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Thursday, 25 December 2008

Investing in property may be less profitable than buying shares

Investing in property may be less profitable than buying shares

SHARE markets have generally produced higher investment returns than residential property over the long term.

Theoretically, then, those who rent a property and invest their money in quality shares should be wealthier than those who concentrate on paying off their homes.

However, the discipline of meeting regular mortgage payments and gradually taking ownership of a tangible asset, means home owners usually do better financially than those who rent.

Nevertheless, investing in residential property other than your family home is likely to result in higher risk and lower returns than investing in quality shares.

An economy in which business is performing well is likely to be one in which the property market is also growing strongly.

One of the main reasons shares outperform property over long periods is that demand for property, in a market-based economy, is derived from the success of business.

Of course, the business cycle and the property market do not work in perfect lockstep.

There are periods of economic stagnation in which the property market enjoys a 'catch-up' boom, and periods of recovery in which it goes through a down cycle.

On average, the risks of investing in property are understated and returns from investing in property are overstated.

As a result, investors pour too much money into residential property, forcing prices higher than they would be if investors accounted fully for the potential risks and returns.

Five myths about property investment hold sway in every boom:

- Property values are not as volatile as share prices;

- Property prices never fall;

- Property prices might fall occasionally, but never as far as share prices;

- Property prices rise with the cost of living, so investment in property always keeps you ahead of inflation; and

The only way to lose money on property is to buy real estate in a declining population centre, or a house on the main road.

So why are property risks understated?

Property seems easy to understand, so investors may have a perception of control. Property has the ability to elicit an emotional response unlike shares or bonds, which lack the sense of substance and permanence that attracts people to property.

Just as important, the pricing of residential property is infrequent and informal. Property investors never see red ink on a statement unless it is on the day of the sale.

And most property investors never formally evaluate the performance of their investments at all. Imagine if you looked in a newspaper at the price of your home each day, just as you do with the price of your shares. Your attitude to risk would most likely be quite different.

Returns achieved from property are also generally overstated, which has the effect of further narrowing the risk/return trade-off for the asset.

Indexes that measure property market performance generally capture only the increase in the sale price of existing dwellings, but fail to take into account major developments in a nation's housing stock.

Share investors can effectively 'buy the market' and participate in its long-term performance because of the ready availability of accumulation indexes that are net of costs incurred in achieving gains.

Investors cannot 'buy' the return of the residential property market like this, because the sales measures available are gross of costs such as construction outlays.

In practical terms, investing in residential property has it own risks, not unlike investing in a single stock. While these risks can be mitigated through research into location, the quality of the property and so on, opportunities for broad diversification and protection of a residential property investment portfolio are more restricted.

The one main advantage of investing in residential property is that individual investors with time on their hands have a greater ability to add value to their investment.

For many people, buying a family home is their one truly effective means of saving.

But for the amateur investor, who does not wish to become a property investor, investing in a residential property is likely to be expensive, more time-consuming and riskier than investing in a well-run, diversified share portfolio. And it will probably yield a lower return too.

Arun Abey and Andrew Ford
Sun, Oct 28, 2007
The Sunday Times
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