I am often asked whether it is better to invest in a rental property or into a diversified investment portfolio. To help answer that question I will quickly outline the differences in this apples and oranges comparison.
Let just consider a single self-managed residential rental property purchased with the help of someone else’s money via way of a mortgage.
One key benefit of owning a rental property is the ability to use borrowed funds to multiply the returns on your initial investment. If you take out a sizeable mortgage added to your smaller deposit to make the purchase you effectively gain control of an asset worth several times your initial investment. This gearing up or leverage can provide exceptional capital gains in an environment of rising house prices.
Returns you make on the property are made up of your rental income and theoretical capital gains minus all your expenses such as maintenance, rates and your own time put into managing it. New Zealand rental properties have a long history of solid performance which provides a good deal of comfort to many people familiar with this type of investment. These investors often appreciate the fact that you can see and touch it, being a solid bricks and mortar investment along with tax benefits.
Things to consider
Having your own and borrowed funds invested in a single rental property in New Zealand is a very concentrated risk. New Zealand makes up well less than 1% of the global economy as measured by Gross Domestic Product (GDP). Actually, we currently make up 0.2345% of global GDP (IMF figures) but even though we are small there is nowhere else I would rather be during this time of pandemic.
Having one rental property in this region is effectively putting all your eggs in the one very small basket. If you needed milk for your coffee would you own just one cow (or 0.2345% of a cow) and take the risk of something happening to your cow, or would you prefer to get your neighbourhood together, collectively own 100 cows and guarantee there was a share of milk for your coffee each morning?
Let us consider a diversified portfolio of investments recommended by a suitably qualified Authorised Financial Adviser (AFA) with the portfolio held by a custodial wrap platform like that offered by Investment Custodial Services Limited (aka Aegis).
One key benefit of the type of investment portfolio we provide is diversification. It may seem like a single investment as you will generally focus on a single total portfolio return figure. However, that return is made up of all the underlying interest payments from bonds and cash, dividend payments from shares, distributions from managed funds, and any capital gains, all consolidated into one figure. You own many different assets spread across sectors and geographically.
If an asset held within your portfolio does poorly then generally other assets offset this with outperformance. For example, during the initial stages of the Covid-19 outbreak, Australasian listed property went down in price dramatically as investors predicted the death of retail shopping mall spending. Because listed property was only one small part of the greater whole, portfolios were able to come through that phase relatively unscathed.
If you had only owned shares in the Kiwi Property Trust which owns Sylvia Park, you would still be down about a third since the start of this year. The same may be true for direct owners of smaller individual retail premises, but since valuations are only conducted sporadically this will not be realised until the owner goes to sell.
Always having a market value can be both a blessing and a curse for investment portfolios. Generally, assets held within portfolios can be readily bought and sold which will create fluctuating portfolio values on a daily basis. If you could see the value of your rental property going up and down by tens of thousands of dollars daily, would that make you nervous? Your professional adviser is there to take that stress away from you so that daily fluctuations should not be a concern.
Always remembering that investment portfolios along with rental properties are considered longer term investments and not speculative assets to be traded all the time. Also note the professional advice and custodial fees you pay on your portfolio are usually tax deductible. Simple consolidated end of year tax reports are another benefit.
Things to consider
As with a rental property your investment portfolio returns are not guaranteed or certain as they contain an element of capital gains. If capital gains were certain you would simply put all your money where you could get the greatest gains. Since we can never be 100% certain which asset will provide the greatest gains, we spread your risk using your portfolios asset allocation. This way we hope to capture those gains but also protect your investment from unnecessary losses.
I am an enthusiastic fan of diversifying your risk by owning a spread of shares/cash/bonds/managed funds/listed property/infrastructure/hedge funds and alternative assets all contained within one investment portfolio. You will find people equally as passionate about the virtues of direct rental property ownership and there is no right or wrong answer.
Any investment options need to consider your individual goals and objectives as well as your timeframe for investing. To discuss your options please contact one of our team of advisers, we are here to help. As I said at the start, this is definitely one of those apples versus oranges comparisons.
We had a booklet called ‘making better financial decisions’ that explains this in more detail.