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Australian stocks will crush housing over the next decade

I am a reluctant writer on Australian real estate because the sector doesn’t need more promotion. It gets enough of that from quacks and lobbyists that fill the daily newspaper columns and broadcast airwaves.

Yet I can’t help but notice a large gap in the coverage. There’s lots of news about housing prices, clearance rates, ‘hot’ suburbs, interest rates, and where to get the best loan. There’s much less about property values, or valuation. It’s a curious omission.

After all, there’s constant talk of valuations when it comes to stocks, bonds, and other assets. The price-to-earnings ratios for stocks are regularly spoken of, as are the yields on bonds.

For residential property, not so much. Why is that? Perhaps, valuations on housing don’t matter. Or maybe they don’t fit the uniformly bullish commentary on the sector.

I’m going to suggest that valuations do matter and they’re little mentioned because housing remains ludicrously priced. Up to 40% overpriced in my estimate. And that housing here is far more expensive than the ‘Magnificent Seven’ US tech stocks, which are richly valued yet have infinitely better growth prospects.

I’ll also argue there are very high odds that returns from the ASX will handily beat those from residential property over the next 10 and 20 years.

The maths on property valuation

How do you value a property? Commercial property valuers will tell you that valuations are based on the discounted cashflows generated from an asset. The reality is a lot of valuations are based on capitalization rates – net operating income divided by market value – or price-to-book values from recent transactions.

In residential property, it gets murkier. Valuations aren’t based on land value. They’re not based on cashflows. They’re not based on book values. In my experience, they’re largely based on recent transactions in the neighborhood.

The problem with this is that current prices or recent transactions tell you nothing about the value of a property. It’s like saying that the current price for the stock market equates to fair value of the market – because prices equal fair value. It’s a circular argument that doesn’t make sense.

How do we value the Australian residential market, then? One possible method is to take the so-called risk-free rate of return and apply a premium to reach a fair value estimate. The 10-year Australian Treasury yield is generally regarded as the risk-free. It’s regarded as risk-free because you loan the Government money and are guaranteed (in theory) to get your money back in full. As I write, the 10-year yield stands at 4.11%.

All other assets are priced off this risk-free rate. For taking the risk of owning an asset, an investor will demand a premium to that risk-free rate. The extent of the premium is open to debate.

The advantage of this method is that we can compare yields and risk premiums across different assets. Below is an updated chart from a recent article in Firstlinks.

Form the chart, you’ll see that the yield on residential property is well below the 10-year Government bond. It’s also below what you can get from cash and a term deposit. And it’s way lower than the current inflation rate.

It doesn’t tell the full story though. The yield on residential property is based on a gross yield. It’s before taxes and costs. That’s not the case for the ASX and S&P 500, for instance. So, the chart isn’t a like-for-like comparison.

What premium to the risk-free rate should housing command? There’s no hard and fast rule. Stocks generally trade at 1.5-3% above the risk-free rate. Commercial property can be +3%.

Given housing is less risky than stocks or commercial property, a risk premium of close to 1.5% seems appropriate. That would put residential property on a gross yield of 5.61% (risk-free rate of 4.11% plus the risk premium of 1.5%). And it would fair value for housing at 40% lower than current prices.

Does this fair value make sense? Let’s cross-check it against other valuation tools.

Valuation sanity checks

Perhaps an easier way is to look at it from a price-to-earnings ratio (PER) basis. At a 3.5% gross yield, property is currently on a PER of 29x. Though that’s not quite accurate as the earnings are gross earnings not net earnings. Applying a 30% tax rate (which is the tax rate on an average salary) to those earnings would increase housing’s PER to 40.8x. That’s more than double the valuation of the ASX All Ordinaries 17x PER and almost 2x the S&P 500’s 21x PER.

That doesn’t paint the full picture, either. That’s because that PER is before costs, and maintenance costs for property can quickly add up. Input those costs and the PER for property is easily north of 50x.

The ‘Magnificent Seven’ technology stocks in the US are priced at 33x forward earnings. Therefore, it can be argued that Australian property is priced at a far higher multiple than these stocks, which themselves are regarded as richly valued albeit with vastly superior growth prospects.

At our fair value estimate, housing would be valued at a PER of 17.8x (the inverse of a 5.61% yield). Again, though, that’s based off a gross yield. Applying a 30% tax rate to housing earnings would lift the PER to 25.5x. That would equate to a 50% premium to the ASX’s PER. That’s a sizeable premium though not unreasonable.

Why Australian housing is so richly valued?

Housing is incredibly expensive even compared to other countries. The 2023 Demographia Affordability Survey says the median multiple of house prices to income for major cities is 8.2x in Australia versus 5x for the US and UK. In Sydney, it’s more than 13x. And the time it takes for someone on a full-time wage to save for a 20% housing deposit has doubled from 5 to 10 years since the 1990s.

The question is why have prices become this expensive? Looking at the chart above, it’s really since the 1980s that prices have taken off.

What changed then, and since? One obvious answer is that from 1980 to 2022 we had falling interest rates. I’d argue it was more than that though. Especially over the past 15 years, the RBA and central banks around the world kept interest rates below the rate of inflation, otherwise known as financial repression. This stoked speculation across most assets and resulted in an enormous increase in global debt. It also led to the ‘financialization’ of economies, where capital flowed into financial assets at the expense of real assets (think of the lack of infrastructure spend in Australia, for example).

Interest rates can’t be the sole reason for expensive housing here because it doesn’t explain why Australian property has steamed ahead of most other countries.

Supply issues have undoubtedly played a role. Up until around 2006, the market was roughly in balance, where there was enough supply to meet demand. Since then, there’s been a persistent shortfall. Currently, the shortfall is around 120,000 dwellings, and that’s expected to increase over the next few years.

The reasons for the supply shortfall are many. From a lack of development approvals combined with the rise of NIMBYs (not in my backyard) to capacity constraints to, lately, construction firms struggling to stay afloat amid cost pressures.

The Federal Government has heard the message and is targeting to build 1.2 million new homes over five years from 2024. Over the past five years, we’ve built around 1 million new homes, so this isn’t a significant step up, and is unlikely to be enough to stem the supply shortfall.

On the demand side, surging immigration has played a part. In the early 2000s, net migration averaged 100,000-150,000. That surged to 518,000 in the year to June 2023. Part of that was a catchup from the pandemic, but net overseas migration has been at high levels since 2006.

