My wife and I have much of our net worth tied up in equity investment. However a likely property purchase within the next 6 months or so has got me thinking about what the ideal property allocation should be in a portfolio.
I have long preferred equity investment to property investment. I think it’s partly because I can better understand what drives a business than how property prices move. Sure, property values are fundamentally based on the forces of supply and demand, but there are a whole bunch of other factors that feed into property values like school districts, access to transport, road links etc. Its not as straightforward to analyze a property as it is a business in my mind. The underlying drivers of business value seem to me to be a lot clearer!
It’s likely because of this that I’ve chosen to deploy a significant amount of my wealth in equity investments and generally stayed away from property, apart from owning the condo that we live in. With that said, I feel that we are significantly underweighted property as far as total asset allocation is concerned.
Having a good mix across all assets helps avoid the volatility that comes with being overly exposed to a single asset class. Different asset classes tend to not go up and down in unison over long periods of time.
In addition, there a few specific reasons why I think bulking up on my property weighting could be a good move.
Maximum use of other people’s money!
I’m a big believer in leverage as a way to drive long term wealth. Using other people’s money to supplement your own resources is a great way to rapidly build up your assets. And there is no better asset class to deploy significant leverage than property. With share investment, buying on margin typically limits you to borrowing up to 70% of the equity that you hold (ie if I have $100, I can borrow to buy another $70 worth of stock). Property allows you to have direct asset ownership using other peoples money in a much bigger way than you can with shares. I can typically use $10 of my own money and someone else’s $90 to buy myself a $100 dollar asset!
Reduces frequent “market checking” & trading
This one is a little more subtle, but the fact that you don’t see your property value continually change on an hourly or daily basis is a significant advantage compared to shares. From a psychological perspective, this really helps keep you focussed on the long term. You don’t have the tendency to check property prices every few days, like you may do with shares. Even if there are drops of 5% or 10%, they don’t smack you around in the face like share losses do. Thus you are less likely to react to things on a short term basis. Frequently checking your net worth can make you take actions that aren’t consistent with growing long term wealth.
No margin calls!
Property prices can go down significantly, to the point that you have negative equity in your home (ie your outstanding loan balance is actually more than the value of your home). However the banks typically won’t ask you to either sell your home or inject more equity into the home if you can continue paying your mortgage.
The reality with shares that are bought or margin is quite different. Because of the real time nature and mark to market valuation of shares, the moment your equity goes below a certain level (when you may even have positive equity) your lender will step in and either demand that you sell stock, or inject additional cash into your portfolio.
Stock investment, where you buy on margin, is much more sensitive to volatility and changes in price that require immediate action on your part. In general, a property investment isn’t as impacted by volatility and price swings don’t create the need for an immediate response.
Things I don’t like about property as an asset class.
High transaction costs
Your cost of getting access to investment property is pretty high. There are legal fees, title fees, inspection fees and taxes that all have to be paid as costs of acquiring and owning the asset. Share ownership is relatively less challenged in terms of the barriers to entry. Typically, it’s a $10 fee to buy a stock. It’s that simple.
Hard to vary your property exposure
There occasionally arises a need to vary the size and extent of your asset exposure. This may occur as a result of strong capital growth in an asset class, or a need to rebalance, given sector problems. The large size and scale of a property asset means that is very hard to vary your exposure. A reduction in the amount of property you hold typically means its an all or nothing approach.
You are either all in, or you have to completely sell out to moderate your exposure. There is no “partial property sale”. That makes tinkering with your property allocation very difficult. Share ownership makes the disposal and acquisition of small fractional ownership possible.
Tough to quickly take advantage of opportunities
It’s not very easy to enter the property market. The nature of the beast is such that you need a solid credit score to get a good loan rate, a deposit of at least 20% to avoid paying costly mortgage insurance and a large loan with regular interest payments just to be able to afford the property.
This is in addition to strict documentation requirements on income, W2 statements etc. And of course, all this assumes access to a robust property supply to execute a transaction, which is at the moment is proving to be pretty challenging.
With an investment in stocks, you can quickly deploy resources to take advantage of a temporary market mispricing, from earnings downgrades or slip ups that a company has. It’s a lot more difficult to be as flexible and to move as nimbly with declines in property.
Rental income not concessionally taxed
Unlike dividend income, there is no favorable tax treatment for rental income. While the nature of the dividend tax concession is to make up double taxation of the same income (ie once in the hand of the corporation and again in the hands of the individual investor), from an investor perspective the tax advantages of dividend income tend to cast it a more favorable light than similar rental income.
Having a well diversified portfolio with exposure to multiple asset classes is something that I am becoming more open to. In my view, property should have a place in such a well diversified portfolio. While share investment makes more sense during the infancy of a portfolio, investors should be able to make a place for property as they’ve amassed greater equity.
Property as an asset class does come with a number of limitations including high transactions costs and an inability to rapidly move in relation to opportunities. It does however allow the most effective use of leverage in a way that doesn’t impact an investor in markets where there is significant volatility.