Should I invest in shares or real estate?
It seems that you must choose between the two asset classes. Australians are very passionate and have definite views about investing in property.
But what if you are a late starter? As in you only started your journey to Financial Independence (FI) at the ripe old age of 47, like me. Typically, your timeline is shorter. And you don’t have the luxury to be able to correct your mistakes and re chart your course of action.
On my Late Starter to FI series, I share other late starters’ stories and the strategies they used or are using to achieve FI and maybe retire early(ish).
I notice that many US late starters either already or aspire to invest in real estate, establishing a portfolio of short term or long term rentals to help them achieve enough income to be financially independent.
This is not the case among the Australian contingent, myself included.
I wonder why. Are we missing something?
Some Australian real estate facts and figures
The median house price in a capital city in Australia, its year on year growth, together with median house rents and rental yield* as per Domain for the June 2020 quarter are as follows:
Median House Price
Year on Year Growth
Median House Rent Price
Median House Rental Yield
There is no doubt that Australian properties, especially in Sydney and Melbourne are expensive! The rental yields as shown above are the gross yields ie operating costs of a rental property has not been taken into account. Net yields will be much lower as a result.
One has to work hard to find properties that are reasonably priced, with good prospects of capital growth and/or better than average rental yield in an area of low vacancy rate.
How about the US market?
According to the National Association of Realtors (NAR), America’s national median single family home price in June 2020 quarter was $291 300.
The top five most expensive cities are San Jose, California ($1.38m), San Francisco, California ($1.05m), Anaheim, California ($859 000), Urban Honolulu, Hawaii ($815 700) and San Diego, California ($670 000)
What I found interesting too was the breakdown in existing home sales by price range in July 2020 –
$0 – $100k 6%
$100k – $250k 33%
$250k – $500k 41%
$500k – $750k 12%
$750k – $1M 4%
In other words, 80% of homes sold in July 2020 was under $500k
One of my favourite podcasts is Afford Anything, where Paula Pant regularly teaches her listeners the ins and outs of real estate investing. She often talks about the 1% rule – ie the monthly rent should equal 1% of property purchase price (including all costs and renovations). For example, a $200 000 house should be able to rent for $2000 a month otherwise it is not worth your while. This translates to a 12% gross rental yield!
These are very different numbers to the Australian market.
Why I chose not to invest in real estate as a strategy to achieve FI
I was so happy and content I achieved this goal that I stopped investing altogether. In particular, I was tired of spending my weekends going to open houses and attending auctions. And I was nervous about taking on more debt. I was already working 60 hours a week – I really didn’t want the added responsibility of two or more mortgages. Plus the idea of being a landlord was terrifying.
So, with all those excuses, I basically missed the boat as property prices continue to hike upwards. Sixteen years later when I paid off my home, I made an appointment to see the loans assessor at my bank. I was 47 at this stage.
Banks had started to tighten their lending practices to investors – he wasn’t very interested in me. And to be honest, I really wasn’t comfortable with going back into debt again. But I thought I should enquire nonetheless as that’s what smart people do – invest in property.
When I discovered FIRE concepts, I was relieved that there was another way – investing in index funds or ETFs. As I learned about diversification of assets, I was glad that I did not go down the property investment route – so much of my net worth is already tied up in my house.
Don’t get me wrong – I am grateful that capital growth has seen my home appreciate in value – 2.4 times what I paid for it according to various home valuation websites.
But for me, it is time to invest in another asset class, and one that I don’t have to outlay a lot of money in the beginning.
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Since I do not have any personal experience in property investing, I reached out to two Aussie FIRE experts who are also real estate investors, for their views on investing in property for late starters.
Serina, The Joyful Frugalista and Dave from Strong Money Australia very kindly replied to my questions. They are giants in the Aussie FIRE and personal finance community, whose opinions I value greatly.
What are the advantages and pitfalls of real estate investing (both short term and long term rentals)?
1. People prioritise property investing
A key advantage is that real estate investing is something that
people are more likely to make a priority as an investment. In other
words, many people are likely to make sacrifices to meet a mortgage
repayment but might not make the same commitment to making regular investments in other assets such as superannuation, direct shares or ETFs. That’s changing a bit with the FIRE movement, which has a focus on ETFs, but in general, owning property is a huge motivating factor!
2. You can negotiate
Good property investors are usually good negotiators. This doesn’t mean that you are like a vicious guard dog, snarling at real estate agents, yelling ‘take it or leave it’ and being generally arrogant. Far from it! It’s about having the courage to make offers lower than the real estate agent would like you to, having your finances in order before you look at property, impressing a real estate agent as credible and if sold at auction, reading the mood of the crowd. With property, it’s important to be prepared to walk away if it doesn’t suit your budget. There’s always a better one!