Demand has also been fuelled by massive government subsidies. Whether it’s first homeowners’ grants, negative gearing, or capital gains tax concessions, all have helped to propel demand and prices.

What’s little talked about is the staggering number of individual investors in the housing market. It’s somehow considered normal here that 36% of new housing loans go to investors. In the US, that share of loans to individual investors is about half of Australia’s.


Source: CoreLogic

I have friends and acquaintances who’ve purchased investment properties well before they bought their own homes, some that own two investment properties and don’t own their own home (and have recently moved back into their parent’s place), and several others with average paying jobs who own multiple investment homes. And all of them are loaded to the gills with debt.

The fact that investors are willing to buy houses that are almost guaranteed to lose them money on a cash basis (for instance, the average CBA variable loan at 6.5% exceeds the average capital city rental yield of 3.5%) shows you the power of government subsidies and the optimism about future returns.

Future returns

How about the future returns of property versus shares? It’s difficult to estimate short-term returns though much easier to predict long-term ones.

To calculate the potential returns over a 10-year timeframe, we can use the following formula:

Starting net yield + earnings growth rate + % change in earnings multiple

For property, the starting net yield is 2.45% (this is before costs, which are difficult to calculate and are therefore subjective). What would we assume for rental earnings growth? Though rent has ballooned over the past two years, during the 2010s, average rent growth was 2%. In the long-term, we’d assume that it heads back towards that rate. Let’s assume 2.5% annual rental growth.

If there was no change to the earnings multiple, that would give you an annual nominal return for housing of 4.95%.

Predicting no multiple change is a big assumption. Remember, housing is currently priced at a PER of 40x before costs. If we assumed a 25% haircut to the multiple, that would reduce annual returns to 3.71%.

We can assume different rent growth rates and multiples to come up with different estimates. I would suggest a range of 2-5% in annual returns over the next 10 years is reasonable.

Let’s apply the same formula to estimate stock returns over the next decade. The current dividend yield on the ASX is 4.44%. A conservative earnings growth estimate is 3% per annum. Given the current PER is almost bang in line with the long-term average, let’s assume no change in the multiple. That gives you an annual return of 7.44%. I consider this conservative.

Again, we can play around with earnings growth estimates and dividend yields (possible cuts?) and the earnings multiple. I would put the range of future annual returns is 6.5-10% for the ASX All Ordinaries. For reference, ASX stocks have returned 7.3% per annum over the past 10 years.

Putting this together, I think the odds are very high that ASX stock returns will handily beat those from residential property over the next decade.

What are the chances of a meaningful housing correction?

Given the high prices for property, can we expect a larger correction at some point? I doubt it. In the near term, supply shortfalls are severe and that will keep prices up. Long term, it’s up to the Government to bring meaningful reforms to the sector to bring prices down.

But that isn’t going to happen. The Government has no desire for house prices to go down. It may talk about bringing on extra supply, and doing other things around the fringes, but it has no intention for property prices to fall.

To understand why isn’t hard. The average parliamentarian owns multiple investment properties. Also, 67% of the population are homeowners.

As Charlie Munger once said, “Show me the incentive, and I’ll show you the outcome”.

The Government could remove all subsidies for housing and prices would quickly drop. But major changes won’t come until they’re incentivized to do it. And that won’t happen until the majority of voters aren’t homeowners. When that occurs, the political calculus will change.

 

James Gruber is an assistant editor at Firstlinks and Morningstar.com.au

 

76 Comments
Wolfgang Bose
January 22, 2024

Most people miss the point completely here and perhaps Esabel Dallas' comments above were the most appropriate ones and she said in her comment : .....tell me one reason they want to invest in a rental property is to help their kids get into the property market, using their own home equity, feeling their kids are priced out on their own.......................... and she is spot on.
This is exactly right and I even go a step further - being now 81 years old I can say with confidence that our generation and all the associated political parties during that time have totally failed the younger generations having now to save for a deposit and having to pay 13-14 times the average annual income of an Australien worker to pay for it and then looking at me who bought my first home unit in Mosman and having only to pay about 3 1/2 - 4 times the average annual salary...... and I am ashamed. We are failing the next generations of Australians in a big way.

Dudley
January 22, 2024

"failing the next generations of Australians":

Raise real interest rates; price of homes plunge, young wait for price to bottom while saving to pay cash on knocker.

The populous productive generation switch from saving for retirement thereby generating 'surplus' capital and pushing down interest rates to spending accumulated capital creating capital 'deficit' pushing up interest rates.

Kam
January 11, 2024

At 50 years is buying an apartment as a first home a good idea?
I can stay renting where I am at the moment but the environment isn't great - I would love to hear any opinions.
Thanks

Dano
March 30, 2024

Not a good idea - Your first property should be your personal home as Capital Gains are tax free vs investment properties taxes at marginal rates on 50% of the gain, which is under threat as the labor and greens what to increase the CGT. Your second property should be the investment property as you can then negative bear it reducing your overall tax paid.

Barry
January 04, 2024

I like how the author of this article has chosen to ignore reality and plugged in his own made-up numbers to justify his narrative that housing is a bad investment and he has also acknowledged that he is doing this.

Even though rents have grown by around 9% per annum in each of the last 3 years of 2021, 2022 and 2023 the author has chosen to ignore that and said, I'll just ignore reality and plug in 2.5% rental growth instead into my formula so that I can make it look like housing is not priced correctly and it must come down because I say that rents should only grow at 2.5% even though they have actually been growing at 9% in each of the last 3 years.

The future is too hard to predict. If we have high inflation then rents will rise at a pretty fast clip too.

James Gruber
January 04, 2024

Hi Barry, think that's a bit unfair. I did acknowledge the strong recent rental growth and have forecast above trend rental growth going forward. Do you think we'll have 9% annual rental growth in future then? If so, I think you're off with the fairys as that would mean rents double over the next 8yrs. Subscribers are smart enough to make their own judgments on future growth and can calculate as such.

Isabel Dallas
January 03, 2024

As a financial planner, a large number of clients of all financial walks of life, tell me one reason they want to invest in a rental property is to help their kids get into the property market, using their own home equity, feeling their kids are priced out on their own. This is a huge motivator for rental investors in my experience. It is at an aggregate level counter productive, but on an individual level, entirely rational.

