Buying residential property results in unavoidable concentration risk
The decision to purchase a residential property in Australia is an expensive one. The median property price in our two largest cities at the end of 2015 was $718,000 in Melbourne and in Sydney this increases to $1,013,000. Melbourne and Sydney have been called the fifth and second most expensive cities in the world respectively, based on multiples of household income.
Conventional wisdom says we should spread our eggs to reduce our risk, but when buying property it makes this very difficult. For most of us, we do not have this money just lying around so we require the assistance of banks to achieve a purchase, through a loan. What this means is that not only are we not spreading our eggs, but we are gearing even more heavily towards the potential success of this asset.
Obviously it follows that to buy a residential property in Australia most of us are taking a significant punt on the success of this asset class and fortunately for most of us, the residential property market has delivered. The fact that Sydney and Melbourne are amongst the most expensive cities in the world, reflects this.
But even considering Australia’s residential property success, some properties have under-performed. The very definition of a median is the middle of the best and worst and for those who have already selected an under-performing asset, the impact of a concentrated approach is already being felt.
To illustrate this, consider the performance of the Melbourne suburb of Officer, which was down 10% over a three year period, to August in 2015. Another example is mining town Karratha, which last financial year fell 32%. This second example is an extreme one, as we all know about the fall out of the mining boom and most of us would not have invested there in the first place, due to its highly speculative nature, but it does illustrate the point that not all property is created equally and there are several more examples to draw on.
It also highlights how vitally important it is to get the investment selection right as unlike other growth investments, like shares for example, where its likely your portfolio will be diversified to a range of companies, if you are only buying one property, your total portfolio success is riding on it.
Consider now how this could look if multiple investment properties are purchased. It’s not uncommon for property investors to try and compound their success, by consistently leveraging to further property purchases. Investing this way could deliver the best long term portfolio performance and again for many people in Australia over the past 30 years it has, however the point here is how it impacts concentration of risk.
Looking at the positives of multiple investment properties in a portfolio, it provides the opportunity to spread some of the ‘concentration risk’, by diversifying and purchasing in a different suburb or even more broadly a different state. It is, however, amazing how often I meet people who have invested a second, or even a third and fourth time, in the same area they hold their original investment. The logic being they have achieved some initial success and they feel they understand that particular market. On the point of concentration of risk, the implications are obvious.
Concentration of risk is something that all investors should be mindful of, regardless of how bullish they are on the specific asset class prospects. Simply put, high concentration of assets lends itself to periods of out-performance and periods of under-performance, compared to the alternatives, and with the impact of debt leverage overlaid into the equation, can result in being forced to realise negative outcomes by virtue of having fewer other options to draw on.
Property is a great part of a well-rounded portfolio of assets and several of our clients own investment property, however the point of concentration risk goes to the heart of good portfolio management. Regardless of how you choose to invest, the starting position should be to consider the five asset classes of Cash, Fixed Interest, Property, Australian Shares and International Shares against your personal objectives and risk tolerance. The better diversified you are, the lower the volatility generally speaking and being diversified provides more flexibility in trading in and out of investments, for personal or investment reasons, throughout the asset cycle.
James McFall, CFP®
Yield Financial Planning
The Advice Exchange http://www.yieldfinancialplanning.com.au/
James is the founding director of Yield Financial Planning and has over 15 years experience. A CERTIFIED FINANCIAL PLANNER® professional, he also holds a Master of Commerce (Financial Planning), and a diploma of Financial Planning.
Whether you are a professional or business owner, retired or contemplating retirement, James and the team at Yield are committed to helping you grow your wealth sustainably, protect your downside and retire with confidence and peace of mind.
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