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Why you can't invest in residential property on the stock exchange

In April 2020, many experts predicted that residential real estate was set for a significant correction over the coming year based on expectations of a deep recession and sharp increases in the unemployment rate. Westpac's economists forecasted an 8% fall in GDP in the coming year, unemployment to reach 10%, and a 20% fall in house prices and, based on this, took a $2 billion provision for expected loan losses.

Instead of falling, house prices accelerated over the past year with the latest CoreLogic RP Data Daily Home Value Index for March 2021 showing a +5.7% increase in national house prices led by Sydney and Brisbane.

As the manager of a listed property fund, Atlas has recently received questions about gaining exposure to rising residential real estate prices without buying a house or apartment. However, as residential real estate is only a tiny portion of the overall listed property index on the ASX, this is an asset class that institutional investors largely ignore. Why?

Listed real estate is not houses

Unlike the US or UK, where residential is a significant component of the listed property index (US residential REIT exposure 18%), the Australian index's residential real estate exposure is relatively small at only 5% (see below table).

Further, the residual real estate exposure on the ASX consists of the development arms of diversified property trusts such as Stockland (mainly house and land packages) and Mirvac (predominantly apartments). Moreover, neither of these two trusts intends to hold residential property on their balance sheets over the medium term. Greater returns are available from developing and selling residential real estate rather than collecting rents. However, Mirvac has one build-to-rent project located in Sydney's Olympic Park, assisted by some tax concessions, namely a 50% discount on land tax for the next 20 years.

Residential property has attracted little interest from institutional investors as retail investors have an investment edge. In the above chart, residential real estate comprised 5% of the S&P/ASX 200 A-REIT index in April 2021 or $6 billion. This is dwarfed by the value of the currently 'beaten-up' discretionary retail ($34 billion), industrial ($49 billion), and office ($26 billion) real estate assets listed on the ASX.

In our view, there are three structural reasons why retail investors rather than institutional investors are the primary buyers of residential real estate in Australia.

1. Capital gains tax breaks for homeowners ‘crowds out’ corporates

Firstly, in Australia, the tax-free status of capital gains for owner-occupiers selling their primary dwelling bids up the purchase prices of residential real estate. For example, when a company generates a $500,000 capital gain from selling an apartment, they would approximately be liable to pay $108,000 in capital gains tax. In contrast, the owner-occupier pays no tax on the capital gains made on a similar investment.

This discrepancy in the tax treatment allows the owner-occupier to pay more for the same home, anticipating tax-free capital gains not available to institutional investors such as property trusts.

2. Negative gearing

Similarly, individual retail investors benefit from the generous tax treatment in Australia that allows them to negatively gear properties. There are three types of gearing depending on the income earned from an investment property: positive, neutral and negative. A positively geared asset generates income above maintenance and interest costs, and obviously, neutral gearing generates no income after expenses and interest.

A property is negatively geared when the rental return is less than the interest repayments and outgoings, placing the investor in a position of losing income annually, generally an unattractive position. However, under Australian tax law, individual investors can offset the cost of owning the property (including the interest paid on a loan) against other assessable income. This incentivises individual high-taxpaying investors to buy a property at a price where cash flow is negative to maximise their near-term after-tax income and bet on capital gains.

Whilst companies and property trusts can also access taxation benefits from borrowing to buy real estate assets, a wealthy doctor on a top marginal tax rate of 47% has a stronger incentive to raise their paddle at an auction.


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3. Yields on residential property too low

At current prices, the yield that residential property is not attractive for listed vehicles. At the moment, the ASX 200 A-REIT index offers an average yield of 4%. This compares favourably with the yields from investing in residential property. SQM Research reported that the implied gross rental yield for a 3-bedroom house in Sydney is only 2.7%, with a 2-bedroom apartment yielding slightly higher at 3.4% in April 2021. After borrowing costs, council rates, insurance, and maintenance capex, the net yield is estimated to average around 1%. This low yield on residential real estate contrasts sharply with the average yield after costs on commercial real estate currently above 4.5%.

Our take

While housing comprises the most significant component of the overall stock of Australian real estate assets and talking about house prices is the one sport that unites all Australians, residential real estate holds little interest for institutional investors, especially for income-focused investors such as Atlas Funds Management.

Speculating on houses and apartments is one of the few areas of investment where retail investors have an advantage over well-resourced institutional investors.

In the future institutional investors could play a greater role in owning residential real estate as they do in the UK and the USA. However, this would require either the extension of further tax concessions to corporates or alternatively removing these concessions such as negative gearing from households, two politically very unpalatable courses of action.

 

Hugh Dive is Chief Investment Officer of Atlas Funds Management. This article is for general information only and does not consider the circumstances of any investor.

 

12 Comments
Shirley McIntyre
July 29, 2021

I found this an excellent article. It specifically answered my question which came about while I was looking at ways to diversify my SMSF.