Trevor Stewart
December 25, 2023

I think a good strategy is to find a house (not apartment) that ticks all your boxes (location, build quality, size of block etc) and that is affordable based on your expected earning capacity, negative gear it until such time as the tax benefits become negligible and then move into it and never sell it.

Peter C
December 25, 2023

Trevor, negative gearing is a dumb strategy unless you can guarantee the real growth in prices will be higher than the money you lose by negative gearing. This appears unlikely. I know professional property investors who have all left the passive investing in residential property because it no longer makes financial sense. (They do invest in commercial property).
Your strategy may say never sell it, but what if you are forced to sell to enter a nursing home? At that point you will be subject to CGT on the (discounted) nominal gain, not the real after inflation gain, Besides your strategy is not repeatable as you can only have one main residence.
Far better to look for growth assets which have positive cash flow and are not costing you money to hold.

Trevor Stewart
January 02, 2024

Peter, you seem to be talking about residential property investment. I'm talking about buying a home. Two different things. Unless you're happy to rent all your life you need to buy a home.

If I'm forced to sell to enter a nursing home CGT will be the least of my worries. Also I assume the CGT would be calculated on that part of the gain accrued up to the point where the house becomes my principal residence rather than the whole gain.

And yes, you can only do it once. That's why the property needs to be one that you will never want to sell.

Paul
December 24, 2023

One factor that always seems to get glossed over is the leverage that is gained from owning a house.

You put down 100k, the bank lends you 500k , and you buy a house worth 600k.

Your 100k has given you access to the growth on a 600k property.

I have looked at borrowing to invest in shares but the only product are margin loans with very high interest rates, and so have not gone further with it.

Marcus
December 25, 2023

Absolutely spot on.

Kevin
December 25, 2023

I don't know if the banks still have a line of credit on a house but that's what I did in the late 1980s.The house is security rather than the shares.The deregulation of banks.

What happens is use the equity in the property,so $6K to buy 1,000 shares in CBA in 1991. Reinvest the dividends and you now have around 6000 shares in CBA. The shares are worth ~ $660K,the house is worth whatever it is worth.

If you bought a good bank and a bad bank then you borrowed $12K and bought 1,000 CBA,and 1,000 NAB. 6,000 NAB @$30 each is $180 K.

So a house worth $ X,plus shares worth $840K + whatever you have in super. The money tree seedling was planted 32 years ago.You can relax in the shade now if you think 2024 is the first year of retirement.Obviously pay the loan off as fast as you can and take out more equity to invest.Leverage is not for everybody,it can be dangerous if you get over leveraged or lose your job.

Kevin
December 25, 2023

Some companies have excellent calculators on their web sites.Rio is one. RIO ASX cost approx $15K plus brokerage on 4/1/1999.You now have 2738 shares in RIO using the DRP. You'll need to look at the price and it will change every day.See what the money tree is worth on 31/12/2030 if you decide 2931 is the first year of retirement.

When E mail came out US companies were great. Send them an E mail and they sent you back a very good investor pack.I sent for Wrigley's and JnJ. Wrigley's gave you history back to 1901?. Four columns share price,dividend .Share price and number of shares using the DRP. Share price and how much you had collected in dividends if you didn't use the DRP and just depended on share splits to increase your shareholding.Obviously compounding is magnificent over 100 years for a good company.

JnJ gave you full history going back to starting in the US civil war making bandages. They split adjusted on price working backwards $100,$50,$25 etc.Adjusting then 1 cent in 1944 without using the DRP was worth whatever the share price was ~ 2000.If they have had no more splits since then then 1 cent grows to whatever the share price is today.

Charlie Munger calls it the fortune for waiting.Fisher's book title Uncommon profits from common stocks.

Alex
December 25, 2023

One thing that you seem to gloss over is the fact that you have to eventually pay back the 'leverage' (which is just a fancy term for debt or liability) of 500k in your example.

As you delever, and once you consider the borrowing costs (which could be as high as the price you pay for the house itself over the 25-30 years of the loan term) and other expenses you'll have to incur just for maintenance/upkeeping, the 'growth on a 600k property' may be illusory.

There's also an opportunity costs associated with putting down a significant cash upfront (100k in your example) into an illiquid brick and mortar that doesn't produce anything.

Mark Nicholl
December 28, 2023

Yes the power of using OPM (Other People's Money) the bank, the tenant and the Governments (via tax returns)

Baz
December 31, 2023

There's several other products, including NAB Equitybuilder, or strategies to get leverage with shares

Raj R
January 17, 2024

There's nothing to gloss over "leverage" - because it is one the best ways to lose money. Charlie Munger: “there is only three ways a smart person can go broke: liquor, ladies and leverage”!

On a more serious note: Leverage might have worked in the past when property prices were much lower & most importantly interest rates were very low and potential for capital growth was much higher. I have modelled multiple scenarios and honestly there are just so many variables/moving parts involved with residential property investment that a common "layperson" on the street would find it extremely tough to keep track of everything such as: in-depth "location" market research (school zones, demographics & socio-economic backgrounds of likely buyers, public transit connectivity, demand growth, new supply coming online, capital growth potential, planned infrastructure developments that might impact property value), interest costs, rents achievable, days property sitting empty, rental growth potential, complex tax rules, admin paperwork to track each & every dollar of Opex & Capex costs spent on the property, research/tax/real-estate/buyer's agent commissions, buying/selling costs, legal due-diligence to ensure no illegal works have happened on the property, etc. Even for the more financially savvier person, it seriously looks so tough to earn a decent return even compared to low-risk options such as simply parking your cash in an offset account (on your PPR home loan), term deposits, Govt/high-grade Private bonds, etc. or in generic index tracking ETFs or LICs for higher returns, lower costs, low admin paperwork, highly liquid, *almost guaranteed returns (without taking on any "leverage" if you have decent savings)!!! Of course, people who want to get rich quick get tempted by "leverage" with the promise of "magnified" gains.

Genuinely feel property spruikers need to be outlawed by the Govt. So many people busy with their day jobs and zero financial "due diligence" skills or propensity to do any research/analysis get sucked into this Ponzi scheme by media headlines & smooth talking "investment experts" with terms such as "leverage" just a fancy term for eye-watering debt. You ask these so-called "investment experts" for a single spreadsheet to model a few scenarios and most of them have nothing to show other than imaginary numbers on a whiteboard! Highway robbery - everyone from the Govt to the Banks to the multiple Middle Men/Intermediaries want a slice of the pie that you the great "property portfolio investor" take on all the risk & sweat so hard for like a slave!

