Most people invest in property to create wealth, but this means different things to different people.
I think the pursuit of wealth is often a means an end (something else), and generally has a positive societal impact.
If I were to one day achieve financial freedom, there’s no way I would stop working. I love the challenge of work/business and I get a lot of satisfaction trying to create value for people, and trying to make the world a better place, even if it’s only in the smallest of ways.
If I stopped working I would lose my passion.
When society condemns people from pursuing profit… then chaos strikes. (slightly off topic, but see Atlas Shrugged by Ayn Rand for further reading)
Don’t diversify, specialise (find your niche)
You have to do something with your money, because by itself cash in the bank earning 2% p.a. interest (less than inflation) actually takes you backwards.
To reach the enviable goal of owning say a $1.5 million family home outright, and then also having assets which passively generate $100k p.a. after-tax… you need net worth (in today’s dollars) of over $4.0 million.
Unless you have a massive inheritance, it’s virtually impossible to achieve this without investing. And so the options are really business, property or securities (stocks/bonds)…
The conventional wisdom tells us to diversify our investments (to lower risk), but most successful investors don’t actually diversify as much as you might think.
Instead they find a niche (property, shares or business), and then they specialise in it. They find a way to make money, and then they repeat the process.
This approach reduces risk because you develop knowledge, contacts, experience and expertise, and then you’re less likely to make mistakes.
For over six years my wife and I have been investing in business, property and shares. Along the way we’ve made money and also lost money, but our best results have come from investing in blue chip residential properties that we can add value to through renovations and/or development.
It helps with the work I do but this is our specialisation. What is yours?
Why do the majority of Australian’s choose property as their preferred vehicle for wealth creation?
There’s no such thing as a perfect investment.
Property for example is an illiquid investment, it’s not the highest growth asset, and the buy-in costs are relatively high.
Property remains the favoured asset class for wealth creation in Australia though …
Here’s why:
- Track record of strong/stable returns. Over the years well-located residential property has delivered consistently strong and stable capital growth as well as increasing rental returns.
- Conservative investment. The property market is underpinned by home ownership, there is a finite supply of blue chip residential real estate in major capital cities and particularly as our population grows it will always be in strong demand.
- Favourable tax laws. The ATO allows you to reduce taxable income with losses from your investment properties. Also your income from the capital growth in property isn’t taxed unless you sell, yet you can borrow against this income (equity) to continue growing your portfolio.
- Not volatile like business or shares. The property market is not volatile like other markets, partly because it’s an illiquid asset class and significant time, money and effort is required to buy and sell. Some say lack of liquidity is a bad thing, but it’s actually a good thing because the market doesn’t experience volatile fluctuations in value, and therefore you’re less likely to crystalize a loss.
- High degree of control. Real estate gives you more control over your assets, with the right skills/team you can take advantage of an “imperfect market” and secure returns by either buying below market value and/or finding opportunities to add value through improvements or development. Making money is less dependent on timing the market and external forces you have no control over.
- Ability to leverage. Due to it being a relatively safe investment, banks allow you to borrow more against property than against other investments. This allows you to control a larger asset base and increase your dollar for dollar returns. (more below)
The power of leverage
Using borrowed money to magnify your returns is an important concept, some say this is the main advantage of property over other asset classes.
The ability to use leverage with real estate allows you to control a larger asset base, and so this can significantly increase the returns you can make.
Here’s a worked example:
Investment A
10% p.a. growth
vs.
Investment B
5% p.a. growth
Investment A is clearly superior right? (it’s year on year returns are double!)
But what if the bank would only allow you to borrow 50% against Investment A, vs. up to 90% for Investment B… are the returns for Investment A still better?
Say you put $100,000 cash into each investment…
Investment A
- Cash $100,000
- Borrowed money $100,000
- Amount invested $200,000
- Leverage 50%
- Value of investment after 5yrs at 10% p.a. growth – $322,102
- Less the $100,000 borrowed, equals $222,102 (equity)
- Return on equity 222,102 / 100,000 = 222%
Investment B
- Cash $100,000
- Borrowed money $900,000
- Amount invested $1,000,000
- Leverage 90%
- Value of investment after 5yrs at 5% p.a. growth – $1,276,282
- Less the $900,000 borrowed, equals $376,282 (equity)
- Return on equity 376,282 / 100,000 = 376%
I’ve used an extreme example, but the lower growth investment, despite only having half the yearly growth, is orders of magnitude superior.
Borrowing to invest in low risk stable assets is a time tested and fundamentally sound investment strategy.
The key is buying low risk stable assets though. Not all properties have these characteristics.
It’s also worth mentioning that unlike shares so long as you make your mortgage repayments banks don’t call on your money when you invest in property.
This is another major advantage for property because you’re never ‘forced’ to sell (which is when many investors otherwise book losses).
The risks are actually with ‘you’!
In my role at the Australian Lending & Investment Centre I’m in the fortunate position where each year I literally see hundreds upon hundreds of scenarios involving people buying and selling property.
One of the key risks with property is that for whatever reason you’re forced to sell at an inopportune time, for example when something unexpected happens and you need your money back.
Say it costs 5.5% stamp duty/registrations/legals to buy your property in the first place. Then if a real estate agent charges a ~2.5% fee to sell your property, one can easily be down 8.0% ($80,000 on a $1.0 million property) by having to sell, even if your property hasn’t fallen in value. This is a lot of money. Add another 5.5% if you eventually have to buy back into the market, then the costs increase again.
By educating yourself, and building an A1 team around you, you can make your investment journey a much safer one.
In the example above, what if you structured your finances differently so you retained access to more cash? You may then be in a position to hold onto your property for longer, and allow for higher capital growth. A good finance adviser would ensure this.
Or what if you bought a terrible property today, and then in a few years from now you need to sell it (to upgrade, or for any other reason) and it has fallen in value by say 10%… what if you don’t have the money to make up the difference, you may find yourself in a position where you’re stuck and you literally can’t sell, even if you wanted to.
Buying well mitigates these risks. For example if you buy the right asset in the right suburb then the chances of that property falling in value are a lot less likely, and if you bought the asset below market value then you retain the ability to sell/upgrade at any time if you need to.
Few people realise it, but the risks with property lie less with the properties you buy, or the asset class you’ve chosen, and more with you, and your skills, and the team of experts you build around you.
Risks are mitigated when you educate yourself and develop expertise, and when you have experienced people on your advisory team.
Summary
In Australia property is the favoured asset class for wealth creation, as it presents as a conservative investment with a strong record of stable returns.
For this reason the banks are comfortable offering higher leverage against property and this allows investors to generate superior returns.
Property is the classic “how-to” rather than “when-to” investment. Your success isn’t determined by the yen doing this, and the dollar doing that, and a whole bunch of other market forces that are difficult to predict and totally outside of your control.
The success of property deals is largely within your control.
Educate yourself first, build a great team of experts around you, and devise a strategy you’re comfortable with and that makes money.
If you can do this then don’t worry as much about diversifying to reduce risk, you have already reduced risk by developing expertise and specialising in your niche.
There are a lot of people who make money out of real estate, and there are a lot of people who lose money out of real estate, despite both groups operating in the same market and under the same conditions.
The investor him or herself is the biggest risk of all.
