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Property can only produce modest returns

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Property can only produce modest returns

As mortgage interest rates in Australia have declined from more than 18 per cent in the late 1980s to just on 4 per cent today, house prices have become more expensive relative to incomes.

The apartment oversupply — combined with failed settlements — convinces me that it will be developers trying to move unsold stock to meet their own debt obligations that will cause lower apartment prices.

And while reports of mothballed development applications have hit the headlines, it seems construction is continuing almost unabated.

According to my friends at investment bank UBS, Australia’s residential crane count has surged 165 per cent since September 2014 to a record high 525 units, with the biggest lift occurring in Sydney. That’s a more than doubling of the number of cranes operating in the residential sector in just 21 months.

Dwellings under construction as a share of GDP at over 3.5 per cent is now at all-time highs and more than double the percentage observed in 2000. Moreover, most of the dwellings are multi-story apartments, rising from a total of $5 billion in 2001 to $40bn today. And if you don’t believe that is sufficient to cause a foreseeable oversupply, consider that commencement data suggests completions will continue on a near vertical growth path for at least another six months.

The simple rule to remember when investing is the higher the price you pay, the lower your return. If interest rates stay where they are, it means the high prices paid will ensure the best return that can be expected is the income produced by the asset with little or no capital gain.

If interest rates rise, you shouldn’t be surprised to see asset values and prices drop, and perhaps even sharply. What goes for property and its ability to produce income also goes for shares or any other asset. Think about this carefully: an asset, any asset, is only worth the present value of the cash flows that can be extracted over its life. To arrive at the present value, one must discount the future cash flows back to today.

This is because $100 received in 10 years time is not worth $100 today; it is worth something less. How much less depends on the discount rate one applies to the future $100 to arrive at today’s value. The higher the interest rate, the lower the present value.

For example $100, to be received in 10 years time, discounted to today using a 2 per cent rate, is worth $82. When the rate increases to 10 per cent, that same $100 in 10 years is only worth $38.55. So there is an irrefutable mathematic reason for the inverse relationship that exists between asset values (all assets) and interest rates. As interest rates go up, the value of an asset goes down. And it doesn’t matter whether that asset is farmland, a business, shares, bonds or a commercial property. Interest rates act like gravity on the value of assets. The higher the interest rate the stronger the gravitational effect. This can be observed in financial markets over a long period of time.

Between 1960 and 1981, interest rates in the US surged, and along with the equity market risk premium, rates rose from about 5 per cent to 18 per cent. Over that 20 year period, the S&P 500 index returned 3.6 per cent per annum. That’s 20 years of low returns. Then, between 1981 and 2000, interest rates plunged, sending the combined US bond rate and implied equity risk premium back down to 8 per cent. In that 20-year period, the S&P 500 returned almost 15 per cent per annum. Twenty years of extraordinary returns. Since 2000 the combined rate has been flat and, perhaps surprisingly, the S&P 500 has returned just 2.5 per cent per annum. Another 16 years of low returns.

But I am not sharing this with you because I want to point out that it doesn’t matter whether the economists who predict rising rates, or those that predict low flat rates, are right — both scenarios will produce low returns for investors.

I am sharing this with you because it seems the same “good-times-are-over’’ relationship can be observed between property prices as measured by house-price-to-income ratios and mortgage interest rates.

To put it simply, every way you look at it you have to expect low returns.

Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery, find out more.

Roger is the Founder and Chief Investment Officer of Montgomery Investment Management. Roger brings more than two decades of investment and financial market experience, knowledge and relationships to bear in his role as Chief Investment Officer. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merill Lynch.

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This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564) and may contain general financial advice that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking advice from a financial advisor if necessary.

19 Comments

  1. Andrew Wright
    :

    I think your article is insightful and accurate. The property clock may well be set at 1 minute to midnight, but the wheel always turns. The prospect of seeing Sydney property at a reasonable price again seems quite an attractive opportunity to me – depending on your time horizons and debt levels of course.

