I want to dive into a topic we’re often asked about: property versus shares. More specifically, we’ll explore the question, “What level of growth does property need to achieve in order to outperform shares?
Many people face this dilemma: should they invest in property or shares? Or, if they already own property, should they sell it to invest in shares? While these are straightforward questions, the answers aren’t so simple. This is partly because investing in property usually involves leveraging — borrowing money to buy a larger asset, whilst investing in shares typically does not. Of course, it is possible to leverage into shares and buy property with cash, but the most common scenario for most investors is to leverage into property and invest in shares with cash.
The intuitive assumption is that, if both asset classes performed equally, i.e. providing the same returns each year, then property would outperform shares. Why? Because you’re using borrowings to hold a much larger asset in property, and through the power of compounding, that larger base can grow exponentially over time. But how much growth does property really need in order to outperform shares? That’s what I’ll explore today, factoring in things like property expenses, interest rates, negative gearing, personal tax rates, income versus capital growth, and even franking credits from shares.
A Real-Life Scenario
To help compare the two, I’ve run the numbers using a simple scenario. Let’s assume someone has an income of $200K, living expenses of $100K, $200K in cash savings, and no other debts or assets. They have two investment options:
- Option 1: Invest in the share market
- Option 2: Use the $200K as a deposit, borrow $800K from the bank, and purchase an investment property worth $1M (assuming they meet serviceability requirements and can also borrow ~$55K for stamp duty).
For the property, I’m assuming an interest rate of 6.5% for the first year, with three interest rate cuts of 0.25% over the next four years. The property has a gross rental yield of 2% and a capital growth rate of 6%, giving a total performance of 8% before expenses. Property expenses, like rental management fees, maintenance, insurance, and rates, reduces the gross rental income by 35%. We’ll also add land tax (in Victoria) and loan interest.
If this individual channels all of their surplus cash flow towards paying down the debt, in 10 years, they would have a net asset position of approximately $1.17M ($920K in today’s dollars). In 20 years, their net asset position would be around $3.20M ($1.95M in today’s dollars).
The Share Portfolio Scenario
Now, let’s consider the share portfolio option. If they invested their $200K in a diversified share portfolio, reinvesting all dividends and investing all of their surplus cash flow along the way, the returns might look something like this:
The Vanguard Australian Shares Index Fund has returned an average of 8.31% per year over the past 27 years (after fees), consisting of 4.44% income and 3.87% capital growth. Looking beyond Australian shares, the Vanguard International Shares Index Fund (tracking the MSCI World Index) has returned 7.55% per year over the same period, consisting of 2.92% income and 4.63% capital growth.
Combining both Australian and international shares, let’s assume a return of 8% per year, with 3% income and 5% capital growth, and 30% franking credits.
Under these assumptions, in 10 years, the individual would have a net asset position of around $1.02M (~$797K in today’s dollars). In 20 years, they would have a net asset position of about $2.82M (~$1.72M in today’s dollars).
Comparing Property and Shares
Even though both asset classes have the same performance – 8% before fees and expenses, the individual’s net asset position is about $231K higher under the property scenario (in future dollars) despite the much higher expenses of property ownership. This highlights the power of leverage, which, as you can see, makes a significant difference.
So, the question becomes: At what level of capital growth from the property would this individual be better off investing in shares?
Surprisingly, the answer is not far below 6%. I calculate the threshold at about 5.4%. That means, for this individual, if their property experiences less than 5.4% capital growth, they would have been better off investing in the share portfolio.
Capital Gains Tax (CGT) Implications
One important factor to consider is capital gains tax (CGT), especially if the individual plans to sell their investments. Property tends to derive most of its performance from capital growth, which means the larger gain of the property will lead to a bigger CGT liability when it’s sold. Shares, on the other hand, generally result in smaller CGT liabilities, as their performance is more income-based.
If the individual were to sell their property in 20 years (whilst still working), they could face a CGT bill of approximately $518K, compared to $262K with shares. Interestingly, if we look at their net asset position on after CGT basis, the property would need to experience capital growth of at least 5.8% to put this individual ahead over the share portfolio on an after-tax basis.
A Retirement Perspective
If the individual were to retire in 20 years and had no other assessable income, the CGT burden would be lower. If they sold their property in the first year of retirement, their CGT would decrease. In this scenario, the CGT on the property would be about $456K, compared to $228K for shares. If they sold their shares down gradually over three years, the CGT would drop to $161K. The flexibility of selling shares in smaller amounts can result in a significant reduction in tax liabilities.
Conclusion: Property vs. Shares
As you can see, there are a lot of factors to consider when comparing property and shares. Property requires a large upfront commitment, carries higher legislative risk (e.g., changes in tenancy laws, land tax), and requires more effort in terms of management. However, it is also a tangible asset that many people feel more comfortable with, offering greater control and the ability to add value through improvements. Shares, on the other hand, are highly liquid, require less maintenance, and offer more flexibility, but they are historically more volatile.
Ultimately, there is no one-size-fits-all answer. Both asset classes have their pros and cons, and a balanced approach that includes both may be ideal depending on your financial goals and personal circumstances. Regardless of whether you choose property or shares, the key is to select high-quality assets that align with your investment strategy and ensure they provide adequate returns over time. In seeking professional advice on these matters, it is important to use a financial advisor who is asset-class agnostic and has equal knowledge of both asset classes.
