Property investment: residential or commercial?

There is no doubt that New Zealanders love residential property as an investment.  The reasons why are easy to note: property is a tangible, easily understood investment – you can see it, touch it, manage it yourself (if you choose).  It generates cash via rent, offers some tax advantages, and generally speaking capital gains have been stellar over the last 20 years, although the market has been flat at best in Auckland for the last 3 years.  

Partly this love of property also dates back to the NZ share market surge and subsequent world-worst crash in the late 1980s.  Many people over 50 today were burnt badly, and have avoided shares ever since.

But for investors looking for exposure to property, commercial property may be a better option – particularly by investing in listed commercial property companies that each own a significant portfolio of commercial properties.  In New Zealand, this is through companies such as Kiwi Property Group, Goodman Property Trust, Precinct Properties, Stride Group, etc. 

The advantages of listed commercial property compared with residential property are:

  • Part ownership.  Rather than buying an entire residential property, investors can enjoy part ownership by buying shares in the listed property company.
  • Liquidity.  Similar to above, investors can sell some or all of their listed commercial property investment on the NZ share market.  Much quicker and easier than selling a house.
  • Yield.  Commercial property typically generates a higher income yield (rental income as a percentage of purchase price) than residential property.  In a market like Auckland, where residential yields can be below 3%, the difference can be significant – commercial property yields above 6% are common.
  • Costs.  Costs are usually lower for commercial property v residential property.  This includes the cost of property management.
  • Diversification.  Listed commercial property companies own a number of properties, often in different geographical areas and sometimes across different segments of the commercial property market – industrial, office and retail.

Overall, property of any description is an excellent growth investment which has the added advantage of generating strong cash flows.  It often performs well when equity markets are in retreat or when interest rates are low, and helps to reduce overall portfolio volatility.  But investors should consider commercial property as an alternative to residential property due to its easier accessibility and superior liquidity.

 

Dean Edwards

 

KiwiSaver Update

KiwiSaver, which began in 2007, is undoubtedly a NZ retirement success story, having grown to around $50 billion invested in the 12 years since its inception.

There are many aspects of KiwiSaver which make it a no-brainer for most people, including:

  • deductions that happen automatically (before you have a chance to miss the money)
  • the payment from the Government each year (free money)
  • matching employer contributions up to 3% (free money)
  • a good range of different KiwiSaver providers and different investment approaches (choice)
  • the ability to use your KiwiSaver to fund a first house purchase or for financial hardship (flexibility)

There are also several changes that came into effect on 1 April this year which are worth noting:

  • a broader set of contribution rate options, now 3%, 4%, 6%, 8% or 10%, although note that most employers will still only match your contribution up to 3%
  • a break from contributing to KiwiSaver is now called a Savings Suspension, not a Contribution Holiday (which sounded too positive!)
  • the payment from the Government is now called a Government Contribution, not a Member Tax Credit
  • People over the age of 65 can join KiwiSaver (from 1 July), and there is no lock in period before they can make withdrawals.

The last point is significant as it will open the door to some KiwiSaver products which are great for over 65s, but to date have been inaccessible if the person wasn’t already a KiwiSaver member.  For example, the Guaranteed Income KiwiSaver Fund offered by Simplicity, which provides an ongoing annuity payment, and is a good way to generate a regular income stream from your retirement savings.

Dean Edwards

Auckland residential property as an investment

I often end up discussing the merits of residential property as an investment with clients.  As I am Auckland based, as are most of my clients, this is usually specifically relating to Auckland residential property.

There is no doubt that the Auckland housing market has seen spectacular growth over the last 20 years.  From 2001 to 2017 average house prices increased by around 170%, fuelled it would seem by a combination of rapid population growth and low interest rates.

But Auckland house prices have plateaued.  There has been little change from around September 2016 until now.

In my view, the major factor in the cessation of growth is that affordability limits have been reached.  Houses have simply become too expensive for many prospective purchasers to afford.

In addition, a raft of public policy changes have been introduced to alter the demand/supply balance or to improve affordability, including:

  • Auckland Unitary Plan rezoning
  • Special Housing Areas (National) and KiwiBuild (Labour)
  • Loan to value ratio restrictions
  • Foreign buyer restrictions

And more are coming:

  • Removal of ability to offset rental cash flow losses against other income
  • Capital gains tax changes
  • More favourable terms and rights for tenants

A net result of all this is that I am cautious about the short/medium term prospects for Auckland residential housing as an investment.  My feeling is that the current flat housing market may continue for an extended period (perhaps many years), but there is also potential for market declines due to the combined impacts of the above policies, with additional risks if interest rates begin to rise.  I’ve heard a number of times that the Auckland housing market will never fall, but I’ve seen it first hand when I lived in London, and it is currently happening in Melbourne and Sydney.

