higher expected return, while property could be used for diversification benefits and to augment the portfolio by introducing leverage. Of course, this is all subject to the specific needs of the investor.

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8 thoughts on “Property vs Equity

  1. Really informative article, Ashraf.

    With regards to my family’s personal investment in property, my dad has a plan to rent out my flat (after I’ve moved out) for a few years and to sell it fully-furnished just before that point where it will start incurring high maintenance costs. I’m not sure how fool-proof this plan is, but at least the oven will last until then, since we replaced it 3 weeks ago! It definitely attempts to mitigate the risk where the property becomes unaffordable to the investor.

    I do like the concept of property investment, and an idea that I have for when I’m earning a chunky salary (probably around the age of 30) is to buy my retirement house and to rent it out until I do actually retire. Obviously there are the risks and one of them is that the area changes and it actually becomes inappropriate for a retired person to live there. But then hopefully I would be able to sell it for a reasonable price and buy affordable property elsewhere. There are actually many more risks with that, but I will not expand on them because I want to sleep.

  2. When we talk about rent income in South Africa (and probably most other countries as well), we often think of a series of regular cashflows that are received from tenants. I don’t have the exact statistics, but that is very unlikely to be the case in Korea. What usually happens is the tenant pays a once-off lump sum to the owner when he moves into the property. And the tenant will receive the lump sum back from the owner when he leaves the property. It varies from one contract to another, but in many cases the lump sum is not accumulated at all; the lump sum is usually a percentage of the selling price of the property.

    Properties in many parts of the country are considered expensive in international standards due to the high population density and the fact that a large portion of the land is mountains. And this once-off lump sum payment of rent is causing some problems, because young people often cannot take not afford such liquidity and borrowing such large amount of money at the prevailing interest rate is often not a viable option.

    On the other hand, there was a stage where many of the property owners took the lump sum rent they received and took out additional mortgage to go on a property-spending-spree, which fueled the demand in the property market, making properties less affordable for the average citizens. So what got me thinking was, is it time that Korea takes away its current lump sum rental system? Even if everyone agrees, it will be a difficult procedure because there are so many contracts that are in force on this system.

    • Is this in North or South Korea?

    • It’s fascinating to hear about what happens in other countries, but I have to say that this lump sum rental system seems very weird to me. I’d presume the lump sum would have to be a very large proportion of the property value to be worthwhile to the property owners, but if that’s the case, it seems strange for the tenants to pay a large capital amount just to rent rather than use that capital amount to purchase their own home. By renting, they’re losing the appreciation of the value of their capital. There are other needs that may still make renting preferable (e.g. the need for flexibility – not being tied down by owning the property), but I’m surprised that many people would choose to rent under this system.

      I’d think that it’s inevitable that this lump sum system would lead to problems among young adults – probably the biggest advantage to tenants of the regular rental system is that there is no need for a very large capital outlay at the beginning, and it’s because of this that a lot of people without much wealth have to rent rather than purchase their own home. Without that option, I’m not sure what else they can do…

  3. Great article Ashraf. I had never thought of the emotional satisfaction of owning property. I think that could definitely play a large role in investment decisions (depending on the type of investor).

    In relation to the point about the difficulties of obtaining rent, I have seen many instances where rent that people are willing to pay, does not even cover the bond/mortgage attached to the property. So you are in actual fact, you are still losing money every month. I find this to be the case particularly when investing in more expensive property. In these cases, it may be optimal to allocate more weight in your portfolio to equities. With this being said, I am not a property expert and diversification is, without a doubt, the best strategy.

    • Your view is interesting – I personally find cases where rent exceeds mortgage payments to be more surprising than where it does not cover the payments. It strikes me as strange that you can use a loan to buy a house, and then use the income from that house to pay off the loan – so that you’re basically not paying any money yourself – and at the end of the repayments, you own the house! It seems a little like arbitrage, although of course it’s not riskless (and the mortgage probably wouldn’t cover the full property price). From the tenant’s point of view, rent payments are lower than mortgage payments, and yet with a mortgage you would end up with a house at the end! So it’s odd to choose to rent instead of purchase.

      When the rental doesn’t cover the mortgage payments, as you mention, don’t forget that there is still capital appreciation on the property, so the owner probably won’t actually be losing money – it’s more of a liquidity concern.

  4. From the tenants point of view, I find that one of the main reasons people rent is because of the difficulty of obtaining the initial credit. Buying property would require large sums of capital that many people are unable to loan due to their current income streams and lower credit worthiness.

    Going on to your next point, there may be capital appreciation on the property but this appreciation may be relatively small in comparison to maintenance and interest expenses that are paid on the property and mortgage. When I mentioned “losing” money, I was referring to opportunity cost. There is no doubt that you will NOT lose money in the end, but there may be far better investment alternatives and in certain cases, leaving your money in the bank may even generate higher returns.

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