Australia has a fascination with residential property. Everyone, it seems, wants to buy it. And everyone thinks they will become millionaires if they do so.

But I have some alarming news. The problem is that we have the impression that property is the be-all and end-all. This, of course, is total nonsense.

But let me be clear. I am not talking about commercial property but residential housing investments. So, this does not refer to a home you are living in.

And it does not matter if it is old or new: whether you do it up or not, do much at all but rent it out to tenants. And to be clear, I am not talking about property development either.

I did some serious and sophisticated scientific research on this. To be quite honest, there was not much sophistication involved, nor was any science involved, but nonetheless, what I found was amazing. Well, it was not amazing to me – I have known about this for some time – but for you, this might be amazing.

The Australian property market is a bit different from the rest of the world. Australia is vast. Yet the population tends to be concentrated in and around 4 cities. This creates challenges in itself, and we are finding that building more property is lacking considering demand.

When I was at university, I studied economics. In between taking drugs and being sick in the student union bar, I occasionally managed to attend a few lessons. I was taught that if demand exceeds supply, the price goes up.

And this is all too excellent for words if you are a residential property investor.

There is, however, a problem. You see if prices go up in the 4 main cities, you don’t really have options but to try and climb on the housing ladder because that’s where all the jobs are.

In other countries, this is not the case. In the US, there are thousands of other cities with jobs in most, if not all, those cities. In the UK there are many cities too. The more cities and jobs there are, the lower housing becomes. And that means Australians feel if they do not get into owning a home in those 4 cities they will never get on the ladder.

Let me get another thing out of the way. I am not suggesting that you do not make money from residential property investment. You will. I know you will because I personally invest in residential property and have made money. All I am saying is do not ignore the other options that are available for investment.

Holding and other costs

The problem is that the gains made in property are often inflated.

We have all heard about the gains. They go something like this:

‘I bought my property 5 years ago for $600,000. It is worth $1,100,000 now so I am $500,000 richer.’

Err…. No you are not. Here’s why.

Firstly, when you buy a property there are costs – legal costs, borrowing costs such as interest loan fees and stamp duty. Then add holding costs such as rates and building insurance. And now add every single trip you have made to Bunnings over the last 5 years. Every repair cost and every refurbishment. And don’t forget that when you sell you have to pay 2-3% agent fees with more legal fees to sell.

But the other cost that people ignore is the one when you are negatively geared. More on that later.

Over time these really add up.

There has been much research done in this area (even if you exclude my non sophisticated non scientific research). You could say that there many fuzzy haired and mad looking people who research this type of thing.

According to them after taking costs into consideration the return is just under 4% a year. Compared to shares that is crap because on average the share market produces returns of just under 10%.

Liquidity & Risk

Warren Buffet has two rules of investment:

Rule 1 – don’t lose money.
Rule 2 – See rule 1

The biggest risk of any investment is losing money. There are many others, but this is the biggest one. What are the other risks?

– interest rate risk (interest rates going up)
– inflation risk (losing the value of gains over time)
– operating/management risk
– Government policy risk (changes in rules), and finally
– liquidity risk.

Liquidity risk is when you are at risk of running out of cash or liquidity and how quickly you can turn an asset into cash.

Real estate transactions take a long time if buying or selling – on average a settlement will take 30 days assuming no hiccups. On the other hand, selling shares and converting into cash can be done in a few days.

And then there is the issue of division. With shares, you can sell 20% of your portfolio. You can’t exactly sell a bedroom or a kitchen of your residential home.

Yield

Yields are pathetic for investment property. I have just calculated the yield on my investment properties based on current prices. The gross yield is about 3.5%, and after taking into consideration management fees, property costs, interest, etc., the net yield is much lower.

Don’t forget the RBA rate is 4.35%; inflation is about 5%, and mortgage rates are about 6%-7%. Not great.

Negative Gearing is Bad for Wealth

To understand negative gearing, you need to go back to the 1980’s. Then the tax rate was 60% which kicked in at about $80,000 in today’s earning power. And remember, interest rates were about 15% then.

So, being negatively geared made tax sense in the 1980’s.

But today? Well, the top rate is 45% but does not kick in until $180,000 and from next year $190,000. Interest rates are much lower too. The benefits are not so great.

But the main thing is this. If your investment property is negatively geared, you are losing cash EVERY YEAR and that not good news for wealth building. So, if you have run a negatively geared property with a loss of $20,000 and your tax rate is 30% you will get $6,000 as a tax deduction. But that means there is still $14,000 less in your bank account.

Over 10 years, that is a $140,000 loss. Ouch. Even if you pay top rates of taxes, the losses will be a bit smaller, but you will be significantly out of pocket.

Before you assume a property is the only way to go, just consider all options. That way, you know exactly what you are getting into.

Investing is step 7 of our 9 steps to working less, earning more and creating wealth. If you want to know more contact Hitesh at hitesh@medisuccess.com.au or call 07 3161 9548.