My preferred property investment is commercial property.  Prospects for the sector are generally good, rental yields are significantly higher, it’s an easy investment to access via property companies or property funds (which also provides diversification and liquidity).  And finally commercial property is an excellent defensive investment – often performing well when equity markets are struggling.

Dean Edwards

Equities are on sale!

Well, its been a wild ride for equity markets over the last quarter of the year.  In fact, a bumpy downhill slide might be a better way of characterising what has happened.  All major markets are significantly down over the quarter.  As I write, the major market indices have fallen 7% for New Zealand, 12% for Australia, 11% for the UK, 14% for Japan and 13% for the US from their high points in September.

I’ve yet to come across an investor who enjoys seeing the value of their investment portfolio fall.  But in fact, significant market corrections, the likes of which we are going through now, do represent good buying opportunities.  A good way to look at it is that equity markets are currently “on sale”, and it’s a good time to get a bargain.

This is where portfoilio rebalancing comes into its own.  All investors should have defined an appropriate asset allocation based on their personal situation, financial objectives and risk profile. As an example, a “balanced” investor, might have a benchmark portfolio of 50% growth assets (shares, property) and 50% defensive assets (fixed interest, cash). 

But now, with the market turmoil, that balanced investor may find that equities only account for 40% of their total portfolio.  This is a strong signal to convert some fixed interest funds into equities, to return the weightings to 50/50.

This can be hard to execute. If markets have fallen, it can feel very wrong to be buying.  But it is the right strategy to maintain an appropriate risk profile (avoiding your portfolio becoming too risky or too conservative). And if done well it’s a structured way of buying low and selling high, and can make a meaningful difference to your long term portfolio returns.   A note here that you should also rebalance when the opposite happens i.e. when equity markets surge ahead.  This is a sell signal, to again return your portfolio to its benchmark asset allocation.

Going forwards, there are a few global issues that might make markets jumpy in the short term: US/China trade tensions, Brexit, rising US interest rates, etc.  I encourage investors to keep a long term perspective, stay invested, don’t get spooked by short term market volatility, but do look for opportunities to rebalance when the markets are having a sale.

Happy holidays!

Dean Edwards

The emotional impact of market downturns

A rocky month of October for equity markets has come as a rude wake up call for many investors who had become comfortable with several years of steadily increasing returns.

How you feel about your investments during the bad times is often a great way to assess whether you have the right mix of growth and defensive assets in your portfolio.

To illustrate this, consider the portfolio outcomes for and an aggressive investor (100% equities) and a balanced investor (50% equities, 50% fixed interest) during short, medium and long term periods where equity markets fell.  This is based on the actual yearly returns of the benchmark US S&P500 Index:

 

Investment portfolio performance during the following periods: Aggressive Investor Balanced Investor
One bad month (October 2018) -7% -3%
One bad year (2008) -37% -18%
Three consecutive bad years (2000-2002) -42% -20%

Ask yourself whether you could cope with seeing your investments fall for 3 years in a row, and over 40% in total, which is what happened in 2000-2002?  Or if you could handle a 50% drop in 2007/8? (for calendar year 2008 the fall was -37%)

If the answer is no, then you are probably better off having some defensive assets in your portfolio (eg. bonds, fixed interest investments), which usually provide steady returns even when equity markets are tumbling.  The above table shows how a balanced investor would have faced losses less than ½ as much as an aggressive investor, during the same negative periods.

For the majority of investors, having some defensive assets in their portfolio helps to cushion the fall during market downturns, plus provides a pool of money that can be used to rebalance a portfolio if indeed equity markets do fall significantly, by buying more equities when they are cheaper.

Yes, this approach will come at the expense of greater returns when markets are rising, but if your losses during crashes are not catastrophic, you will feel better emotionally, and you are more likely to stay the course and not panic sell at the worst possible time.

 

Dean Edwards

 

Musings from the US

I recently returned from a 2 week vacation in the US (it was great to briefly escape the miserable Auckland winter!).  While in the States, I couldn’t help make a few very unscientific observations, based purely on what I did and what I saw:

  • The parts of the US economy most visible to a tourist appear to be thriving.  I’m talking airports, hotels, shops, restaurants, night spots, attractions, etc.
  • The scale of the US (and the US economy) is just so big.  You notice this particularly when you see the size of the transport networks, the massive ports, criss-crossing airport flights, vast industrial areas, and extensive competition for just about everything.
  • More than any previous overseas trip, I was totally reliant on the services of major US technology companies.  I used Google Maps and Google searches constantly; I stayed connected via Microsoft OneDrive and handled emails with Outlook; transport was often via Uber or Lyft;  I shopped on Amazon and ebay; I Facebooked.   I didn’t however use any Apple product or service (and probably never will … some habits die hard!)

