Dangerous liaisons with property

A friend was overjoyed recently when she sold her house for $700,000 after buying it for $350,000 a decade earlier. That's an average annual compound return of 7 per cent, which sounds all right.

However, once you take into account inflation of at least 3 per cent, that leaves a real rate of return of 4 per cent.

Then there are the maintenance costs: the coats of paint, the repairs and the council rates. She built a garden wall and the kitchen was refurbished at a cost of about $10,000. Plus there was the real estate agent's commission for selling the house.

Reworking the rate of return after costs, the real return was probably not that much more than inflation.

On the positive side of the ledger, there is no capital gains tax on the sale of the home, which makes it the only investment where tax does not have to be paid on any profits.

The emotions surrounding property ownership can muddle the thinking of otherwise hard-headed people.

There are, of course, the immense non-financial benefits of home ownership but it looks as if some of that mushy thinking must be behind people's decisions to buy property as an investment - how else to explain the high portion of the population that owns investment property?.

Last year the ASX-Russell Long-Term Investing Report showed that the "real" return of Australian shares was higher than residential property over the past 20 years to the end of 2005. "Real" returns are those after tax and the costs of making the investment.

Australian shares returned 12.4 per cent and 10.4 per cent at the lowest and highest marginal tax rates respectively. Over the same period, residential investment property returned 10.9 per cent and 8.9 per cent at the lowest and highest marginal tax rates.

The ASX-Russell study was more sophisticated than most because it took into account the costs of acquiring, holding and selling residential property. Other studies simply use the crude measure of median house prices versus the return of the Australian stockmarket.

The biggest factors in the love affair with property for small investors have been generational-low interest rates and the halving of capital gains tax in 2000. The third factor is negative gearing. This is where investors are able to claim the shortfall between the interest on their mortgage repayments and the rent received as a deduction against their taxable income. Yes, the investment is running at a loss but the investor hopes to more than make up for the losses when the property is eventually sold for a capital gain.

But some areas of Sydney and Melbourne are experiencing flat or falling prices and with the recent cuts to superannuation taxes there is an incentive for older property investors to sell and whack the proceeds into super.

It's also worth noting that if investment property was really such a good investment, the fund managers would be into it. Many listed property trusts have business arms that build apartments and sell them. Or they invest in non-residential property such as shopping centres and office towers.

Brian Eley, the co-founder of small companies boutique fund manager Eley Griffiths Group, says fund managers cannot get enough yield from residential property to make it worthwhile. An owner of a unit worth $500,000 would be lucky to be renting it out for $300 a week, although rents are on the rise.

But at $300 a week that is a gross yield of 3.12 per cent. After costs, the net yield is probably closer to 2 or 2.5 per cent. The yield on Australian shares is more than 4 per cent and when franking credits are taken into account, the yield rises to about 6 per cent. Listed property trusts investing in office towers are yielding about 7 per cent.

For most people the houses they own or are paying off are just as much about lifestyle and status as about investment. The danger for investors is allowing that emotion to affect their thinking about investment property.