Deo
April 14, 2021

Thanks great article that points out the natural owner of residential property and probably explains some of the difference between the passing yield of residential and commercial. However, as alluded to by a few posters above, it is a bit more complicated. Firstly, one difference is the different capital gain expectations between the two sectors. Residential may have longer effective lives for their fixed assets, with refurbishments generally having a longer cycle than commercial (a great result, given the environmental benefits of longer cycles). Secondly, the impact of CGT exemptions is probably overstated. You can only claim this exemption on 1 property, so there is a natural limit of demand for this kind of buyer. Of course, you could buy a really expensive property to maximise your exemption, but as you cannot pay yourselfs rent, this cancels itself out as a result of the higher imputed consumption. Thirdly, negative gearing should only have a mild impact on institutional disadvantage. While, households at the top marginal rate can reduce their taxes from year-to-year with gearing there is theoretically nothing stopping them from doing so by investing in other asset classes. A rational household investor should be ambivalent about whether they put their marginal investment dollar in bricks and mortar, commercial property or the stock market. By comparison, institutional investors benefit from a >30% tax rate and their shareholders get the benefit of franking credits, which offsets a lot of the advantage of households. I think the real reason why residential is priced more sharply than other property assets is because households are predisposed to placing their surplus funds in residential assets due to: a) general financial illiteracy, concern about volatility (perception associated with mark-to-market asset classes) and distrust of the equities market b) agency risk associated with third party funds management c) and the perception of houses as being safe. Institutions are quite right to avoid this market; but governments are equally quite right not to provide institutions tax breaks to even the playing field.

Geoffrey
June 20, 2021

Thanks Deo for listing a) (general financial illiteracy) and b) and )c (distrust of the less understood) . Australians are brought up to have a bias towards residential housing investment plus they like to be "hands on", failing to count the cost of the time and money involved - AKA a hobby?

Peter Henery
April 11, 2021

As a long term resi prop investor I salute your analysis. Very few 'get it '....but you did pretty well.
Here's what you missed! (1) You cannot save your way to wealth. You must use OPM ( aka leverage.) Name me one other asset where the banks 'fall over them selves' to lend you 80% LVR ? ( 90%+ with LMI) And so long as you service the loan, won't make a margin call if the value falls! (2) Now work out the IRR when you only have 10-20% skin in the game and property rises just 3% per year. And that happens year after year and nobody bliks an eyelid ! When we have a 'boom' year, the returns should be illegal ! (3) Next, all the banks and all the gov't are 'in on the bet' and they are on your side. Just take VIC gov't income. Mostly land tax and stamp duty. Do they want property to keep going ? What makes up the banks balance sheets ? Do they want it to 'keep going'? The only game in town for dumb old Aussie battlers.

Sarah
April 11, 2021

As a long time resi investor also, I agree with your analysis 100%.

Ern
April 11, 2021

Residentials rental housing is not exempted from capital gains tax and interest on you resident is never tax deductible or other maintenances (unlike in other countries).
The company tax rate is at worst 30% and can be effectively ZERO. Ask some of the overseas companies supposedly resident in tax havens. 47% plus medicare levy is 49%, that is 63% higher than max company tax rate. Negative gearing is also available to companies. Companies can get better net returns in a shorter time than holding residential housing is the real reason.
Also managing a large holding of residential housing has a more time consuming problem of dealing with a large number of individual tenants, plus increasing tenancy acts to deal with.

Ruth
April 14, 2021

After >30 years of being a landlady, I have found the obligations of managing rental property increasingly onerous and expensive. If it were not for potential capital gains, it would not be worth the effort. I doubt any listed company would want these obligations.

Jack
April 09, 2021

Thanks, Hugh, great points I have also wondered about. What about some of the smaller property trusts like Cedar Wood? Are building services such as Boral and CSR (maker of gyprock) a better way to gain residential exposure?

Hugh
April 09, 2021

Jack, while CWP have a greater exposure to resi real estate than the diversified trusts such as Stockland, fundamentally they are in the same business of developing and selling real estate, not actually owning property.

Building materials companies CSR and Boral have exposure to residential construction (new dwellings) but obviously don't benefit from higher prices for existing houses. However in my view the market have consistently overestimated the leverage that these companies get from increased housing demand, a situation not helped by the tendency to construct new brick and tile plants at the top of the market to service peak demand.

Hugh Dive
April 09, 2021

Thanks Peter and Kevin. As the manager of a listed property fund, I am frequently asked about my thoughts on the direction of house prices, but like all fund managers in this sector, I have minimal special insight as my daily research activities focus on commercial property, which comprises 95% of the investible universe of listed property.

Also as discussed in the article the exposure to resi real estate is based on developing and selling as quickly as possible and then recycling the capital into a new project. If the trust ends up actually holding onto an apartment or house, this is a negative outcome as it indicates that the buyer has defaulted on their contract.

Kevin
April 08, 2021

I have always wondered about this. Thank you for the article. Very well explained. Kevin

Peter Thornhill
April 08, 2021

Brilliant piece Hugh. It highlights the tragedy that is Australia. The bulk of the productive savings shovelled into non productive housing and industry can go hang or be soaked up bu overseas investors.

 

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