Residential investment property is perceived as the most attractive asset class by many investors. Recent changes to superannuation legislation have diminished the relative tax advantage of investing in residential property over superannuation. Will this legislative overhaul change investors’ behaviour, or will investment property continue to exercise its hold on investors’ wallets and consciousness?
This article is the first of a two-part series examining the composition and reporting of property returns and the intersection of property with investors’ behavioural biases. The first part focuses on the performance of residential property.
The attractiveness of residential property owes in large part to its perceived characteristics as a safe haven (safe as houses) and its impressive performance over the last decade. Yet performance of property over the very long-term has been poor. Using data from the United States from 1890 to 2004, Yale University economics professor Robert Schiller calculated that inflation-adjusted US home prices increased by 0.4 per cent a year.
Why then is there a disconnect between investors’ perception and reality? According to the Reserve Bank of Australia (RBA), investors often fail to weigh the “changes in the composition of properties sold and changes in the quality of housing”. Given that the quality of properties has increased dramatically in the past 20 years, existing prices reflect the higher capitalisation of new and existing properties. Property price indices fail to differentiate “between pure house price appreciation and price changes, due to depreciation or home improvement”, according to a Federal Reserve Bank of San Francisco research paper.
In Melbourne, reported property prices indices increased dramatically in the 1990s. The median price for two bedroom apartments in inner- Melbourne almost doubled from $269,000 to $500,000 in the period 1998-2002. Yet surprisingly, many apartment investors significantly underperformed the median price indices. Australian property consultants Charter Keck Cramer found that while prices for ‘off the plan’ apartments increased strongly, capital gains from resales of existing apartments had been meagre.
Using a longer time frame (1992-2001), the change in capital value of existing apartments was a miserable 0.29 per cent a year, significantly below the inflation rate. The shift to luxury innercity apartments in capital cities has fundamentally skewed median apartment prices. It has created the illusion of higher capital gains.
Residential property is further complicated by the regularity and accuracy of pricing. Property pricing occurs infrequently, giving investors the perception returns, even when negative, are smoothed. Transaction-based indices are skewed by small sample sizes and a high number of new homes being transacted, which have higher values. A recent study by the RBA indicated the quarterly median statistics are based on low turnover (1.5 per cent a year), with 60 per cent of variation between quarters explained by changes to the composition of high and low priced suburbs.
Against the backdrop of infrequent and inaccurate pricing is the loose regulatory framework that governs marketing of residential property. Many claims made around residential investment property would not easily pass the test applied to managed funds or direct equities.
Residential investment property is susceptible to systematic mispricing, as “most market participants have little experience, making transactions only infrequently”, the Federal Reserve Bank of San Francisco says. This is compounded by pronounced “asymmetric, or incomplete, information between buyers and sellers about demand and prices”, it says. Investors are unable to facilitate transactions easily, with costs high, and there is no way to short the market effectively. The structure and regulation of the market further exacerbates these problems.
A variety of factors have caused investors to have a misplaced bias towards property at the expense of other asset classes. Advisers need to play an important role in explaining and educating their clients about this asset class, particularly about how perceptions of historical and future returns can be distorted. This is particularly important in the current environment where prices are likely to undergo a reversion to the mean.
