The debate of whether to invest in shares vs property is one that rages on in the investment community. Whilst there isn’t actually a right or wrong answer, what you choose to invest in really depends on the kind of investor you are.
Property investment versus stock investments is a debate that many investors deliberate between, but the truth is, there are benefits with both kinds of investments, which we will discuss in this article.
Property investors have the advantage of leverage, meaning you can borrow against the asset, whereas with stock market investments, this is not one of the possibilities, yet your stocks are more of a passive and a liquid investment – you can sell them off at any time.
Property prices and the property market can change quickly and as we have seen, the share market can also be very volatile. It’s important you assess how much you have to invest, your risk profile, and what kind of investor you want to be, before making any investment decisions.
What kind of investor am I?
The type of investor you are will determine which asset class is right for you. Both asset classes might be right for you, there really is no right or wrong answer. A few considerations are how much effort or involvement do you want in the process, how much you have to invest, what your investment time frame is and what kind of risk tolerance you have. You should ask yourself where you fit in the following hierarchy;
Type of Investor
- Passive – I don’t have much spare time and need this to look after itself
- Active – I want to be actively involved in this process and make it work
- Am I impulsive or emotional? Can I stay the course through extreme volatility – if the markets plunge 50% would I cash out or would I invest more?
- Can I study more and educate myself about my investment?
How much do you have to invest?
- Micro investing or Micro transactions?
- Am I investing hundreds, thousands or hundreds of thousands?
- How often will I get chunks of money to invest? Am I a good saver and self disciplined
- Aggressive – Do I risk more to get more return?
- Defensive – Am I afraid of losing what I have?
Investment time frame
- Short term (3-5 years)
- Medium term (5-10 years)
- Long term (10-20 years)
- Life time (20 years+)
Investing or pay off mortgage?
So you’ve figured out what type of investor you are and you are now thinking about starting investing in ETFs, but you have debt in the form of a mortgage and you are wondering if it’s a better option to pay that off first?
When deciding whether to start investing in stocks or pay off your mortgage, you really need to be comparing apples with apples. The return from your stocks is going to be taxed, whereas any money you save off your mortgage is money that you are saving which you would have already been taxed on!
Grossing up your return
For example – if your home loan mortgage is at a 4% interest rate and you’re on a 37c/$1 tax bracket then by simply putting your money into your mortgage offset you are going to get an equivalent of about 6% ‘Grossed up’ return. This is guaranteed savings on interest with pretty much no extra risk on your behalf. The Grossed up return is calculated by dividing your home loan or interest rate by 1 minus your tax rate, or in an equation Grossed Return = Net return (loan interest rate) / (1 – .73)
Investing in stock market ETF vs Paying off the mortgage
So with your investment property you are going to get 6% back Grossed up Return1 on Investment. When we compare that to the stock market where we see average returns of around 10%, we can see that with current interest rates a stock portfolio will outperform paying off your mortgage. If you invest in shares you are going to get potentially a 4% extra gross Return on Investment, or an extra 66%! I don’t know about you, but my money is on the shares in this instance!
The Hidden advantage of property
But this argument fails to take into consideration the one biggest advantage that property has over stocks – Leverage – which we will delve into shortly. Maybe then, the question of what to do with your surplus cash ought not to be ‘should I invest in shares or pay off my mortgage’ but rather, ‘should I invest in shares or get ANOTHER mortgage’! Property investing has some critical advantages over stock market investing, so let’s explore that a bit further…
Before we delve deeper, let’s go over some of the pros and cons of each asset class. Real estate investments and shares are two very different classes of investments and each has some unique benefits and drawbacks over each other.
- Leverage2 -The ability to easily and cheaply borrow against the asset which you couldn’t afford outright
- The Cash-on-Cash return that occurs on a leveraged investment in a rising market
- Can add value through renovation (sweat-equity) of this tangible asset
- Can use long-term tenants (conventional lease) for security or short-term rental market (such as Air BnB) for higher returns
- Can contract out most of the work fairly easily
- Tax advantages such as negative gearing and depreciation schedules
- By renting your property to a tenant they can pay a portion (or sometimes even all) of your loan repayments
- Does not get re-valued every minute of every day so less temptation to hawk-eye the price
- Can potentially refinance the loan to withdraw equity for future investments.
