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WHAT ROLE SHOULD residential property play in an investment portfolio? It’s a question often asked of my wealth-management colleagues at JBWere. Property is undoubtedly a strong asset — over the past 20 years, residential property has tended to deliver better risk-adjusted returns than other asset classes — but there are significant differences between property and, say, shares or bonds. Australians have a relatively high rate of home ownership compared with the citizenry of other G20 countries. Data from the OECD suggests that about 30% of Australians own their property outright, while about 33% have a mortgage and the remainder rent.

Housing is, by far, the largest component of a household balance sheet in Australia, both on the asset and liability side. About 53% of gross household assets are held inland and dwellings (superannuation assets are the next biggest holding, at 23%). Of course, returns vary according to a property’s use. For investors, there’s capital gain and rental yield. For owner-occupiers, the total return is simply capital gain —similar to owning gold or a venture capital investment — as there’s no explicit income stream (although it could be argued that owner-occupiers benefit from a stream of imputed rents).

One issue with this kind of asset is that it tends to be less liquid, especially if prices are declining. Moreover, the asset class itself is not fungible; for example, an inner-city apartment in Melbourne is quite different toa detached dwelling in Rockhampton or a harbourside property in Sydney. Plus, there are nontrivial transaction costs involved when entering and exiting the market (stamp duty, agency fees), which is not always the case with other financial assets. On the upside, you usually have more leverage with residential property, and investors and owner-occupiers alike have access to significant tax advantages, including negative gearing and capital gains tax exemptions. 

Housing is the largest component of a household balance sheet.

Putting together a portfolio 

Our analysis shows that the addition of domestic residential property to a theoretical 60/40 portfolio (60% growth assets, 40% defensive assets) would have reduced the volatility of portfolio returns over the last 20 years. Particularly during periods of turbulence in equity markets, we see that an allocation to residential property reduces the overall variability of portfolio returns, as drawdowns are generally less pronounced in periods of risk aversion. However, when risk markets are performing well, we observe more upside in a portfolio that does not include residential property.

When we look at the difference in returns between a simple AUD-denominated portfolio with an allocation to residential property (at the expense of equities) relative to one without, it averages out to a 0.71% per annum underperformance over a 20-year period. However, the portfolio with property would have less volatility, suggesting that the risk-adjusted returns would be higher. 

When times are good 

Clients often ask if property is a good asset in times of inflation. Since 2002, residential property has exhibited significant- outperformance versus inflation. In other words, real house prices have increased by a magnitude.

The correlation between quarterly changes in inflation and quarterly changes in house prices is generally positive (they usually move in the same direction) and has become stronger in recent years. Given the myriad factors that influence house prices, there is no simple or obvious explanation as to why the positive correlation between house prices and inflation has strengthened since 2015.

Regardless, the point remains that, like many of its real-asset peers, residential property appears to outperform versus inflation and exhibits strong positive correlation to inflation outcomes. It is important to note that, in the period we’re referring to, secular trends have been biased towards lower interest rates and lower rates of inflation. This may shift in the next decade, but we don’t think it will necessarily change the ability of residential property to outperform against inflation. 

What lies ahead

It seems that annual returns on residential property won’t be as strong in coming years as they have been over the last couple of decades. If historical precedent is any guide, we think rental yields will be pinned to the longer-term trajectory of risk-free interest rates. At some point in the next year or so, capital gains will be handicapped by affordability, given that household incomes are not rising at the same rate as house prices. Near-term, the greatest threat to house prices is likely to be more macro prudential regulation, given the sharp rise in investor lending of late and the increase in lending with elevated debt-to-income ratios. 

Already the prudential regulator has mandated tougher standards for banks assessing whether borrowers can afford loans, which analysts say may limit the amount many can borrow by as much as 5%. Longer-term, the main issue for capital gains relates to interest rates. To the extent that the bull market in interest rates has run its course, the tailwind to house prices over the next decade will need to come from other sources.

Population growth may contribute as borders re-open but, given the already favourable tax treatment and ongoing monitoring of lending standards, it is hard to see what else could replace the role declining interest rates (and deregulation of the financial system) have played in fuelling growth since the 1990s. Land supply issues in large capital cities may help the relative outperformance of house prices in Sydney and Melbourne, but that’s contingent on those cities continuing to absorb the lion’s share of net migration flows.

It’s fair to say, however, that the two main challenges to house prices — unemployment and higher interest rates — aren’t likely to be major problems in the next two years. Unemployment is trending downward and, all else equal, this should support house prices. Borrowing rates have begun to rise, but we suspect the magnitude and pace of any tightening cycle will be modest, even if it begins a little earlier than the Reserve Bank of Australia now expects.

The information contained in this article is gathered from multiple sources believed to be reliable as of the end of October 2021 and is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. Before acting on this information, JB Were recommends that you consider whether it is appropriate for your circumstances. JB Were recommends that you seek independent legal, property, financial and taxation advice before acting on any information in this article. ©2021 JBWere Limited ABN 68 137 978 360 AFSL 341162.