From an investment perspective, everything I saw and did highlighted the importance of having highly diversified investments.  In this part of the world we have no exposure to the huge US technology sector (Apple, Google, Microsoft, etc), let alone other huge sectors such as automotive and pharmaceuticals.  The US economy is surging ahead, while the NZ economy is slowing.

And lets not forget that the market capitalisation of US stocks is around $30 trillion or just under half of the world’s market cap.  The US is big!  Stock prices have risen significantly over the last few years, but are supported by very strong company earnings.

Granted, there is an unstable president at large in the White House, but despite this, the US seems to be surging forwards, and still looks to me like a good place to invest.

 

Dean Edwards 

 

 

Questions of legacy

Many of the middle aged and retired clients that I see have an understandable desire to leave a legacy for their children – usually in the form of an inheritance of financial assets and/or property.  Often this is a reflection of their upbringing – in many instances they benefited from an inheritance themselves when they were younger – and also an ingrained belief that they should pass on their wealth to their children.

A traditional legacy involves leaving behind your remaining wealth to your children when you die.

However, life expectancies have increased and are likely to increase further, and this raises the question of whether providing an inheritance after you die is leaving it too late.

A person reaching the current retirement age of 65 has a very realistic chance of living to 90 or beyond.  The implications are that children may be aged in their 60s or 70s by the time that person dies.  In fact the children may have retired themselves!  60 or 70 is a relatively advanced age to receive an inheritance.  Financial patterns are set, assets are often well established, and simply put, children of near-retirement age may not have as much need or be able to benefit from an inheritance as much as a younger person.

A better option may be to distribute some of the wealth intended as a legacy well before you die.

Consider some of the advantages:

  • Children are more likely to be at a stage in life where receiving some financial support could be of real benefit – for example, buying a first house.
  • Parents can be actively involved in how the financial support is provided and how it is utilised – ie they can set the rules and are there to provide guidance.
  • Parents will also be able to see their children benefiting from the financial support, which can itself be tremendously satisfying.

To provide a “while-living legacy” you will need to have a good handle on your net worth, how much you are likely to spend as you get older, how those costs can be met, what you will need as a safety net, and the returns you can expect from your investments.  You can then make a (conservative) estimate of what you could provide as a legacy.  If that sounds daunting, a good financial adviser will be able to help.

You may also need to get good legal advice.  Gifting is no longer taxable but there still could be unintended consequences (as there can be with wills and inheritances).  For example, gifts made to a child in a relationship that subsequently ends may find that half of that gift goes to the other partner.

 

Dean Edwards

 

Comparing NZ passive funds

For many investors, their preferred investment style is via passive, index tracking funds.  Passive funds are typically characterised by low management fees, as the funds automatically hold all of the shares within the particular index they track, and don’t need to employ a fund manager/research team to pick stocks that they believe will outperform (this is the domain of Active funds).  Hence the management costs for Passive funds are low compared with Active funds – a significant advantage they hold (for a more detailed look at Active v Passive funds, see my earlier blog post here).

For Passive investors investing in NZ equities, until recently the only choice available (outside of KiwiSaver) was via SmartShares, which offer a range of funds including the NZ Top 50 Fund which, as the name suggests, invests in the 50 biggest NZ companies.  The management fee is 0.5%.

However this position has changed recently, with KiwiSaver/investment fund provider Simplicity introducing the NZ Share Fund.  This also invests in the top 50 NZ listed companies, but significantly, the management fee is a mere 0.1% – one fifth of the fee charged by SmartShares.

On the surface favouring the Simplicity fund looks like a no-brainer.  However, there are some important differences in the two offerings worth noting:

  • The SmartShares fund has a 5% cap on any individual stock, the Simplicity fund doesn’t.  SmartShares argues that the performance of the “capped” index has been better than the uncapped index by 0.63% pa over the last 10 years.
  • For SmartShares, investors can choose to have dividends paid in cash.  For Simplicity, dividends are reinvested.
  • The minimum investment is $250 for SmartShares, $10,000 for Simplicity.

What is my view?

One of reasons I have favoured (good) Active fund managers for NZ investments is that the management fee of the SmartShares passive funds is too high and does not provide a significant enough cost advantage over the (good) Active fund managers.  The Simplicity offering with its 0.1% fee is much more in line with overseas passive fund costs.  It will be interesting to see how SmartShares responds, and if they lower their fees. 