Brad
January 28, 2024

I agree Paul.

Tony
December 24, 2023

Excellent article James.

I agree, investing in property no longer stacks up, especially here in Victoria. I have two investment properties yielding $85k rent p.a. From next year, my land tax bill will be $23k, which is more than three months of that rent. That, and with rental laws now stacked in favour of tenants, means I'm selling up, and never going back.

CC
December 25, 2023

Which is exactly why politicians will do everything they can to keep property obscenely expensive, so that land taxes stay higher and higher

Mal
December 24, 2023

Residential property trust would be a great response to multiple issues in the Australian residential housing market. Why are there no residential property trusts in Australia? Residential property trusts would give investors a lower risk investment plus provide renters with well built, well managed long term occupancy from trust managed buildings with a 50 Year plus rental life.

There must be many commercial issues that make residential property trusts unviable in Australia but my observation is the strata title is one of the biggest ones. The profits from building apartments for strata title, where the building is sold off as discrete dwellings to owner occupiers and individual investors are just too great for any developer to consider building for a residential trust. A residential trust would insist on build quality and total costs absolutely at odds with the practices and profits available for build to strata title.

CC
December 24, 2023

https://www.firstlinks.com.au/cant-invest-residential-property-in-the-listed-market

Warren Bird
December 24, 2023

There is at least one. https://hopehousing.com.au/

Ken
December 23, 2023

Housing is Australia's greatest social policy failure.

We have turned housing from the basic human need and right for shelter into an investment category.

I bought my house for $28,000, and if sold it today I'd probably get $1 million. But so what? That's of no benefit to me because if I sold, anything else I might buy would also have gone up proportionally.

If my house was still only "worth" $28,000 I'd still be getting the benefits I bought it for - a roof over my head, a place to bring up the kids, and somewhere to put down roots into the local community.

David Calver DC
December 23, 2023

From DC
I disagree with your argument as you state, "in the next 10 to 20 years" shares will be the better investment. But for the next 10 years property will be better. With the excessive immigration, 550,000 in the last year and natural increases of 200,000 +, plus the rise in costs of building materials, the lack of builders and rising costs,focussed property investment will give better than 10% return in the next 10 years.
The focus is on location. i concentrated on key areas of Sydney and Melbourne, mostly the eastern suburbs of Sydney, investing in quality builders of top quality apartments, there are quite a few around. They pay 10%+ with only 70% borrowing. I recently sold out of Sydneys east side to move north and made 9.5% cumulative return p.a..after 20 years. After 10 years I may not be around. The builders may have caught up by then.

Gary
December 25, 2023

I agree with you DC. Unless the supply deficiency is resolved property will continue to to outperform. The latest IR reforms will increase building costs, so will all the new global warming regulations. As new home prices increase then so will used prices. Interest rates are still historically low. I see nothing on the horizon which will cause prices to stagnate or drop.

Dane
December 22, 2023

Good article. If you ask a resi property investor what their IRR would bet net of costs, of they sold at prevailing prices they just stare blankly. Investing should be a 'compared to what' scenario. There's such a lack of basic financial literacy. The spruikers and ticket clippers surrounding the transaction leverage this.

It's also rarely mentioned when you buy a property you are not guaranteed to see the same price growth as capital city averages. The risk is you may well experience growth below the average if you invest in the wrong suburb/street. Most investors are punting on growth by running a cumulative loss. I don't think they have a clue about the downside. With shares you can buy an index cheaply and obtain the market return. Big difference.

It really is a poor investment vehicle and the most expensive in terms of upfront and ongoing costs. But as you say the housing politico complex has a vested interest to keep sucking in the marginal buyer.

Allan
December 22, 2023

"[..] The average parliamentarian owns multiple investment properties. Also, 67% of the population are homeowners. [..] The government could remove all subsidies for housing and prices would quickly drop*. But major changes won't come until they're incentivized to do it. And that won't happen until the majority of voters aren't homeowners. [..]"

All that quite simply needs to obtain here is for the greedy government to impose 'eminent domain' in usurping the ownership of millions of properties which'll put the voided voters out on the streets in droves where they then, to get the 'drop' on the government, take but 'vacant possession' of the priceless properties...'scot-free'* (given that something is only said to be worth what the buyer is prepared to pay for it!). This'd make the sub-prime crisis in the US look like small cheese.

Disgruntled
December 22, 2023

With Real Estate vs Property, view Suburbs as individual stocks.

Some will perform quite well, some will be ideal as yield stocks providing consistent solid returns and others will not do so well.

I'm holding 3 stocks in my portfolio that I believe will outperform any Real Estate purchase next year.

David MC
December 22, 2023

My experience as a baby boomer with professional adult children is that the average person has some knowledge of and familiarity with housing, whether as their own home or an investment. It is a topic of much social conversation and discussion, and they are more or less comfortable with the idea of taking out a big/huge loan for the purchase. Once bought, a property is not exactly sit and forget, but certainly a fixed part of their financial situation. However few people are knowledgeable about equities and the need to watch their share portfolios (including ETFs) week to week or day to day. That is they might be said to be financially illiterate (unless they manage an SMSF). They do not read articles like this, and they think that their superannuation covers the equity side of their investments, - which the advent of compulsory super has probably encouraged. They do not follow share markets. They certainly would not take out a loan of several hundred thousand dollars to invest in the sharemarket even when interest rates are very low (as they have been). Neither would I!
But there have been times when the property market is stagnant, and I think of the 1990s, when the share market is roaring along and everyone starts talking about shares (the legendary bell-boy and taxi driver) until the inevitable crash. Maybe housing is less prone to this?

Richard
December 22, 2023

Hold and Hope strategies apply equally to Shares and Housing, but shares are more easily sold than a house. Grants for buyers have pushed up prices. At heart of Negative gearing is being able to claim interest cost and other costs on borrowings which you can also do if you borrow for shares, so remove one remove the other would be the issue. Owners need to evaluate their property price annually and determine what the rate of return is vs current price. I am putting mine on the market as if I release the equity I can earn a greater return on the cash at 4% for a lot less hassle, time, and energy than the approx 0.5% return today, and thats with always being a positive cashflow landlord, the last year of rate rises having cruelled the return.
To lower housing cost, Remove all of the handouts, or give the first home buyer grant after they have been a year in the property if you must. As for negative gearing you can keep (votes) but change the rules making the expenses only claimable when you sell as part of the CGT calculation, that would further limit the number of people foolish enough to seek negative returns.
Cant wait to have that contract signed and cash in bank

Isabel Dallas
January 02, 2024

Or as for businesses, a rental loss can be only offset against rental income - can be carried forward to future years when the property becomes cashflow positive.

