Tag: real estate

Living Through Inflation and Rising Rates: Leveraged Real Estate vs Living Off Dividends

Now that interest rates are rising, there are many people who are wondering if they should fix or not. However, they are faced with a very difficult decision as fixed interest rates are higher than the variable rates. What we are seeing now is that rising interest rates are making many people realise that buying a house is not without risk. House prices now are indeed going down. Furthermore, many people are under significant stress due to rising interest rates.

Meanwhile, those who live off dividends seem to be doing fine. Assuming that you own enough dividend stocks or ETFs and do not have any debt, living off dividends is a stress-free alternative to leveraging into real estate. It is true that dividends can be cut (e.g. during COVID), but you should structure your lifestyle such that you are able to reduce your spending when dividend payments decrease.

The way human psychology works is that risk is not perceived until a disaster happens. For example, if you drive a car without wearing a seat belt and have never crashed, you are unlikely to truly appreciate how risky it is to drive without a seat belt on. However, if you crash your car and slam your head into the windshield and almost die, you are likely to always wear a seat belt from then on. In psychology this is called recency bias: “Recency bias is a cognitive bias that [favours] recent events over historic ones; a memory bias. Recency bias gives ‘greater importance to the most recent event.'”

As I mentioned earlier, the current economic conditions highlight just how risky real estate can be. All that is necessary to create a perfect storm that results in rising interest rates and declining house prices is inflation, and although inflation may have been rare in the last few decades, it is certainly a phenomenon that I think will be more pronounced as the world deals with emerging challenges such as overpopulation and dwindling natural resources.

The benefit of owning an ETF is that you have a more diversified portfolio. For example, if we look at the dividend payments from owning one unit of the high-dividend IHD ETF, you’ll notice that dividend payments are still high and have been slightly trending upward over time (in the chart below, the more recent dividend payments are at the left of the chart, not the right). Even though companies are struggling with inflation and rising interest rates, the benefit of a diversified ETF is that you have exposure to multiple sectors, so while during the recent downturn you would have sustain losses from sectors such as tech, you gain from other sectors such as energy. When you buy real estate, you are leveraged into one asset, which significantly increases risk.

Dividend payments from the IHD ETF have been trending upwards over time.

Of course, just as it is unfair to compare leveraged property to unleveraged ETFs during good times, it is also unfair to compare leveraged property to unleveraged ETFs during bad times. If you are able to buy a home to live in without any debt (i.e. paying cash) then this can give you safety during the recent economic crisis by shielding you not only from rising interest rates but also rising rents. Furthermore, having an investment property (as opposed to a home you live in) insulates you more from rising interest rates because the rising interest costs are offset by rental income. Another consideration is that Australian equities are naturally low in tech stocks and high in energy stocks relative to other countries e.g. in the US there is a much higher percentage of tech stocks.

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.

cbasharesasofoct2017.jpg

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.