3. You can time the market
All investment classes go in circles, but property is often more predictable. When the economy is going well, when interest rates are low, prices are generally going up.
4. You can make improvements
Some people have natural design flare and talent, and love the challenge of a fixer upper. If this is you, then you may do well with property. The challenge is to avoid over capitalising. Another challenge is to recognise that while you might like red walls and pink fluffy carpet, not everyone will. Aim for middle of the road and conservative. (I once had an investment property with a mirror on the bedroom ceiling – purchased that way – and we struggled to rent it until it was removed. Yes, people noticed AND commented!)
5. Your tenant helps you pay your mortgage
Your tenant is contributing to paying down your mortgage
6. You can negatively gear
It’s easy to negatively gear – just buy something that is overpriced and don’t negotiate your mortgage! That said, for high income earners, this is a good way to buy property that is likely to appreciate in value over the long term. Yes, it is often best to buy positively geared property but for most people, these properties are hard to find. (Not impossible, we purchased one 2 1/2 years ago but that’s another story.)
7. You can leverage Other People’s Money (OPM)
Yes, you can borrow to buy shares but property is where loaning money really becomes advantageous. The careful use of debt is a good way to make gains with property.
8. You can park your emergency funds in your mortgage
Having a mortgage, and making additional repayments, is a great way to have an emergency fund AND pay down debt.
1. Lack of liquidity
If something unexpected happens (say, a marital separation or sudden illness), it can be hard to sell up quickly. Yes, you can withdraw funds from an offset and yes, you can refinance. But if that’s not enough then it takes time to sell up and move on. Sadly, I know about the pitfalls of liquidity in property from personal experience.
2. Bad tenants
It’s easy to joke that your investment property would be so much better without tenants – and some people do buy and hold as a strategy – but anyone who has had a disagreeable tenant knows how upsetting it can be. I feel blessed that in 15 years of property investing, I have only had a few difficult tenants – and only two who I sought to remove due to failure to pay rent (only one successfully). Most things can be worked through.
3. Repairs and maintenance
If you are the sort of person who don’t have any money in your budget for unexpected expenses then property is not for you. Just this month, I had to pay $1300+ for a new hot water system. I was actually happy to pay this as my husband once tried to fix a leaking tap only to flood an apartment where the hot water system had rusted from within! Best to get onto those problems early.
4. The money pit
In 1986, Tom Hanks and Shelly Long starred in a classic comedy called The Money Pit about their efforts to fix a renovator’s nightmare. It’s easy to laugh, but I’m sure the owners of apartments in Sydney’s Opal Towers (and others affected by structural building problems) won’t see the humour! Some places are structurally unsound and, even if there is a property report, the cracks can appear later.
5. Some people shouldn’t climb ladders
Two older males in my family have suffered falls while fixing problems in a property on a ladder, and while their injuries healed, I’ve heard stories of people who have suffered much more serious problems. The moral here is that if you aren’t sure that you can safely DIY things on an investment property, then don’t. If you are usually a humble accountant during the week, don’t become a weekend warrior on a ladder on a fixer upper if you don’t know what you are doing. You might hate to pay a painter or a gutter cleaner, but it’s much cheaper than taking months off work to recuperate.
6. Taxes, insurances and other costs
Rates, land tax, capital gains tax and insurances – these all go up and often go up more than CPI. And strata/body corporate is in a class of its own.
7. Poor body corporate management
If you purchase an apartment or town house, chances are you will have a body corporate. There will be a company engaged to carry out repairs etc (body corporate management company), and a committee of owners (executive committee). Earlier this year, I attended a body corporate AGM that was like WWIII. I was shell shocked for hours afterwards at the yelling on each side! Conflict aside, poor management led to a water leak in common property not being rectified, costing thousands more than usual. Poor management is a key risk.
Even if you have a property manager, there is a greater time commitment involved in property than in other investments. For me, that includes body corporate AGMs, emails to strata managers, emails to property managers and sometimes even contact directly from tenants.
9. You can’t always choose your neighbours
Two years ago, the building next to mine was purchased by the government and converted to public housing. We know when it’s social security payday because there’s usually a party – a loud one. One day, I was walking my kids to school past three cop cars. You might ask – why don’t we move? Well, we like it here and we like having a small mortgage. But the neighbours have resulted in tenants moving out and owners selling, putting a downwards trend on prices.
10. Low rental vacancies
Rental markets go up and down, and this affects the price you can generally charge and the time in between tenants. When I first started residential property investing in 2005, we struggled for weeks to find tenants. It tends to go in waves. Just because rental vacancy rates might currently be low in your area, don’t assume it will always be the case.