Guy Mudie
December 22, 2023

When I first approached the Savings Bank of South Australia seeking a home loan in the early 1980's the limit to what they would lend me was 4 times my average deposit held with them over the previous 12 months, along with my capacity to service the loan.
Imagine those restrictions now!

Ian Hamilton
December 22, 2023

A very good article as well as excellent comments covering all bases. To me a residential home in Mungindi will probably rent well but not appreciate in value per se, to inflation and costs, but a badly managed small listed company on our ASX, may never pay a dividend or increase in value as well.
Far to many variables to ever really compare these two.

Alex
December 26, 2023

It's hard enough comparing real estate and shares in general. It's even harder comparing residential home in a specific area (Mungindi, using your example) to a hypothetical individual ASX stock.

Most of use are not great stock pickers, but we don't have to be - we can buy a broad-based index funds, ETFs and/or LICs, and enjoy the benefits of both capital growth and dividend income from the underlying companies. You can't achieve the same level of diversification with the same amount of money when it comes to residential property, not to mention the significant transaction fees (both when you buy and sell the asset) and ongoing maintenance costs.

Mark
December 22, 2023

Great article James. I also would add that a read of the Eichholtz paper on long run property prices, better known as the Herengracht Index (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=598) gives an enlightening perspective on the very long term (modest) returns from property.

Whitney Drayton
December 22, 2023

Great article James. You hit the nail on the head with respect to negative gearing. Just ask Bill Shorten. It is political suicide to propose taking away the goose that lays the golden egg. Negative gearing investment properties has the same effect as franking credits. It artificially elevates valuations. We compound the problem with increased immigration, supply shortages, and a lack of trades people. Never underestimate the power of a government sponsored trend!

Lou
December 29, 2023

Negative gearing with capital gains tax as the trade off. Any government that would talk of dropping negative gearing and not dropping capital gains tax would need to be swiftly thrown out of office.

Jon Kalkman
December 22, 2023

For home buyers the salient question is often not the house valuation, or even the size of the loan. What matters is their capacity to service the loan and their borrowing capacity is directly related to interest rates. PropTrack’s research suggests that borrowing capacity reduces by around 10% if interest rates rise by 1%. Meanwhile, a 2% interest rate increase will see borrowing capacity fall by 19%.

The reverse is also true. From the early 1990’s until May 2022, interest rates mainly headed downwards. At the same time the community moved from single households to double income households, thereby increasing their borrowing capacity even further. Ironically, most mortgages now require two incomes and that has other effects on family formation and the need for childcare.

If interest rates don’t reduce much more and there is no increase in borrowing capacity, it’s difficult to see much growth in prices and yet most investors seek their return from capital gains because the income yield is so low.

We have a whole generation of people who only know rising house prices. In addition the media only focus on shares when prices fall and property when prices rise. With our low level of financial literacy, it’s no wonder then that many people (including politicians) earnestly believe that property is a guaranteed path to wealth but the share market is a casino where you will lose your shirt.

The quickest way to lower house prices by almost 20% is to raise interest rates by 2%. The problem is, that would kill the economy stone dead.

Kevin
December 22, 2023

Exactly what I thought for decades John,with an added,I bought a house for investment purposes ~1989. The house cost ~ 4 years wages at single income. All these years later and the house is worth ~ 5 years wages,it might be worth 5.5 X.
The ability to meet the loan payments is correct.Paying 19% on 4 years wages is hard.Paying ~ 6.5% (?) on 5- 6 years wages looks easy ( dons suit of armour for incoming flak).

Back then house,land,finished product.Sit on milk crates until things get better.Fence it yourself,internal paint it yourself and everything.

These days a Mcmansion 4 bed two bath please.Finished with fences,painting,carpets,everything.No car port,a 2 car garage is a must with a remote control door.

Off we go with intergenerational warfare.In 40 years time people will look back with astonishment at how cheap and easy everything is today.

Planning ahead dons second suit of armour and lock all doors.

Kevin
December 22, 2023

Another addition.The house is worthless.I have excellent tenants that look after it well. They are coming up to pension age now.I can't leverage off it,the bank wouldn't look at me for a loan.I can't sell it as they would be homeless and probably unable to find a house to rent. So after tax etc it produces an income for me.I would never bother working out what the ROI is.The small print on the tin was hidden under the price ticket. Tiny print,this is what can happen.

Steve
December 22, 2023

The myth that property only ever increases in value was what led to the infamous GFC. Bankers in the US saw that property was a "sure bet" and decided the best way to make more money was to lend more to housing. BUT the only way to lend more was to lower lending standards. In the 80's you needed 20% deposit in the US to get a loan. This dropped to zero! Further, mortgage brokers worked on commision and made more when they lent more, so they rigged the paperwork to make a loan get through that wouldn't have in the past. Note a big difference here is that most loans the banks write stay on their books so there is a degree of self-preservation in their loan criteria. We took out a first and second mortgage from a small local bank (early 2000's) and the next day the first mortgage was sold to another bank. Flipping loans to another party was very common and removed the mortgage originators skin in the game (hence the sub-prime loans classed as AAA - because they were supposedly backed by mortgages). If you haven't watched The Big Short, do so soon. It is an eye-opener!

S2H
December 21, 2023

Great article James. I'd be interested to see if there's any data on it, but allowing SMSF to invest in housing seems another form of government support.

Frank
December 21, 2023

This argument about stocks vs Residential property or the reasons for unaffordable property has been ongoing for the past 30 years. Alan Kohler summed it up well. The reason property prices are escalating is because of lack of infrastructure. People have been now commuting over 2 hrs one way to get to work, and everyone wants to live next to a train line. Then there is slow and bureaucratic nightmare getting plans approved and developments ready. Until these are other blockers (too numerous to mention) property will be unaffordable to the future generation of this country

Michael
December 21, 2023

Real estate prices may be overvalued but I think you are missing some key points that will help increase that overvaluation in 2024-25.
1. Lack of supply of medium density in the more affordable outer rings of the cities.
2. Lack of trades people and building materials and supply chain issues which each pushes up costs
3. Increases in salaries and materials due to inflation.
4. Reducing manufacturers in Australia means more reliance on importing which has higher transport and customs costs.
5. Increased state and council taxes on new builds.
6. Introduction of six star energy efficiency standards by Federal/State governments which are expected to add $50K to any new build.
7. Increases in renovations due to higher costs of new builds and the resulting impact on the above.
8. Increased immigration, while less than this year's record, it will remain over the long-term average.
9. Restart of foreign students at universities.

