If you are considering borrowing to invest in a quality property, I would like to remind you of three important considerations.
Firstly, it is my thesis that property investors must be more selective about which property/s to invest in. In that past, investors have benefited from a rising tide (driven substantially by rising borrowing capacities), which benefited all properties. However, borrowing capacity is likely to be stagnant over the coming decades. Therefore, a property’s fundamentals are likely to be more important which means you must invest in better quality properties. I have discussed this here and here.
Secondly, the reason that borrowing to invest in property is such an effective wealth accumulation tactic isn’t due to property per se. It’s due to the high level of gearing (borrowing), which I discussed here. The decision to borrow is the key here – not the decision to invest in property.
And finally, I have discussed that borrowing capacity has reduced by 30% to 40% over the past year (because interest rates have been hiked 4% over the past 11 months), which means fewer people will be able to afford to invest in investment-grade property.
If you can’t do it properly, don’t do it at all
If your borrowing capacity isn’t enough to allow you to (safely) buy a high-quality, investment-grade property, and if you don’t anticipate your borrowing capacity improving in the future, then you shouldn’t compromise and invest in a lesser quality property. The quality of the assets you invest in will determine your future investment returns. You cannot expect above average investment returns from an average or below-average quality investment. Quality is king.
And remember, just less than half of your overall return will be delivered by the fact that you have borrowed (6.55%) and slightly more than half of the return (13.96 – 6.55% = 7.41%) from the asset you have invested in as depicted in the diagram below. That asset can be anything – property, shares, bonds… whatever is going to drive the highest return over the long run.
What is your alternative?
The two major growth asset classes are property and shares. Over the past 4+ decades, both asset classes have delivered total investment returns of approximately 10% p.a. It is a reasonable assumption to make that both property and shares will deliver similar returns in the future i.e., one will probably not be materially higher than the other.
Therefore, if you cannot afford to invest in a high-quality property, then perhaps you should consider investing in shares.
Prepare yourself for double the volatility
The Australian residential property market has a volatility rate of around 10%, whereas the rate for shares is circa 20% – shares are twice as volatile as property. That means, approximately 70% of the time your annual return will be between 0% and +20% if you invest in property and between -10% and +30% if you invest in shares (being the average rate +/- the volatility rate). The return range for shares is much wider, so you must have the stomach for that.
It is important to note that in the long run, volatility isn’t important. If you make a fundamentally sound investment today (albeit a highly volatile investment) and don’t look at it for 20 years, I’m certain you will be happy with the returns 20 years from today.
Volatility only matters in two situations. Firstly, if you need to sell the investment sooner than expected i.e., you can’t wait 20 years. Secondly, if you look at investment returns regularly and worry if they fall in value. Remember, a short-term fall in value doesn’t tell us anything about long-term returns.
Leave the asset allocation to the experts!
“I don’t know anything about shares, so I wouldn’t know where to start.”
This is a common objection about investing in shares, not property. Property is a physical asset that is easier to understand. Shares are more subjective and can seem more complex.
But you don’t need to be an expert. You can simply invest in what is called a diversified ETF. This is a stock that is listed on the ASX that invests in a variety of sub-asset classes such as Australian and international share markets, emerging markets, small companies, bonds and so forth. Vanguard provides more information here.
You will need an online share trading account to make these investments, such as CommSec.
Two best diversified ETFs
Vanguard has a Diversified Growth ETFs (the code for growth is VDGR and high growth is VDHG) which invests in shares, bonds, emerging markets and small companies. It costs 0.27% p.a. ($270 p.a. for every $100k invested).
Australian ETF provider, BetaShares offers a Diversified All Growth ETF (DHHF). It charges a management fee of 0.19% p.a. and invests in developed and emerging share markets only (no bonds or small companies). There is an ethical alternative in DZZF with a higher cost of 0.39%.
If you or the person you are investing for don’t have other investment assets (e.g., if you are investing money for your children), I would suggest VDGR is probably best. However, if you have other investments and your aim is to increase exposure to shares, then DHHF is probably most suitable.