  2. Interesting point about failed settlements Roger.

    The AFR’s Larry Schlesinger reported today that roughly one in 20 Melbourne off-the-plan (OTP) apartment buyers abandoned their purchases in June, with roughly two-thirds of those foreign-based, according to law firm Maddocks.

    I believe that’s around double the usual rate of failed settlements. This will not end well.

    Thanks for another great piece.

  3. Hi Roger,

    Moderate single digit returns seem to be the future currently with most asset classes property and shares – but if you are able leverage more effectively with property -could you safely assume that your net return in dollar terms would be better with property allowing you to meet your goals sooner?

  4. Andrew Bunting
    :

    Hi Roger.
    Thanks for posting. I needed that. As a mid forties Sydney renter in the middle of a mid-life career shift I get stressed out by the pressures of Sydney property and feel the powerful tide of the zeitgeist that screams ‘buy, buy’. But I’ve averaged 20% capital growth on modestly geared shares for the last seven years so rationally don’t want to buy into this market. Thanks for the clarity.

  5. danny Stojovski
    :

    Your point that interest rates acting like gravity may be correct but does not look like the case this time around.
    ASX200 index was close to 6000 in March 2015 with interest rats at 2.25%. Fast forward to today and we are at 5300 with interest rates at 1.75% and increasing likely to go lower…

  6. Hi Roger. Good article thanks.
    This raises for me the issue of what rate of return should be used in calculating the intrinsic value of a stock in the current environment. Could you comment, and also on what rate Skaffold uses? (Last time I checked I think it was 11% for an “average” stock, as does Value.able.).

    Keith

    • The rates vary but they are in a band that sits around those rates. It is tempting to lower one’s hurdle rates to allow the possibility of investing in shares that have hitherto been ‘missed’ but I believe that compromising standards invites risk.

  7. Thanks. Whitman pointed out the only stocks to do well in the 1970’s were insurance stocks that remained solvent. Their investment income went up with higher interest rates, and they could invest in lower priced stocks of other companies.

  8. Hi Roger,

    Great article I echo your thoughts. I agree also that share markets & property are in for modest returns.

    I have a question (sorry if wrong forum) around plan of attack for my son (18 months old) and setting him up financially for when he is 18+. I like the idea of index fund (I see buffet does as well) but the modest return for risk is not exciting me..

    Cash is ok but purchasing power will reduce as you have said in previous articles..

    His starting position is modest ($4-5k)

    Thank you for taking the time to read my comment

    • Speak to someone about whether the Montgomery Fund is right. I’d like to think we will do better than an index, which in Australia, are overweight large but mediocre businesses. If or when property prices fall meaningfully I would have thought some modest gearing at fixed rates (if rates aren’t egregious) and the commitment to rapidly pay off the debt would ensure decent returns on capital.

  9. Hi Roger,
    Great article, while I mostly agree with you, the rental market in Sydney is still very strong. Along withe the oversupply, the wild card here is China. I have been hearing reports that the Chinese govt in bid to stop outflow of capital is putting in strict measures for moving money overseas. Even forcing citizens to repatriate money from overseas. This will be a nightmare scenario if the Chinese investors are forced to sell in my opinion. Any thoughts?

  10. Hard to argue with the basic logic Roger, but one trump card that doesn’t apply to other broader assets is the ability to manipulate demand.

    Govt incentives is one (QLD just increased the FHOG), the other is population growth. All major parties support a big Australia policy, both sides of parliament have actively encouraged a decade of record immigration (with most flowing to Sydney and Melbourne). This has been achieved with little awareness let alone understanding by the general public.

    I’m not suggesting this alone is capable of avoiding a price correction, but all manner of vested interests will be screaming to open the population floodgates at the first glimpse of market correction.

    • Yes and we have written about the government’s incentives (keep health care funding costs off their balance sheet) to ensure baby boomers (the bulk of whose wealth is tied up in property) are protected.

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