- Can become an expert in property over time
- Can conduct property developments to buy at wholesale price
- High transaction costs: Over 5% to buy, and 2-3% to sell which can amount to many tens of thousands of dollars.
- Need tens of thousands of dollars to get started for a deposit for a sensible (80%LVR) investment loan
- Investment loans and Interest only loans are often at higher interest rates than owner-occupier (home loans)
- Many costs which might feel ‘hidden’ including stamp duty3, agency fees, bank fees, inspection fees, legal fees, strata fees, council rates. There are many ‘hands in your cookie jar’ eroding your profits.
- Must maintain the property – i.e. gardens, roof, paint, hot water heater, aircon/heater etc
- Costs to insure the property (building and or landlord insurance) against things like fire, floor, tenant damage
- Property managers are inherently lazy and will tend to bother you or maybe just not take good care of the property.
- May not have tenants all year round (loss of rental income) or tenants can damage rental properties
- Active investment and will require some commitment of time (the more you contract out the less profitable it will be)
- If the property goes down in value you will be stuck with the mortgage debt even if you sell the property.
- If the interest rates rise4 then you may experience mortgage stress. If you are unable to service the loan this could lead to distressed sale or loan default and even bankruptcy (bye bye retirement savings and credit rating!)
- Non liquid – cannot sell a portion of the property if needed.
- Stricter and stricter lending standards mean you might not even get a loan in the first place.
- Must have income to service a loan
- Can get started investing with as little as $50 (but wiser to make larger chunks of around $1000 due to brokerage costs)
- Low transaction costs: through Pearler or Self Wealth flat fee trades (less than $10) this means transaction costs (brokerage) is virtually nothing.
- Virtually completely passive – Set it and forget it!
- Ultra-low management fees on ETFs – for example VTS costs $30 per year for a $100,000.00 investment.
- Ultra diversified index fund ETF and LICs options mean you’d need almost every major company (Microsoft, Google, Nestle, Toyota etc) on Earth to go bankrupt for you to lose everything.
- Dividend reinvestment options for automatic reinvestment of your dividend payouts
- Liquid investment5 – can easily sell stocks and have the funds within 3 days to cover short-term needs or emergencies.
- Peace of mind that if your stocks all go to zero, you can only lose what you put in – and don’t end up bankrupt or losing retirement savings, your own home or car etc.
- Franking credits in Australia for a tax-effective income strategy.
- Free portfolio management
- Typically cannot leverage the investment (some lenders allow margin loans for stocks however it is only up to a maximum of 50% and you can be margin called if the stock prices fall – Stay AWAY from this kind of loan at all costs)
- Cannot become an expert at ETF / index investing – it is incredibly effective due to its simplicity
- You have to ride the market – no control over prices or the performance of the companies you are investing in
- You cannot add any value to the ETF portfolio.
Tax in real estate
Many people can benefit from some of the Governments rules, which allow them to claim their loss on cash flow as a tax deduction; this is called negative gearing. This is used extensively in Australia and is often a core investment strategy sold to high-income earners by the finance industry (not that I necessarily agree with that!). Negative gearing sort of helps to artificially prop up the Australian property market, and is thought of as ‘short term pain for long term gain’.
Now, how lucrative this is depends on your tax bracket7. The higher tax bracket you’re on – the more lucrative negative gearing becomes.
You can also take advantage of further tax write-offs such as depreciation on your physical property8 and fittings. On average, you should be able to claim between $11,000 to $15,000 depreciation each year.