If you are investing larger amounts (e.g., you project your portfolio will be worth more than $700k to $1m on 10 years’ time), then it may be worthwhile engaging a financial advisor to develop a more bespoke investment portfolio.
How to do it
When investing in shares, it is good to use borrowings and some of your own surplus cash flow – like what you would do if you were investing in property. For example, if you have an investable surplus cash flow of $1,000 per month (after interest costs), you could consider investing say $4,000 per month (being $1k of your own cash plus $3k of borrowings).
Here’s how you do that:
- Establish a new interest-only investment loan secured by your property. For example, you might request an investment loan of say $300,000.
- The day after the investment loan is established, repay $299,000 back into the loan to reduce its balance to only $1,000.
- Each month redraw $3,000.
- Together with your own cash flow, buy $4,000 worth of VDGR or DHHF via your online share trading account.
Redrawing the amount each month creates a clear transaction trail that demonstrates the purpose of these loan funds to ensure the interest is tax deductible.
If you have a home loan (i.e., non-tax-deductible-debt), you might decide to direct all your cash flow into reducing your home loan and borrow the full amount of the share investing, as this would be more tax effective.
The cost of this strategy
Over the past 3 years, on average, these diversified products have generated an income return of between 6% and 8% p.a. (consisting of dividends and capital gains). It is likely that your interest rate will be circa 6.40% (including last week’s rate hike). Therefore, if you don’t reinvest dividends, this strategy is likely to be self-funding and maybe generate a small amount of taxable income.
However, I would encourage investors to automatically reinvest all dividends (i.e., opt into the Dividend Reinvestment Program) and pay for the interest cost from their own cash flow.
In the long run, the amount of income these products pay will likely reduce to 4% to 5% p.a. Income amounts have been higher over the last few years probably due to volatility. Therefore, in the long run, its likely this strategy may generate negative gearing tax benefits.
Should you invest in a lump sum or monthly tranches?
If you want to adopt this strategy, should you invest in a lump sum or in monthly tranches i.e., spread your investment over a few years – often referred to as dollar-cost-averaging?
I have crunched the numbers for you. I compared investing $300,000 in one lump sum in August 2001 (when the ASX200 index began) versus spreading the amount over 48 equal tranches of $6,250 and investing this amount at the end of each month (i.e., spread your investment over a 4 years). The third scenario I looked at was investing on monthly basis, but on the most expensive day of the month i.e., consistently terrible timing.
The table below sets out the investment returns achieved in each scenario.
This analysis reveals that investing in a lump sum achieves better investment returns, especially in the short run.
But what if you invest just before the market crashes?
The risk with investing a large lump sum in one tranche is that the market crashes soon after you make that investment. I compare the two strategies assuming you first invested at the beginning of 2007, one year prior to the market crash caused by the GFC.
This analysis reveals that investing in a lump sum achieves better investment returns, especially in the short run.
But what if you invest just before the market crashes?
The risk with investing a large lump sum in one tranche is that the market crashes soon after you make that investment. I compare the two strategies assuming you first invested at the beginning of 2007, one year prior to the market crash caused by the GFC.
This analysis shows that spreading your investment across several monthly tranches is a superior strategy in this scenario.
Why I prefer to invest in monthly tranches
I acknowledge that how you invest (be it monthly, in a lump sum or on the worst day of the month), makes little difference to your returns over the long run (i.e., 20+ years).
That said, when investing, I like to minimise risk as much as possible i.e., minimise the probability of losing money. Therefore, my preference is to almost always invest in monthly tranches.
In addition, if I’m investing a lot of money, and expect to do so for many years, it allows me to direct those monthly investments into the cheapest (attractively priced) segments of the market thereby reducing my downside risk and maximising future returns at the same time. This advantage isn’t reflected in the above analysis as I only considered one share market i.e., ASX200.
Consider borrowing to invest in shares
Instead of being singularly focused on property, and risk investing in a sub-par property, perhaps you could consider directing your borrowing capacity towards progressively investing in share markets. I have discussed this previously here as well.
If you are going to invest a large amount of money (either borrowings and/or cash flow), you must consider obtaining personalised financial advice to ensure it is appropriate for your circumstances.
