The role of residential property in an investment portfolio
Property is a strong asset. Over the past 20 years, residential property has tended to deliver better risk-adjusted returns than other asset classes, but there are significant differences between property and shares or bonds.
Australians have a relatively high rate of home ownership compared to other G20 countries. Data from the Organisation for Economic Co-operation and Development (OECD) suggests that about 30% of Australians own their property outright, while about 33% have a mortgage and the rest rent.
Housing is by far the largest component of a household balance sheet in Australia, both on the asset and liability side. About 53% of gross household assets are held in land and dwellings. Superannuation assets are the next biggest holding, at 23%.
Returns vary according to a property’s use. For investors, there’s capital gain and rental yield. For owner-occupiers, the total return is simply capital gain — similar to owning gold or a venture capital investment — as there’s no explicit income stream (although it could be argued that owner-occupiers benefit from a stream of imputed rents).
One issue with property is that it tends to be less liquid, especially if prices are declining. And the asset class itself is not fungible - for example, an inner-city apartment in Melbourne is quite different to a detached dwelling in Rockhampton or a harbourside property in Sydney. There are also nontrivial transaction costs involved when entering and exiting the market (stamp duty, agency fees), which isn’t always the case with other financial assets.
On the upside, you usually have more leverage with residential property, and access to significant tax advantages, including negative gearing and capital gains tax exemptions.
Putting together an investment portfolio
Our analysis shows that adding domestic residential property to a theoretical 60/40 portfolio (60% growth assets, 40% defensive assets) would have reduced the volatility of portfolio returns over the last 20 years. Particularly during periods of turbulence in equity markets, we see that an allocation to residential property reduces the overall variability of portfolio returns, as drawdowns are generally less pronounced in periods of risk aversion. However, when risk markets are performing well, we observe more upside in a portfolio that doesn’t include residential property.
When we look at the difference in returns between a simple AUD-denominated portfolio with an allocation to residential property (at the expense of equities) relative to one without, it averages out to a 0.71% per annum underperformance over a 20-year period. However, the portfolio with property would have less volatility, suggesting that the risk-adjusted returns would be higher.
How property performs when times are good
Since 2002, residential property has shown significant outperformance versus inflation. In other words, real house prices have increased significantly.
The correlation between quarterly changes in inflation and quarterly changes in house prices is generally positive (they usually move in the same direction) and has become stronger in recent years. Given the myriad factors that influence house prices, there’s no simple or obvious explanation as to why the positive correlation between house prices and inflation has strengthened since 2015.
Like many of its real-asset peers, residential property appears to outperform versus inflation and exhibits strong positive correlation to inflation outcomes. It’s important to note that, in the period we’re referring to, secular trends have been biased towards lower interest rates and lower rates of inflation. This may shift in the next decade, but we don’t think it will necessarily change the ability of residential property to outperform against inflation.
What lies ahead for the property market
It seems that annual returns on residential property won’t be as strong in coming years as they have been over the last couple of decades. If historical precedent is any guide, rental yields will be pinned to the longer-term trajectory of risk-free interest rates.
At some point in the next year or so, capital gains will be handicapped by affordability, given that household incomes aren’t rising at the same rate as house prices. Near-term, the greatest threat to house prices is likely to be more macroprudential regulation, given the sharp rise in investor lending of late and the increase in lending with elevated debt-to-income ratios.
Already the prudential regulator has mandated tougher standards for banks assessing whether borrowers can afford loans, which analysts say may limit the amount many can borrow by as much as 5%. Longer-term, the main issue for capital gains relates to interest rates. To the extent that the bull market in interest rates has run its course, the tailwind to house prices over the next decade will need to come from other sources.
Population growth may contribute as borders re-open but, given the already favourable tax treatment and ongoing monitoring of lending standards, it’s hard to see what else could replace the role declining interest rates (and deregulation of the financial system) have played in fuelling growth since the 1990s. Land supply issues in large capital cities may help the relative outperformance of house prices in Sydney and Melbourne, but that depends on those cities continuing to absorb the lion’s share of net migration flows.
It’s fair to say that the two main challenges to house prices — unemployment and higher interest rates — aren’t likely to be major problems in the next two years. Unemployment is trending downward and this should support house prices. Borrowing rates have begun to rise, but we suspect the magnitude and pace of any tightening cycle will be modest, even if it begins a little earlier than the Reserve Bank of Australia now expects.
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