James Gruber
December 23, 2023

Hi Michael,

Thanks. Yes, I did say in the article that prices will be supported in the near term: "Given the high prices for property, can we expect a larger correction at some point? I doubt it. In the near term, supply shortfalls are severe and that will keep prices up."

Steve
December 21, 2023

As you said, a reluctant article. There is actually very little in common between stocks and housing. The former is optional with a global ranges of choices and the option of sitting out of the market if you can't see value; the latter is non-negotiable unless you plan to live in a car or become homeless. You don't have many alternatives except share housing maybe. It is all about supply and demand. But the affordability will be the limit. I would argue as a general rule, people buy the best property they can afford to live in (less of a criteria for property as an investment but still a factor - is it near public transport etc). Which brings me to my pet hate on this subject - FORGET the headline price comparison, it is the COST that matters. How do these differ? The cost includes the mortgage, the price does not. Very few people borrow for share investments. A better comparison would be an interest rate factored cost - I'll leave the experts to decide on that but I know one thing, any conversation that excludes factoring in interest rates (actual mortgage repayments) as part of the actual comparison is wasting everyones time. Which comes back to affordability. Of course lowering interest rates allowed people to borrow more (lower interest rates produces higher prices for the same cost!). As do schemes such as first home owners grants, dipping into super etc. All these do is juice up the amount of money people can throw at an auction. So to me the big question is where does affordability go from here? How many pips does this lemon have left to squeeze? What factors will put more money into peoples pockets to bid up prices? Answer that question and you are well on your way to making a reasonable forecast.

Mark
December 21, 2023

However, the bank gave me a $700k+ home loan to buy investment properties, whereas they wouldn't have given me a loan for the same amount to buy shares.

Kevin
December 21, 2023

They would Mark.If you own or have equity in a property.Leverage is used to buy a property.Leverage is used to buy shares if you go down that path. Put say $700 K into a property and you have $700K compounding from day 1.Same happens in shares.The high cost of holding property,the low cost of management fees. I dislike comparing anything,you will agree with the person telling what agrees with what you want to see. So now I will compare.$50K into a property in 1980,see what it is worth now,after high holding costs,repairs,modernisation,insurance etc. 50K into the accumulation index.Acc index is now ~ 93K.So 50 X 93K,a bit short of $5 million,eroded by annual fees and taxes of course.Say $3 million after fees and taxes.The run of the mill average sparkys house isn't with $3 million . Steve is right,I would make slight variations but why split hairs. The cost of a stable roof over your head is $1 or it cannot be calculated?

Ronald
December 21, 2023

James, you make some great comments and observations and I certainly can't advise on whether the ASX can provide better returns over the next decade because it's impossible to generalize about listed companies and their potential activities and outcomes over projected time.

However, having been in the Building Industry for over 40 years, I can say that housing prices are high, but there are many reasons some of which you have also pointed out, will continue to keep them high.

The biggest reason for continued high costs are replacement of land and building construction costs.
It's impossible to replace land, or buy a site within close proximity to the big cities around Australia, especially Melbourne, and Sydney without a high price tag. Quality Builders and good tradesmen are expensive due to being in scarce supply and thus houses are escalating in value because its difficult to buy stock if its in demand and impossible to replace. Building more higher density housing does not relieve or reduce housing costs.

This scenario will not change as demand outstrips supply and governments are keen to keep this model for self interest, the protection of values and Bank values of mortgages, and by increasing migration this boosts demand and keep this investment cycle heading in the higher direction.

It is not a great investment to seek a low rental return based on the cost of the investment, as you point out on a house investment, but the ongoing cost of replacement (and inflation) seems to protect the capital gain outcome. It is also all about timing and naturally if you're lucky with your chosen entrance and exit strategy- profits will continue to be made in housing - but that also applies to ASX shares as well. !

Alex
December 24, 2023

All the points you raised essentially confirm James's arguments, Ronald.

As you said, the 'price' (not 'value') of property will remain high because of the high replacement costs. This is due to inflation. But guess what, inflation drives up the price of all other items too (not just the replacement costs of land and building). It also drives up the costs of replacing capital behind every company (or shares). Even if the price of your house appreciates by 100%, it's very likely the price of similar houses in similar areas would have increased by the same proportion, so you'll have to fork out more money too to replace your existing house - in other words, your effective capital gain/profits is not as high as what you think it is.

"This scenario will not change as demand outstrips supply and governments are keen to keep this model for self interest." - This only proves that price is just a function of demand and supply (which can be influenced by factors that are not even embedded to the asset itself), and not necessarily an accurate reflection of the underlying value of the asset. I don't know about you, but borrowing a significant amount of money to purchase an overpriced asset with very low yield (sometimes negative) knowing the return from the asset is at the mercy of external factors (e.g. government's interference, migration, interest rate, etc.) sounds more like a speculation than a rational investment decision.

Fergus
December 21, 2023

While I wish for a large correction in property prices as the social and community impacts of property prices continuing rising has been predominately negative.

I don't see it occurring as the FUNDAMENTALS get trumped by the combination of:

- low interest rates (thanks RBA)...yes higher currently...perhaps not a permanent level ?
- reducing mortgage buffers - The price of a property is directly related to how much the BANK will lend you (thanks APRA)
- lax lending standards and liar loans (thanks lack of checking of applications by banks and the mortgage brokers)
- immigration (thanks Govt Policy at the time of a housing shortage)
- tax policy (neg gearing / 50% CGT discount etc)
- AML policy (Govt yet to implement TRANCHE 2 AML - "AUSTRAC estimates that, in 2020 alone, criminals linked to China laundered $1 billion through Australian real estate" - https://www.abc.net.au/news/2023-02-03/afp-money-laundering-bust-highlights-real-estate-vulnerability/101923160)
- Govt hand-outs (1st home owner grants / firsthome builder grants / etc etc "In the last decade, Australian state and federal governments have outlaid $20.5 billion for various first home buyers schemes" - https://rogermontgomery.com/how-can-we-ensure-affordable-housing/)
- powerful lobby groups determined to keep property prices high
- lack of political will / guts
- Developers withholding stock and land-banking to keep prices inflated.

