We property types tend to see ourselves as a breed apart from professionals of other investment asset classes. We inhabit a domain of bricks and mortar, auctions as street theatre and home sweet home. It’s real life and it’s tangible.
From our vantage point, our counterparts in financial instruments seem intent on boiling away any charm that comes their way, reducing every business to a set of standardised numbers, crunched by supercomputers for dispassionate measurement and nanosecond trades.
Such a view of shares, bonds and derivatives is, of course, insular and clichéd. But the caricature is not uncommon and can lead to a blinkered attitude: that we have little to learn from the world of financial instruments.
The reality is that there is more that binds than divides the fiefdoms of property investment and tradeable financial products.
We share the same ultimate goal – to make money. We operate within the same economic environment so share drivers – presently, near-zero interest rates, cautious consumers, the rise of China and the end of the mining boom. And we are each faced with the challenge of distinguishing good assets from the bad ones.
I was reminded of this by a recent article by Philip Baker – a former bond trader – in these pages. He skewered the suggestion that share investors should target high-yielding stocks in order to obtain income.
He wrote that “smart investors would be happy to choose stocks that yield 1 per cent as they are often the stocks that, over time, pay more income than those yielding 8 per cent, and provide the best share price appreciation”.
Swap the word property for stocks in Baker’s quote and you have encapsulated a fundamental principle of property investment.
The best property assets have low percentage income yields but deliver both higher income and capital growth than high yielding assets.
DON’T BE BLINDED BY THE YIELD
But it is a principle that so many property investors fail to grasp. Too many are drawn by the allure of an initial high percentage yield. They assume the asset will continue to generate a strong income for years to come.
But it won’t; it’s a mirage. Rather, the income is likely to flat line in real terms, because it’s derived from a poor asset – say a high-rise apartment in the central business district or a house on a busy road on the far edge of suburbia.
In contrast, the high-quality property (in, say, a popular inner suburban location) with the low yield is always in demand.
The owner is better able to effect rent rises as they have pricing power. As important, the low yield property is appreciating in value whilst the high yielding property stagnates. Of course, this increase in property value means that the high-quality property retains its low yield despite delivering a higher income than its poor-quality counterpart.
Baker mentions Goldman Sachs’ advice to clients that they should focus on “sustainable dividends” – returns underpinned by stable income. Amend that expression to “sustainable rent” and you have a similar message for property investors.
The marketing literature for new apartments invariably trumpets the high rental yields with misplaced pride. On many occasions, the rent is guaranteed by a developer.
But what happens when this rental guarantee ends and the investor is subject to genuine rental market forces? And when the property’s freshness fades and four or five new residential complexes have been built nearby? Of course, it turns out the initial rent isn’t sustainable and the investor has to cut it to meet the market.
Despite its dryness, it pays for property investors to think like a sharemarket analyst. Leave your emotions at the door and evaluate the realistic path for income in coming years in the context of economic and social factors and the actual and prospective competition for rental dollars. You’ll soon work out if a property asset is a buy or a sell.
The above information has been sourced from smartinvestor. Article by Richard Wakelin, Director of Wakelin Property Advisory.