As it stands today, I favour Simplicity over Smartshares for NZ passive investments in the top 50 NZ companies (assuming the investor has the $10k minimum).  The ability to have dividends paid in cash with SmartShares is nice, but of secondary importance.  And I’m not sold by the historical outperformance of the 5% stock cap (this doesn’t mean the capped fund will outperform over the next 10 years).    

As they have done with KiwiSaver, it’s great to see Simplicity also entering the NZ passive investment market, and giving it a good shake up!

 

Dean Edwards

 

Note: I am a fully independent Financial Adviser and do not receive any commissions, payments or incentives from any product providers.

 

Designing the perfect investment portfolio

Many (maybe most) investors are looking for the perfect investment portfolio – the ideal mix of investment assets that will lead to outsized gains, and low volatility, over an extended timeframe.

There are many, many factors to consider in designing an investment portfolio, and an almost infinite set of criteria that can be applied.  A by no means definitive list of options could include: stocks v fixed interest v property v cash, passive v active management, developed v emerging markets, NZ v Australia v international, currency hedged v unhedged, short term bonds v long term bonds v term deposits, commercial v residential property, value v growth, high v low volatility, momentum v contrarian, etc, etc.

Unfortunately, building the perfect portfolio is only possible in retrospect.  There simply is no way to definitively know what particular mix of investments will be best going forwards.

That said, I do have some recommendations for designing an investment portfolio:

  • Define your investment goals. What do your investments need to deliver to meet your goals?  Are your investment goals compatible with your risk profile (see next point)?
  • Set the right risk tolerance. This is the degree to which you can stand ups and downs.  Ups are all good, but can you cope with your portfolio losing 30% in one year?  This is a financial capability question and an emotional tolerance question.  If you can’t cope, either financially or emotionally, design a less risky portfolio (as long as it still meets your investment goals).
  • Match your asset allocation to your investment goals and risk tolerance. If you really couldn’t cope with a 30% fall in the value of your investments, don’t invest everything into shares or property (as an example).  A financial adviser can help with this.
  • Keep things simple. This is easy.  If you don’t understand how an investment works, don’t invest in it.
  • Diversify. Diversification is one of the few “free lunches” available to investors.  A well diversified portfolio (a large spread of investments) can achieve the same expected returns as a less diversified portfolio, but with lower volatility.  It’s a theoretical advantage worth having.
  • Rebalance. Your ideal portfolio may be 50% shares and 50% fixed interest.  If your actual mix strays significantly from this (say more than 15-20%), it’s time to rebalance back to your ideal mix by selling some assets and buying others.  This is a disciplined way of selling high and buying low and works when markets are rising or falling.
  • Sick with it, and be patient. Maintain your portfolio mix for years, and maybe even for decades.  It’s easy to get excited by the latest fad – crypto currencies, tech stocks, Auckland real estate, whatever.  But don’t get sucked into chasing returns by “skating to where the puck was”.  This will usually be counter-productive.

It’s highly likely that your investment portfolio won’t turn out to be the optimal portfolio – there will always be portfolios that will do better (higher returns, less volatility) – but you won’t know which ones until after the fact!  However, if you do stick with the above guidelines, you will be giving yourself a very good chance to be successful and to meet your financial goals.

 

Dean Edwards

Term deposits: what if you need your money in a hurry?

Despite bank interest rates for savings being at historically low levels, term deposits remain popular investments for the defensive part of an investment portfolio.  I also support the use of term deposits; in the current environment of low, but gradually rising, interest rates, they are often a better alternative than bonds, where there is a real risk of capital losses if interest rates do rise (note the opposite applies in times of declining interest rates).

But sometimes life comes along and interrupts the best laid plans, and you need access to your term deposit money in a hurry.  What happens?

Usually banks will allow you to break term deposits.  However, the rules applied around these breakages vary significantly from bank to bank.

In a recent example, a client with similar term deposits held at both ANZ and RaboDirect needed to get cash in a hurry to settle a house purchase.   For RaboDirect, the term deposit could be broken immediately, with funds available that day, no loss of accrued interest, and no other costs incurred.  However for ANZ, there was a 30 day notification period to break the term deposit, and a loss of interest of 3% for the portion of the term deposit broken – which would be charged back if the interest had already been paid out.

These are significantly different treatments between banks of essentially the same situation.

The moral of this story is when making term deposit investments, understand the bank’s policy if you need to break the term deposit for any reason.  There are other factors to consider with term deposits than just the headline interest rate.

 

Dean Edwards

 

PS.  This is not a recommendation for RaboDirect over ANZ (or any other bank) for term deposits.  For RaboDirect, breaking term deposits can sometimes result in penalty charges – it depends on the term, current interest rates, and historical interest rates.  The point is that this is important knowledge to be armed with when making term deposit decisions.