Buy a House vs Invest in ETFs

This is a common dilemma. You are saying up money and want to know if it is better to buy a house and live in it or invest in ETFs and rent (also known as rentvesting).  Personally I would invest in ETFs. The reason why is because the key difference between the two options is you pay far higher taxes when you buy a house.

For example, if you buy a house then you’re need to pay stamp duty. On a $1 million house that is roughly $57k in stamp duty, which will reduce your net worth. Assuming you save up a $200k deposit, then right after you buy your house your net worth will be $143k whereas if you simply keep your money in ETFs you’d still be at 200k.

However, an argument can be made that if you buy a house, because you have borrowed money to buy $1m worth of asset then you have leveraged exposure, which moves you up the risk-reward curve (also known as the efficient frontier). If you save $200k and invest it in ETFs, if there is a 10% increase, you have made $20k. However, if you have purchased a $1m house and it goes up 10% then you have made $200k. However, what is misleading about this comparison is that it compares apples with oranges, that is, it is comparing leveraged real estate vs unleveraged ETFs. To compare apples with apples, you need to compare leveraged real estate vs leveraged ETFs. Leverage does not increase returns without any consequences. Leverage increases risk, which may result in higher returns.

You can move up the risk-reward curve with ETFs simply by reallocating a portion of your ETFs into internally leveraged ETFs e.g. GEAR or GGUS. Another option is to invest in higher risk niche ETFs (e.g. ROBO or TECH) to move up the risk-reward curve. The benefit of buying higher risk ETFs is that there are no mandatory monthly mortgage payments or, if you take out a margin loan, margin calls. The effect of leverage is handled by the fund itself and there is no obligation for you to pay anything.

Gearing into equities is expensive before tax but cheap after tax

Another way to move up the risk-reward curve is to take out a margin loan and buy ETFs with it. The downside to taking out a margin loan is higher interest rate compared to home loans. According to Canstar, the cheapest margin loan rate is 5.20% from Westpac whereas the cheapest home loan it is 3.49% from Reduce Home Loans. However, if you buy a home to live in, the mortgage debt is not tax deductible, but the margin loan debt is tax deductible, i.e. you can negatively gear into ETFs by taking out a margin loan, which effectively lowers your interest rate by your margin tax rate. Assuming you earn between $87k and $180k and face a 37% margin tax rate then rather than pay 5.20% interest rate you are effectively paying 3.27% which is in fact lower than the home loan. If you have chosen to leverage using internally geared ETFs, because the fund manager has high bargaining power, he or she is able to get low interest rates anyway. According to the GEAR and GGUS brochure from Betashares, “the fund uses its capacity as a wholesale investor to borrow at significantly lower interest rates than those available directly to individual investors.”

Another advantage of investing shares or ETFs is that Australian shares often pay dividends with attached franking credits (e.g FDIV pays 100% franked dividends), which lowers you tax burden even further.

Capital gains tax has little impact

Even though living in a home does not make you eligible for negative gearing, you are eligible for capital gains tax exemption. However, capital gains tax is easy to avoid if you buy a hold shares or ETFs. Because capital gains tax is triggered with you sell and because capital gains tax is charged at your marginal tax rate, simply buy and hold and wait until you are retired. When you are retired, you will earn no salary, so your income will drop and your salary will likely face lower income tax, perhaps even being within the tax free threshold. You then sell off shares or ETFs bit by bit when you’re retired, ensuring that you pay little or no CGT.

Low rental yields vs high dividend yields

Now that we have established that ETFs have lower borrwing costs than real estate due to the impact of negative gearing, stamp duty avoidance, and franking credits, a huge argument for investing in ETFs rather than real estate is the huge difference between rental yields and dividend yields. As of right now, a three-bedroom unit in Brunswick East costs $1.3m and has rental yield of 1.42% i.e. around $18.5k in rent per year. However, as of right now, Commonwealth Bank shares are paying gross dividend yield of 8.6%. This means that if you have $1.3m, then rather than buying the Brunswick East unit and living in it, you can simply take out a margin loan, invest $1.3m all in CBA, and then receive $110k in dividend income per year. After income tax and franking credits, this will be around $90k. After paying rent of $18.5k you have roughly $70k per year extra simply by using ETFs.

Not only do you get $70k per year extra thanks to the extreme spread between rental and dividend yields, but the benefits for ETFs are magnified even further because of lower post-tax borrowing costs.

Using one Brunswick East unit vs one high dividend paying stock (CBA) is an extreme example. Not all stocks are the same and not all residential real estate is the same. However, the general trend is indeed that rental yields in Australia are low and dividend yields on Australian stock are high. If you bring up a list of all properties on the BrickX fractional property platform and sort by rental yield, the highest yield property, a one-bedroom unit in Enmore NSW only delivers a rental yield of 2.76% with the average rental yield about 1.5%. However, a broad ASX200 ETF such as STW provides gross dividend yield of 5%.

 

 

 

BrickX and Shares vs Property in Australia

An online ad has recently made me aware of BrickX, which offers Australians the opportunity to buy “bricks,” which represent fractional ownership of residential real estate.

In Australia, many people are convinced that property is a great investment, but I have always believed that shares are better. In the shares vs property argument, most people claim that property is safer than shares, but there is no proof for this. The safety of shares depends on the underlying business. Shares are nothing more than ownership of some business. For example, if you own Commonwealth Bank (CBA) shares you own a portion of the CBA business, which entitles you to a portion of its profits in the form of dividends. If you own enough CBA shares, you can wield enormous influence by e.g. voting in directors. The bottom line is that shares are only safe as the underlying business. Residential real estate is also a business, but that business is houses. If you created a company, use that company to buy a house, and then list that company on the stock exchange, the shares for that company should in theory be exactly the same as directly buying residential real estate taking into account any costs of listing the company or any economics of scale gained.

The launch of BrickX allows people to buy residential real estate in a similar manner to buying shares.  The video below provides a perfect introduction to BrickX.

In my opinion, one of the main problems with residential real estate is that they provide very low yields, and a listing of the properties on BrickX clearly show this, with rental yields of around 1 to 3 percent.

brickxpropertydetails

Of course, someone could argue that even though rental yields are low, the historical growth of around 6 to 9 percent per year in capital gains is impressive. But it is not. For example, STW, an ASX200 ETF, has historically returned 9 percent per year over the last five years with dividend yield of 5 percent. Commonwealth Bank shares have returned 8 percent per year in capital gains with a whopping 7 percent dividend yield.

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Not only are yield and capital gains better for shares, but there are huge tax advantages for shares versus property. The dividend yield of CBA and STW have franking credits baked in, allowing you to reduce taxes. Many people believe that property has an inherent advantage through negative gearing, but negative gearing is available via shares and ETFs as well. It is possible to negatively gear into the stock market. First-time buyers of property can get a first-home-owners grant, but property buyers must pay stamp duty. Those buying shares or ETFs do not pay any stamp duty. Furthermore, property buyers pay tens of thousands in real estate agent commissions as well as conveyancing. If you own an investment property you must pay land tax and capital gains tax. If you don’t own an investment property you don’t pay land tax or capital gains tax, but this doesn’t put you ahead because then your property becomes a PPR, which means you cannot rent it out, which is a loss. Not paying capital gains tax also doesn’t put you ahead compared to shares because shares can be sold in small amounts, which means that when you retire you can sell small amounts of shares so that any capital gains put you below the tax-free threshold, meaning you pay either nil or minimal CGT. Then there is the insurance costs, council rates, and general maintenance costs associated with property.