Richard C.
December 22, 2023

Great article James and many good points raised by others. Regarding real estate, might I add:
No overseas buyers for any land or dwelling. Such persons must have Australian passport and live in the country for atleast 6 months of the year.
Limit on the amount that a rent can be increased at any one time (eg 4% pa)
Renters must have more say over their landlords, especially in areas of maintenance & safety.
I believe that we need to cool the housing market - any way we can. Thank you!

Maximum of 1 investment property per taxpayer.

Geoff
December 21, 2023

Residential property as an investment by small investors seems largely to run on faith. The returns from the actual rental of the property are very small, so everyone is banking on a decent capital gain further down the track. There's also the discipline of having to pay the investment mortgage - seen as a way of enforcing savings.

The mess that is the Australian home rental property market is largely created by having a million different smallholder landlords all doing their own thing. It is a nightmare for renters who can have their entire lives completely upended all because their landlord's strategy regarding their investment property changes.

Sooner, or later, forces (which are starting to mass on the border) will be applied to the current model and change it towards larger holdings, build to rent, etc. etc. Sooner or later a government will make a change to the CGT arrangements and live to fight another day. Sooner or later the negative gearing arrangements will be reviewed. The problem to date is that "big" changes (Outlaw negative gearing! Remove the 50% discount on capital gains! Eat the rich!!) are always proposed and then the war is on.

Sooner or later, a sensible government will just slowly, slowly, slowly unwind some of these taxation positions and MAKE A COHERENT, NON-SCARY CASE FOR DOING SO in a way that won't spook the horses, nor kill investment.

When that happens, the property bubble as we know and love it will be over and people will be looking for other ways to invest their money - placing upward pressure on Australian equity assets, this reinforcing James' theory.

I can't wait... but I doubt it will the this government, or, in the unlikely event that we switch back to LNP next federal election, that government either.

CC
December 21, 2023

Yes housing is absurdly expensive in this country but our politicians will do everything they can to keep it that way, thanks to excessive immigration, lack of housing supply, and vested interests ( they don't want to lose votes by removing negative gearing and CGT discounts, and many of them own property portfolios as well ! )

Max Z
December 21, 2023

Excellent article James.

You state that "The current dividend yield on the ASX is 4.44%" - and I assume that dosen't take into account the benefits of Franking Credits, which would make Share Investing even more attractive relative to Residential Property - especially for Investors on Low Marginal Tax rates or who pay no Tax at all for various reasons (eg Super in Pension Mode and/or the Benefits of the ATO Tax free threshold and SAPTO Rebate )

On the other hand , you also need to consider that Residential Property not purchased for Investment purposes and purchased in the names of Individuals currently has ATO Tax Free status on the Capital Gains, but it still appears that Share Investing still looks the more attractive going forward, although it's possible some Residential properties in well located places will likely outperform Shares , but I generally agree with you that Shares will likely prove to be the better Investment.

Jon Kalkman
December 22, 2023

Max you make good point. I would just point out that the franking credit is a benefit not just to shareholders on low tax rates. For every shareholder the franking credit is additional taxable income (equivalent to the pre-paid company tax) held by the ATO - that is why the dividend needs to be “grossed up”. For taxpayers on high tax rates, that additional income can be used to pay some or all of their tax bill. For taxpayers on low or. Euro marginal tax rates, a franking credit is additional taxable income (held by the ATO) which is excess to their tax bill and they get a refund for that excess pre-paid tax.
A franking credit is not a refund of tax never paid - it is refund of income never received but the size of that additional income is the same for ALL shareholders.
For retirees on a zero tax rate, the franking credit is a full refund of the pre-paid company tax. On that basis many retirees can look forward to an after-tax yield of 6% or more from their shares.

James Gruber
December 23, 2023

Max and Jon, good points and I agree.

John Carney
December 21, 2023

A must-read article. But it ignores one of the elephants in the room. The Howard Government effectively reduced the capital gains tax applying to housing. And house prices have massively increased since. I agree wholeheartedly that politicians don't want house prices to fall.

Rob
December 21, 2023

James - you have answered your own question - Supply vs Demand. Pe's are basically irrelevant in the residential market, as long as we have more buyers, boosted by immigration than sellers, it is upwards till it isn't and that point is, I suspect , upon us. Prices are flattening, Regional and holiday areas are tanking harder than any publicly stated positions as rates and taxes bite.

As to history, do not ignore the 1970's which is when the game really changed, along with the first and second oil crises and resultant inflation, followed by wage spirals. Talk to any Boomer, they will tell you their "wealth" kicked off then!

Ian Saines
December 21, 2023

James - why don’t you recreate your first chart (Yield on Assets) but normalise residential housing for (a) capital gains tax exemption (assuming say the median marginal tax rate), and imputed rent (using some assumption about rental yield say 2.5%)? Without taking these factors into account, other than as after-thoughts, one can’t generate a fair comparison.

This “tax and imputed rent” omission is also missing in the arguments about superannuation. Owning residential property is clearly superior to superannuation when you take into account the fact that it’s a tax free asset and provides free rent (ex running costs). Therefore it’s completely rational to take money out of super to buy a home and why the Coalition is on a winner in promising to bring it back as policy in their next term.

Dudley
December 21, 2023

“tax and imputed rent”:

plus the tax free, capital free, indexed for life Full Age Pension available when capital in excess of Assets Test is dumped into the Home Improvement thereby providing a 7.8% / y return on converting Assessable Assets into non-Assessable Assets.

John De Ravin
December 23, 2023

Great point, Dudley! I looked through all the comments to see whether someone would make your point that the structure of a Australia’s aged pension tests produces a powerful financial incentive to the great majority of retirees and pre-retirees to buy/upsize/upscale/renovate a home. Putting it another way, all but wealthy self-funded retirees are incentivised to put money into a home rather than savings by the time they retire because by so doing, they can access a part or full Age Pension. The present value of the full Age Pension for a couple who have just reached pension age must be of the order of a million dollars.