Markets will crash from time to time, and they have done recently! Continual investing into low fee index funds and LICs over time is going to give us the best result. When the market does crash, it’s just a fantastic opportunity to turn our cash buffers into more stocks! If I told you you could buy an inner city Brisbane apartment for $300K one day and get $300 a week rent, you’d be happy yeah? And what about if I told you tomorrow that due to ‘Mr market’ you could get the same apartment, for $200K, but it only gave you $280 a week rent? I’m sure you’d prefer the second one right?
Captain FI’s takeaway
For me personally, my key lessons that I take away from this is:
- I want to invest in cash flow positive properties at an 80% LVR that put money into my pocket (whilst still taking advantage of depreciation tax benefits) to get the best cash-on-cash return
- I am not going to pay an investment property mortgage down – I’d prefer an interest-only loan but due to the current lending climate it’s cheaper to pay principle and interest. I will pay the minimum as I would rather use that money to invest in ETFs where it gets a higher return than paying down the mortgage.
- I want to hold a large portion of stock market index fund ETFs which I regularly invest more in to my portfolio. This provides me with additional income and a safety buffer; if the right property deal comes along I can sell a chunk of my ETFs to pay the deposit on a loan
- Property is an active investment and will take up some of my time
- Property investments gradually become more cash flow positive9 as time goes on (due to the effect of inflation on the loan amount).
- When approaching FIRE we need to re-evaluate property investments; if we cannot afford the cash flow then we might need to preemptively sell some properties in order to pay down the loans on others, or convert them to ETF / LICs to produce income.
I hope this article has helped to provide some useful information related to both property investment and investments in shares. Investing in assets can help you on your journey to financial freedom but what you’re investing in and how much you have to invest will depend on your individual financial situation.
House prices as well as the share market can change and fluctuate dramatically in a short period so any smart investor makes themselves aware of the risks when investing.
What do you think? Let me know what your strategy is in the comments below or if you think there is something I have missed.
- ‘Gross Rate of Return’, Adam Hayes, Investopedia. Published: August 29, 2020. Accessed online at: https://www.investopedia.com/terms/g/gross-rate-of-return.asp on Sep 29, 2022.
- ‘The Power of Leverage in Real Estate and How to Use it?’, Kate Christensen, Real Wealth. Published (updated): Feb 17, 2021. Accessed online at https://realwealth.com/learn/power-leverage-real-estate/ on Sep 29, 2022.
- ‘Stamp duty’, Business.gov.au. Accessed online at https://business.gov.au/finance/taxation/stamp-duty on Sep 29, 2022.
- ‘Interest Rates and the Property Market’ – Speech, Jonathan Kearns, Reserve Bank of Australia. Published: Sep 19, 2022. Accessed online at https://www.rba.gov.au/speeches/2022/sp-so-2022-09-19.html on Sep 29, 2022.
- ‘Understanding Liquidity And Liquid Assets’, Miranda Marquit and Benjamin Curry, Forbes. Published (updated): Aug 10, 2021. Accessed online at https://www.forbes.com/advisor/investing/liquidity-and-liquid-assets/ on Sep 29, 2022.
- ‘What is Negative Gearing?’, Mortgage Choice. Accessed online at https://www.mortgagechoice.com.au/guides/property-investment/tax-and-gearing/negative-gearing-and-positive-gearing/ on Sep 29, 2022.
- ‘Tax Brackets’, Industry Super Funds. Accessed online at https://www.industrysuper.com/understand-super/tax-and-super/tax-brackets/ on Sep 29, 2022.
- ‘Claiming a tax deduction for depreciating assets and other capital expenses’, ATO. Published (updated) June 22, 2022. Accessed online at https://www.ato.gov.au/Business/Income-and-deductions-for-business/Deductions/Deductions-for-depreciating-assets-and-other-capital-expenses/ on Sep 29, 2022.
- ‘The Complete Guide To Positive Cashflow Property Investment’, Smart Property. Published (updated): July 15, 2022. Accessed online at https://www.smartproperty.com.au/positive-cashflow-property-investment/ on Sep 29, 2022.