By Jan Vlok, 6 March 2017
This is a difficult question to answer simply. All of us have an ambition to invest our hard-earned funds as optimally as possible to ensure we maximise returns. This question is particularly important considering that a one or two percent difference in annual returns significantly impacts the longer-term result.
To try to answer this question, the figures should be thoroughly investigated. The following table shows the annual average returns of shares (measured by the FTSE / JSE All Share Index), money market yields (SteFI Composite Index) and direct residential real estate (average prices of South Africa). This draws a comparison between the potential returns that an investor in the stock market can earn in a bank account versus direct property.
Once the figures are taken into account, it is clear that an investment in equities over the long term provides the highest yield. Also, we saw that direct property prices experienced a boom period during 2002-2007 with an average annual return of 18.2%, and began to show signs of slowing (2008-2016) by delivering an average return of 3.8%.
However, the choice is more complicated than simply considering returns over different time periods. Every South African knows that Cape Town property growth will be more attractive than property yields in smaller towns up-country. So geographical location must be taken into account. If the average annual return of the Eastern Cape (7.8%) is compared with that of the Western Cape (9.3%), it is clear that location plays an important role. This phenomenon is further accentuated with the stagnation of the overall residential property market compared to metropolitan areas, especially Cape Town which still experiences a boom in house prices.
It is also important to understand that the above figures exclude rental income. This component ensures, on average, 5% - 8% additional returns per year in rental yield. The issue of rental yields is more applicable if direct property is bought with cash as opposed to using bank financing. If the rental income is taken into account (at the lower limit of 5%), property falls into the same category of return as equities over the long term (14.65% vs. 14.79%). The choice of investment vehicle will depend on a set of additional factors. These factors are briefly highlighted below.
Once an individual decides to buy a property, the decision is obviously long term in nature (assuming that the buyer does not speculate) and the term is usually 20+ years. If high yields are the ambition, an investment in shares over the longer term, in the area of 7+ years, is warranted. So the investment horizon of residential property is longer than equities, although both must be considered a long-term investment.
Withdrawal from an equity fund (unit trust) takes place within a few days by simply signing a form, while the conversion of direct property to cash is a lengthy process. This aspect is particularly important in cases where your investment may have to serve as an emergency fund. Investments in shares are much more liquid than direct property and only slightly less accessible than money market funds (compared by days to access funds).
No bank will provide a loan of R1 million for an investment in shares - there is no tangible asset to place against the loan. Property, however, has tangible value and a loan can be negotiated for this value. This is a very attractive proposition, using the bank's funds to build your wealth. However, provision must be made for factors such as unforeseen expenses, bad tenants, vacant property in the absence of tenants and most importantly, the interest rate you pay and any possible interest rate increases.
In the case of share sales, investors will pay an individual capital gains tax on the increase in value, as well as interest and dividends tax to a lesser extent. In the case of direct property, the interest can be written off for tax purposes. There are clear tax benefits in property, but with the rise of tax-friendly investment vehicles such as the tax-free savings accounts introduced in 2015, tax efficient solutions for equity investments are now more accessible.
It is assumed that the ownership of property gives you a sense of status. The possession of a physical asset means more to most individuals than simply the financial value attached to it. Property may provide more personal satisfaction than an investment in the stock market. While emotional aspects may make property more attractive, it adds to the risks involved when investing in shares. Investors like to monitor the values of their investments and usually fall into a trap, driven by their own emotional biases. Some of these risks include selling shares when markets are down - the most important time to stay fully invested.
The above arguments show that the choice is not simple. It depends on specific investor circumstances and emotional considerations. Equity investments, through a mutual fund or a tax-free savings account, seem to be a more convenient way to invest your funds and enjoy growth. The historical returns are attractive, it is a very liquid investment, is accessible and the effort to invest is minimal. There are no unforeseen costs and your assets cannot be reclaimed through a financial institution. Do not write off property as an investment though, as leveraging the bank's money to work for you is a very attractive strategy. This applies only if you do your homework, however. If you can get good interest rates, find a property at a good valuation, and are willing to be actively involved in the management of the asset and you have sufficient additional liquidity available for any unforeseen costs, then property may just be your best option.