So who is effectively meeting a large part of the cost of home ownership? The government, due to the major distortions that arose in the assets test when the government doubled the asset test pension offset factor from 3.9% to 7.8% for assessable assets (but not for owner-occupied houses).

Dudley
December 23, 2023

"present value of the full Age Pension for a couple who have just reached pension age must be of the order of a million dollars":

Compare >= 67 year old couples with same starting capital $1,003,000 capital (Age Pension Asset Test = $1,003,000):

One rents and invests $1,003,000 and receives $0 Age Pension due Asset Test $1,003,000.

One buys home $551,500 and invests $451,500 and receives full $42,988 Age Pension due to Asset Test $451,500.

Sticking to cash and allowing for:
Investment Returns 5%, Income Tax, Rent 4%, Capital Gain 5%, the Total Return is:
Renter: $28,090 / y = 2.80%
Homeowner: $91,250 / y = 9.10%

The renter could become homeless at short notice.
The homeowner is greatly better off with share market like returns but much less volatility than the renter.

There is much more comfort in home-owning than share owning when old.

James Gruber
December 23, 2023

John and Dudley,

Thanks for your comments. Agree that the age pension systems favours owning a home. Two things to note: 1) most retirees own their homes mortgage free now. That is less likely in future as future retirees will be loaded with more debt given high prices. 2) one thing to be wary of is that age pension rules will undoubtedly tighten in future (see this week's editorial for more on this).

Dudley
December 23, 2023

"future retirees will be loaded with more debt given high prices":

... and loaded with more super they calculate to use some to pay off debt at retirement:

Real Future Value, 15% earnings tax, 7% nominal earnings, 3% inflation, to 67 from 47, 15% contribution tax, 2 * $12,000 concessional contributions, $400,000 net worth at 47:
= FV(((1 - 15%) * ((1 + 7%) / (1 + 3%) - 1)), (67 - 47), (1 - 15%) * -24000, -400000)
= $1,331,107

Dudley
December 24, 2023

Err:
= FV((((1 + (1 - 15%) * 7%) / (1 + 3%) - 1)), (67 - 47), (1 - 15%) * -24000, -400000)
= $1,244,254

Geoff R
December 21, 2023

> completely rational to take money out of super to buy a home and why the Coalition is on a winner in promising to bring it back as policy in their next term. Unfortunately if one is able to take money out of Super to buy a house then this will just put further upwards pressure on house prices as young couples will have $x more available to bid up prices. And further down the road there will be higher government expenses as more people will be on the aged pension as they have far lower Super available to fund their retirement, having blown part of it on their (more expensive) house.

Steve
December 22, 2023

Not sure where the "completely rational" comment comes from? Any policy that simply adds to demand and pushes up prices is clearly irrational?

Allan
December 23, 2023

"[..] ...the Coalition is on a winner in promising to bring it back as policy in their next term*."

In their next term? Although I'm thinking it doesn't (a)bode well for us, Ian; word* has it that we mere mortals won't need to live in houses come the year 2525* if we're then still around.

Karinvir Gill
December 21, 2023

Definitely agree with all the points raised in the article, and find it hard to see a world where the property market outperforms stocks on a nominal return perspective. The real kicker for property investment, however, has always been the leverage that can be obtained compared to other asset classes. This has resulted in the cash-on-cash returns on property outpacing other investments despite lower nominal returns. With current interest rates this is obviously less palatable given the magnitude of the carry cost of negative gearing, but I think it is a factor that needs to be considered in terms of what asset class will outperform in the long term.

James Gruber
December 23, 2023

Karinvir,

Fair point. Though you can leverage shares too, just not to the same extent. And leverage does entail risk and I suspect the future won't be as friendly as the past 40 years when interest rates consistently fell.

Raj R
January 17, 2024

The real kicker "leverage" might have worked in the past when property prices were much lower & most importantly interest rates were very low and potential for capital growth was much higher. I have modelled multiple scenarios and honestly there are just so many variables/moving parts involved with residential property investment that a common "layperson" on the street would find it extremely tough to keep track of everything such as: in-depth "location" market research (school zones, demographics & socio-economic backgrounds of likely buyers, public transit connectivity, demand growth, new supply coming online, capital growth potential, planned infrastructure developments that might impact property value), interest costs, rents achievable, days property sitting empty, rental growth potential, complex tax rules, admin paperwork to track each & every dollar of Opex & Capex costs spent on the property, research/tax/real-estate/buyer's agent commissions, buying/selling costs, legal due-diligence to ensure no illegal works have happened on the property, etc. Even for the more financially savvier person, it seriously looks so tough to earn a decent return even compared to low-risk options such as simply parking your cash in an offset account (on your PPR home loan), term deposits, Govt/high-grade Private bonds, etc. or in generic index tracking ETFs or LICs for higher returns, lower costs, low admin paperwork, highly liquid, *almost guaranteed returns (without taking on any "leverage" if you have decent savings)!!! Of course, people who want to get rich quick get tempted by "leverage" with the promise of "magnified" gains. Genuinely feel property spruikers need to be outlawed by the Govt. So many people busy with their day jobs and zero financial "due diligence" skills or propensity to do any research/analysis get sucked into this Ponzi scheme by media headlines & smooth talking "investment experts" with terms such as "leverage" just a fancy term for eye-watering debt. You ask these so-called "investment experts" for a single spreadsheet to model a few scenarios and most of them have nothing to show other than imaginary numbers on a whiteboard! Highway robbery - everyone from the Govt to the Banks to the multiple Middle Men/Intermediaries want a slice of the pie that you the great "property portfolio investor" take on all the risk & sweat so hard for like a slave!

Rob W
December 21, 2023

Since the 1980's deregulation of the Australian economy and entrance of new banks, etc. the ability to obtain finance is one of the main reasons for residential property's rise (leading to significant demand side leverage).
I remember back in the mid 1980's when the major banks still had restrictive lending quotas for housing finance. Customers had to meet strict savings and average balance criteria and once the monthly quota of loan funds ran out, that was it until the next month started. These combined to put a clear cap on both how much one could borrow, and how much a bank could lend, both of which contributed to keeping a lid on house prices.
These restrictions came off ~1987 just prior to, or around the same time as, the 1987 stock market crash - and it's been onward and upward for residential property prices ever since.

NB: I'm not denigrating the 1980's deregulation per se, just pointing out a consequence of it.

James Gruber
December 21, 2023

Excellent point, thanks Rob.

 

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