11. People love to hate landlords
Sometimes, I’m hesitant to admit that I have investment properties. Many people, especially younger people, are upset about high property prices and like to vent against landlords. A common complaint is that open homes are full of cashed up older people, squeezing younger people out of the market. I’m not a fan of intergenerational generalisations. I’m proud that I am able to provide housing to people who need it. But be prepared to be a social pariah in some circles if you decide to invest in property.
In Australia, the main advantage is the ability to use leverage (debt) to multiply your return. If you take debt away, residential property here is actually a pretty crappy asset. The net yields (after ALL costs) are relatively low, and the growth outlook isn’t great. But when you can borrow at low interest rates, even modest capital growth can be magnified into a decent return.
The pitfalls are numerous! Capital growth is notoriously hard to predict, as there are so many factors at play and things can and do change all the time. Costs are painfully high – both the purchase and overall running costs (council rates, water rates, insurance, strata fees, management fees, repairs, upgrades, vacancies etc)
These costs have added up to around 40% of the rent across our properties over the years. This means a 4% rental yield becomes 2.4% after costs. For an income stream which only grow with wages / inflation, this is a poor cash flow asset, which makes it very hard to retire on.
And then we have other areas in Oz which are better for cash flow like regional areas, but these tend to have worse demographics. You may be able to get a 7-8% yield, which will be about 4-5% after costs. A pretty decent starting point. But the population doesn’t grow in many of these areas which means there is little pressure for rents or prices to rise.
Short term rentals come with their own list of headaches and become more of a job than a passive investment asset. Because of that, even a high level of cash flow needs to be discounted by some type of ‘hourly rate’ that you pay yourself. I can’t really speak to this type of arrangement as we’ve never followed the AirBnB type strategy.
What does it take to invest in real estate?
What it takes to invest in real estate in Australia is hugely different compared to the US. In the US, I’m aware that there are many cities where you can achieve a high cash flow from day one – in the region of 7-10% or so after costs. Not only that, but you can purchase in half decent cities for $100k.
These numbers are incredible – it couldn’t be more different to Australia! Our cities are highly priced with very poor income. Aussie property is mostly a bet on growth. And because of that, it requires patience!
As I said, there can be many, many years of no growth or falling prices. Even a decade of no price / rental growth is not unheard of. (I own property in Perth so sadly I know this all too well).
So if your time frame is anything less than 20 years, it’s probably not worth it. Especially when you account for the large buy/sell costs like stamp duty, agents fees etc.
Should late starters invest in real estate?
I’d say no, they probably shouldn’t. I see some people thinking that property will solve their problems because they can sit back and have this magical asset compounding for them so they don’t need to worry about saving. This is lazy, wishful thinking.
I’m not saying it can’t work or that property is a bad choice. But if you’re starting later in life, you want to take control, and the best way to do that is to get a handle on your finances and build a strong savings habit. After that, it’s about finding a simple investment process to follow, while you spend the rest of your time focusing on your job, family, hobbies etc.
Not only that, but taking on large amounts of debt later in life is the opposite direction you want to be heading! Ideally, you want to be making your life less stressful and opening up more freedom over time.
This is best achieved with debt free investments which produce income for you with no headaches. As you save and your portfolio grows bigger, so will your passive income and level of freedom. Taking leveraged bets on property growth doesn’t strike me as the best match for this group of people!
So, late starters, will you use real estate investment as a way to achieve FI?
Thank you very much for your in depth and thoughtful responses, Serina and Dave. Your experience and insight in the rental real estate market is invaluable to us late starters.
There is a lot to digest here. Key messages are:
1. Our market is very different to the US – our numbers are nowhere as attractive as theirs – our purchase prices are high and our rental yields are low.
2. As late starters, although we may have higher salaries and stable jobs, banks do not favour lending to us, with our reduced timeline to produce income to service the loan.
3. Having a portfolio of investment properties is a LOT of work – make sure it’s something you enjoy doing. Consider the negotiating, managing tenants, property managers, real estate agents … not to mention the DIY part of fixing renovator’s dreams or counting the cost of paying others to do it.
4. How comfortable are you with debt? In good times when vacancy rates are low, your tenants will help you pay your mortgage. But what happens if there is a drought of tenants? Do you have the means to pay the mortgages anyway? Will you be forced to sell some properties to cover others?
Please do your own research – our circumstances are different and your risk profile may be very different to mine. Explore your market, consider venturing outside it (I haven’t presented any regional data here) and make an informed decision.
Aussie late starters, now that you have read Serina’s and Dave’s opinions and advice on real estate investing in Australia, will you explore this avenue to help you get to FI faster?
I know for myself, this has further convinced me to stay out of the rental property market and continue investing in my LICs and ETFs. I know myself – I have neither the stamina nor courage to enter the fray!