The debate of whether to invest in shares (stocks) or property (real estate) 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.
With that being said, firstly I want to just say that I am really blown away by the engagement here on Captain FI from the FI community. I am getting loads of emails and comments both directly through the site but also through the sites socials accounts (Facebook and Instagram). I try to get back to every single one so bear with me!
The topic of this post came from Steve, a reader from the Sunshine Coast in Queensland, Australia. This is a really good question and I get asked it a lot, so I wanted to use this as an example where we could highlight the pros and cons of investing in stocks versus property (or paying off your mortgage). With his permission, I have published Steve’s email to me below;
“Hi CaptFI, I bought my home in the Sunny Coast and recently bought a second property – a 300K apartment in Brisbane as an investment property at an 90 LVR. I have been paying extra off the mortgage (principle and interest) and my tenant nearly covers the mortgage. I want to diversify and get into shares but I keep hearing about talk of a recession and the yield curve inversion makes it sound likely. I think the markets look ‘pumped’ at the moment and I cant see good value, especially if a crash comes and wipes out my hard earned savings. What would you do?”Steve from Sunshine Coast
Captain FI says;
Hi Steve – thanks for getting in touch. First off, I’m not a financial adviser or planner or anything so this is just general chit chat, and you should probably seek professional advice before making any serious investment decisions.
Secondly with that out of the way – congratulations on investing with your second property. Statistics show that most property investors wont make it to property number two, and even less get to three or more. Whilst interest rates are low and repayments are cheap, I think it is a great time to be benefiting from the leverage of a cheap mortgage. Interest rates might not always be this low, so it would be wise to make hay whilst the sun shines and build up a healthy buffer in a cash offset account, maybe even to be used for a third investment property. Share investing is a great idea to diversify, and I allocate my surplus cash to invest in both stocks and property – but you’ll likely have your super invested in shares anyway so don’t feel like your missing out on the stock market! You’ve got me thinking – I’ll put something together for the site in the next few weeks! Cheers
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 do 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 its 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 your on a 37c/$1 tax bracket then simply by 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 Return 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 arguement 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 aught not to be ‘should I invest in shares or pay off my mortgage’ but rather, should I invest in shares or get ANOTHER mortgage! Real estate investing has some critical advantages over stock market investing, so lets explore that a bit further…
Property vs stocks
Before we delve deeper, lets go over some of the pros and cons of each asset class. Real estate and shares are two very very different classes of investments and each has some unique benefits and draw backs over each other.
- Leverage -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)
- 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 duty, 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 around or tenants may damage the property
- 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 loan even if you sell the property
- If the interest rates rise 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 Self Wealth $9.50 flat fee trades this means transaction costs (brokerage) is virtually nothing
- Virtually completely passive – Set it and forget it!
- Ultra low management fee’s on ETFs – for example VTS costs $30 per year for an $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 investment – 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.
Property case study
Ok so with the basics out of the way, I want to delve a little deeper into property and I want to use Steve’s investment as a Case study. I am just using average figures and industry accepted rules of thumb for everything, as well as other information which is readily found online.
Steve mentioned the apartment is worth $300,000 and is on a 90% Loan to Value ratio too, which means he owns $30,000 equity and the bank owns the remaining $270,000. Although he did mentioned he was paying it off in extra instalments, so his equity will go up by virtue of him paying down the principle of the loan (as well as capital growth on the property). When you consider the capital growth of the asset, leverage is a pretty cool thing.
Leverage allowed Steve to start controlling a large asset with only a very small deposit. By paying a fraction of the asset price, as long as he maintains the loan repayments against that property he can benefit from any rises in price.
There are some analysts forecasting Brisbane’s apartment market to rise by as much as 5.6% in 2020 (as compared to the .7% fall in 2019). If this is true, it means the apartment will now be worth $316,800. This is a capital growth of $16,800. Because he has only put down 10% of the costs ($30,000), that means his cash on cash return is 56%! Although this sounds juicy, we should mention that generally any loan above an 80LVR usually triggers lenders mortgage insurance, and there are significant buying costs. We also haven’t calculated his loss on the property, so this is not a realistic way to calculate the cash on cash return.
Costs to buy the property
Lets say Steve paid the market average of 5% buying costs which equates to $15,000. Home loan experts.com show in their awesome Table of Home loan LMI premium rates that for a normal home loan at a 90% LVR, you’d expect to pay 2.013% as an LMI value, or in Steve’s case $6,039. You should probably note that you’d be hard pressed to get such a high LVR on an investment property these days – generally mortgage brokers say you need a 20% deposit or higher.
