Where should residential property investment be directed?

Question 1 - Is residential property investment a sound proposition?

Yes.The media section of our website contains summaries of articles from Perpetual Trustees, ANZ Bank, and the ASX, all showing that over the long run residential property and equities both show annual growth of between 12-14%pa (depending on start and finish dates).

Question 2 - What about tax, borrowing, etc?

ASX analysis shows that for both residential property and equites, tax reduces returns by about 3% pa, and borrowing improves the after tax returns by about 3% pa (assuming borrowing for 50% of the investment at standard bank interest rates). We know that, in reality, property investors can borrow more than 50%, and that the interest rate should be well below the banks' standard variable rate - so the return on residential property investment should outperform.

Question 3 - What about risk of loss?

ANZ and Perpetual analyses both show that residential property is far less volatile than other investments, so the risk-adjusted return from residential investment significantly out-performs other types of investment.

Question 4 - Should residential property be part of a balanced invesment portfolio?

Yes. Perpetual analysis shows that residential property performance is, on average, countercyclical to equities, listed property trusts, and bonds - the negative correlation is 20-30%.

Question 5 - Is Australian property expensive?

Good assets are always expensive.Australia is one of the world's most affluent and desirable places to live.

Right now, Australia is enjoying extremely low levels of unemployment, an extremely long period of economic growth, a resources boom, a high exchange rate, and the cost of borrowing is at its cyclical peak.With this combination of circumstance, it would be unusual if the cost of acquiring property was not expensive.

Despite the expense, people have to live somewhere, and Australians like to own their own homes. The Housing Industry Association states that we need 175,000 new dwellings each year to keep pace with population growth.ANZ states that there is a current undersupply of 100,000 dwellings, which will rise to a shortage 200,000 by 2010.Gross rental yields have risen from around 3.5% to around 4.5-5%.So residential demand will continue, and with rising population, rising wealth, rising building costs, but no more land, well located residential property will continue to be the excellent investment that it has been for as long as we can remember.

Question 6 - What about the sub-prime crisis?

The Australian situation is totally different from the US. In the US, loans were made to borrowers with low credit ratings at discounted rates - in Australia, a low credit rating means a high interest rate. In the US, many lenders obtained their funds by securitising borrower repayments, and selling them into the capital markets - in Australia, the main lenders obtain funds from deposits.In fact, in Australia, the default rate from borrowers with low credit ratings (lo-doc and no-doc loans) does not materially differ from the default rate for standard home loans.

When the sub-prime crisis hit, the capital markets did not know who was at risk, nor by how much.So the supply of credit was reduced, and the price increased, to all borrowers.This included the Australian banks, even though they had little exposure.As it becomes clear who actually is affected, pricing for those not affected (such as Australian funders) will fall back into line.

While clarity and calmness is being restored, foreign central banks are determined to ensure that a financial crisis does not arise.They have injected whatever liquidity the system needs to stabilise, and have reduced interest rates.

The ongoing impact of the sub-prime crisis on Australia is not expected to be large - it will go the way of all the other sensationalised "crises".

Question 6 - What about inflation and interest rates?

For the reasons noted above (high growth, low unemployment, etc) Australia is experiencing strong, sustained cyclical growth. When growth is higher than normal for longer than normal, it is only natural that inflation and interest rates will be higher than normal.The sub-prime crisis has also had a temporary impact on reducing confidence and increasing interest rates.

However, the natural inflation and interest rate consequences of a strong economy does not mean that the economy is of control. The RBA inflation target over the whole of the economic cylcle should average about 2-3%. This is not to say that during the cycle it should never move outside this range. After a period of strong sustained growth (where we are now) it would normally be expected to be above the upper average band of 3%.It is certainly no reason to panic because at the top of an extremely long growth cycle, inflation is 3 or 4 point something per cent, assisted by record high oil prices and high interest rates. It might also be noted that it is in the government's political interest to seek to create the impression of an economic problem so that they can blame it on the previous government, and then create a favourable impression about the actions they take to fix the "problem". And it is in the interests of the media to sensationalise.

Almost all commentators agree that we are now close to the top of the interest rate cycle, and it is our view that when rates start to fall the residential property market is likely to be supported.

Question 7 - Should we buy residential property now, or later?

The time to buy residential property is when the cycle is at the "Bottom" or in a "Rising market" stage.

All commentators recognise that the different regions of Australia follow different cycles.We believe that one of the most unbiased property commentators is Australia's largest (over 40 offices) independent property valuation firm, Herron Todd White (HTW).HTW does not develop property, sell property, or finance property.All HTW does is value property, every day, all around Australia.Each month, HTW does a report (usually over 50 pages) looking at the Australian property market.

HTW's May 2008 report has only Sydney in the "Rising market" stage. Every other capital is at the "Peak of market" stage except for Melbourne and Perth, which are at the even more-dangerous "Peak of market-declining market" stage.

Part of the reason that Sydney residential prices are forecast to rise more than other capitals, is that Sydney has seriously underperformed since 2003 and is now due for a catch up. However, even within Sydney some areas are better than others.In our view, the mortgage belt, away from the city or the beaches, is under pressure from interest rates and we believe is not the best choice for investors at this stage.The high end multi-million dollar homes have also been affected by the equity crash, margin calls, and reduced bonuses.

The Sydney areas that in our view are most stongly in the "Rising market" stage of the cycle are relatively inexpensive properties (high $300ks to high $600ks) that are close to the city or the beaches, and in areas targeted for growth by the authorities, and ideally in smaller developments.These appeal to renters, investors, and owner occupiers wishing to establish a foothold in the market.