When I first joined the investment world, the conventional wisdom was to split your assets three ways: one-third each into property, shares, and cash or fixed income instruments.
Nowadays, other assets, such as hedge funds, are starting to form an important component of many investors' portfolios, offering yet another source of return.
However, for many of us, the three basic building blocks (property, shares and cash or fixed income) will form a large part of our portfolio. And most of us will be substantial investors in property, whether because we own the home in which we live or because we buy a property to rent out.
In this column, I want to look at the pros and cons of investing in residential and listed property. What does an investment in listed property and an investment in residential property have in common?
Firstly, both benefit from a positive economic and a stable political environment. Secondly, the direction of interest rates is an integral factor when investing in both types of property. For the homeowner, lower interest rates mean that more of their mortgage is repaid with the same amount of money.
For the investor in listed property, lower interest rates stimulate investment by companies and economic growth, as it costs participants in the economy less to borrow in order to expand their businesses. This leads to more investment in property.
With residential property, lower interest rates usually lead to higher prices.
In the case of listed property, lower interest rates usually result in a positive re-rating in share prices. In other words, investors are prepared to invest in listed property at a lower yield, because investors compare this yield to the lower rate they will get if they put their money in the bank.
For example, if a property share trading at R10 yielded an income of R1 last year, it has a yield of 10 percent. If interest rates drop from 9.5 percent to 8.6 percent, investors in the share may also be happy to take a one percent drop in the 10 percent yield, and pay R1 divided by nine percent for the R1 income that the company made last year (10 percent minus one percent equals nine percent). So the value of that R1 income increases as interest rates drop, more or less in the same proportion. This means investors will be prepared to pay at least R11 for that same property share now that interest rates are lower.
What factors should you consider when looking to invest in a residential property?
Firstly, you can make a home out of a residential property. If all else fails and it is paid for, you have a place to live.
Secondly, although you don't get a tax break on mortgage payments, you can have gearing on your side, because you can finance all or part of the purchase, freeing up capital for other investments. You also get a good capital gains tax break of R1 million on the gains made on your primary residence.
The first advantage of listed property is that you can invest relatively small amounts of money. However, unlike dividends, the income is taxable, as are any capital gains.
You may be able to borrow against the investment and claim some of the interest back against income, provided that you can prove to the Receiver that you invested for the long term and with the objective of generating income.
The two most compelling reasons for including some listed property in your portfolio are tradability and opportunity.
For the smaller investor, a listed property investment is more liquid than an investment in residential property. It is relatively easy to trade in listed property investments. Although you pay management fees, the brokerage fees when you buy and sell are quite low compared with the transaction fees of buying and selling residential property.
More importantly, listed property affords you the opportunity to invest in different parts of the property market, such as industrial and commercial property.
It is often impractical, or financially impossible, for an individual to invest in a shopping mall or a factory, because it takes expertise to manage a commercial or an industrial property.
By investing in listed commercial and industrial property, you participate in the retail cycle and the industrial production cycle. These cycles move in tandem with, but not exactly in line with, the residential property cycle.
In my previous column, I drew your attention to the rationale for investing offshore. The main reasons were to tap into investments that diversify your portfolio and give you growth opportunities that are otherwise hard to access. You should view listed property in the same light.