Together this represents a cost of $21,039 – money which magically *poof* disappears after the purchase. Adding to his $30,000 deposit, his actual cash outlay was most likely $51,039. Having made $16,800 in theoretical capital growth in 2020, the cash on cash return is looking closer to $16,800/$51,039 or 33%. Still not bad – although we haven’t counted his holding costs yet
Generally, according to the .1% rule, a $300,000 apartment should rent for at least $300 a week. This rule of thumb means Steve should get an additional $15,600 in rental income throughout the year from his tenant. Great – doesn’t this mean his combined return should be $16,800 in capital growth and $15,600 in rental returns (or real estate dividends). Not quite – Steve mentioned the apartment isn’t cash flow positive.
Of course Steve has financed the apartment through a bank. At todays rate, its probably somewhere around 3.5%. On $270,000 owing, shouldn’t that be roughly $8,100 a year (or $156 a week) in interest repayments, plus whatever the banks want to get you to actually repay off the loan principle? Its actually not that easy to calculate, since banks use a few tricks including compounding interest to really get their moneys worth. Using a quick mortgage calculator for a standard 25 year mortgage at 3.5%, Steve’s repayments are $314 a week (principle and interest) or $182 a week if he just pays interest only.
Now we are starting to understand Steve’s Cash flow; he is receiving $300 a week in rent (we assume) and the bank is taking at least $314 (and he is actually paying out even more!). This means each week, Steve is down at least $14, and that’s before we even account for other fee’s like;
- Property Management fees: 7% of $300 = $21 per week
- Strata fees – average $4693 a year = $90 per week
- Landlord Insurance – average $1,771 = $34 per week
- Council rates = average $1500 = $29 per week
After we account for these costs, Steve is down a staggering $488 per week to own the apartment, and receiving market rent of $300 per week. That means he is in the hole $188 per week or nearly $10,000 per year in cash flow. Even if the apartment does rise by the slated 5.6% or $16,800, in total he is only making a net positive gain of about $7,000 per year.
Lets re-look at that cash-on-cash return. At the end of the year he has spend an additional $10,000 of his money so the equation looks something like $7032/$61039 = 11.5%. Starting to look a bit closer to the return we are getting from shares?
Tax in real estate
Steve can also benefit from some of the Governments rules, which allow him to claim his 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 his tax bracket, but lets just assume if he can service two mortgages that he is on or above the average tax rate of 37c in the dollar. The higher tax bracket your on – the more lucrative negative gearing becomes.
If Steve loses $10,000 per year on the apartment, he can apply for a government rebate of $3700. This ‘caps’ his loss at only $6300. This makes his Cash-on-Cash return better; 10732/61039 = 17.6%.
Steve can also take advantage of further tax write-off such as depreciation on the physical apartment and fittings. On average, he should be able to claim between $11,000 to $15,000 depreciation each year. Again, assuming this same tax bracket and Steve continues full time work, this should be a further tax saving of at least $4000. This boosts the Cash-on-Cash total return up to $14732/61039 = 24.1%. This is over double what the share market will return on average!
Lets say the market continues to boom and in 2021 it continues to rise another 5.6%. This means at the end of 2021 its worth $334,541 or risen by a further $17,741 in capital growth. Steve has lost another $10,000 in cash flow over the year, so his total investment into the project is now $71,039.
He made $17,741 this year, minus $10,000 in cash flow, and was given government rebates worth another $4000 and $3700, meaning his position is up $15,441. This is a Cash on Cash return of 21.8%.
The Cash on Cash return will continue to slowly decrease as he gradually pays the property off and builds equity, until he fully owns the property and has also fully depreciated the property according to the depreciation schedule. Once he fully owns it, he can still claim a tax deduction against losses, but he is losing the benefit of leverage.
It is really important to understand that this only works if the market keeps going up! Leverage is a double edged sword; if property prices fall, you can get stuck with a property which is worth less than your loan. Generally the good news for property investors is that rents don’t seem to ever fall (or if they do, not as much percent as the capital value)
As for the coming crash that Steve mentioned – no one can predict that. If you did have a crystal ball then well maybe you could join with the likes of Warren Buffet. For us regulars out here, continual investing into low fee index funds and LICs over time is going to give us the best result. If the market does crash, its 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 current lending climate its 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 to my portfolio. This provide me additional income and 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 positive as time goes on (due to the effect of inflation on the fixed loan). When approaching FIRE and deciding to quit my job, I will need to re-evaluate my property investments; if I cannot afford the cash flow I might need to preemptively sell some properties in order to pay down the loans on others, or convert them to ETF / LICs.
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
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