Property Is the Best Share Investment

The age old argument, property or shares. "You can't lose money from bricks and mortar" or "You can't sell a room of your property". Most retail investors fit into one of the two categories. I'm not going to take sides here, but I have done well out of shares (and managed funds) and have never invested in property.

Anyway, this topic isn't trying to weigh in to the debate. I want to discuss the huge advantage that property investment has over share investment. It's all to do with the ways you can borrow to invest, with the major advantage being tied to the banks' lending criteria.

Why Borrow to Invest?

Borrowing to invest involves using money that's not yours (ie, the bank's), to invest in property, shares or other investments. In Australia, interest payments are generally tax deductible and capital gains, if the asset is held for more than 12 months have a 50% discount applied to them. Therefore, by borrowing to invest, you can gain access to capital gains on money that's not really your's, whilst getting a tax deduction for your interest payments. Sounds pretty good hey? Of course, the disadvantage is that by investing with money that's not yours, if the value of the investment falls your potential losses are much higher!

Types of loans?

I'll start with property. This is a simple one. I'm going to focus on residential property, as this is what the typical 'mum and dad' will be investing in. If you want to purchase a property you go to the bank and take out a mortgage. Now there are numerous types of mortages, ones with offsets or lines of credits attached, but at the end of the day a mortgage is a mortgage. You put down a deposit. In the old days the banks required a 20% deposit for a mortgage, but competition has reduced that. From some dodgy brothers loan providers you can borrow 100% of the value of the property. Once you get below deposits of 20%, you're usually up for mortgage lenders insurance though, which protects the lender if you default on your loan.

Shares aren't as straight forward as property. There are many ways to borrow to invest in shares. These involve margin loans, protected portfolio loans, internally geared managed funds and using home equity to borrow to invest. The most common form of borrowing is the margin loan and is what I will focus on here. A margin loan shares some similarities as a home mortgage, in that you put down cash or shares as security or a 'deposit', you can then borrow to purchase shares. Generally with a margin loan, you must put down 30% deposit and can then borrow the remaining 70%. For example, lets say you have $30,000 in cash. You can use these funds to invest in BHP shares and then borrow another $70,000 and invest this. Making your entire exposure $100,000. The other point of interest with a margin loan is that if the value of your portfolio falls by a certain amount, you get hit with a margin call. A margin call requires additional funds to be deposited or shares to be sold to bring the portfolio back up the the allowed lending ratio.

Why property?

I can hear you all screaming at me now. Why buy property when it means dealing with dodgy tentants and dodgier real estate agents. Where's the liquidity? Shares provide better long term capital growth. I know, I know. It's not me who's spruiking property, its the lenders.

You see, the potential gains on something where you only have to put 10% deposit down are much greater than that where you have to put 30% deposit down.

An example will explain it better.

Lets say you've been in your professional career a few years and have $30,000 saved, currently sitting in cash. You want to invest this for the long term and seek some solid capital growth. You can deal with short term fluctuations and are not going to lose sleep at night if the value of your investment drops. Right, we've now established you're a suitable candidate for gearing (borrowing to invest).

You see the lender at your local bank. They tell you that with your $30,000, you can borrow $270,000 to invest in an investment property. Therefore having total capital of $300,000. This means you basically put down 10% and the bank lends you the other 90%.

You then see your friendly financial adviser. They tell you that with your $30,000, you can borrow only $70,000 and invest the total in shares. Therefore, you put down 30% and borrow the other 70%.

Lets say your investment property and shares average a return of 8% per annum over a 10 year period and all income is reinvested (you can't reinvest rent income I know, but we're talking hypotheticals). We will also ignore tax and interest. At the end of 10 years, your property has generated you wealth of $647,678 - $270,000 = $377,678 or a return on your original capital of 1259%! You're geared share investment has generated wealth of $215,893 - $70,000 = $145,893, a return on original capital of 486%, nowhere near that of your property.

It can be seen that the lending 'rules' on property investment make it a very attractive investment! A cheaper interest rate than a margin loan makes it look even better.

"Thats it, I'm getting rid of my shares and buying as much property as possible!"

Hang on a minute, lets be realistic here! Share investment has a lot of advantages over property investment. Firstly, my numbers are distorted, as by borrowing more, you are liable to pay more interest on your loan. I have ignored this for my example as tax deductibility of interest payments makes it a difficult calculation to make. Secondly (and this is a big one), in reality how are you going to reinvest your rental income from your investment property? Whereas its extremely simple to reinvest your dividends on your shares. Most top 200 companies have dividend reinvestment options and all managed funds certainly do. This helps to increase the compounding effect of share investment and ensures you don't just spend the money when you get it.

Shares provide a liquidity that doesn't exist in property, are easier to diversify in and require less active decision making than property. I know which one I'd rather invest in!!

Time for the lenders to get real

The major lenders still have this old time mentality that shares are risky investments and property is a risk free investment. They lend at higher ratios and charge lower interest rates than margin loans provide. My argument (and hopefully yours by now) is that shares are the less risky investment! You can easily diversify, there's liquidity and you're leaving the major decisions up to professional CEO's.

My challenge is for a lender out there to provide a facility, like a property mortgage, that allows well diversified portfolios to be geared into at high ratios, without the need for margin call for short term volatility, at an interest rate that is represented by the low long term risk of a well diversified share portfolio.

Until this day, the property investor will always have at least one argument against the share investor.