Pete Wargent blogspot

Co-founder & CEO of AllenWargent property advisory, offices in Brisbane (Riverside) & Sydney (Martin Place) - clients include hedge funds, resi funds, & private investors.

4 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.

"Unfortunately so much commentary is self-serving or sensationalist. Pete Wargent shines through with his clear, sober & dispassionate analysis of the housing market, which is so valuable. Pete drills into the facts & unlocks the details that others gloss over in their rush to get a headline. On housing Pete is a must read, must follow - he is one of the better property analysts in Australia" - Stephen Koukoulas, MD of Market Economics, former Senior Economics Adviser to Prime Minister Gillard.

"Pete Wargent is one of Australia's brightest financial minds - a must-follow for articulate, accurate & in-depth analysis." - David Scutt, Business Insider, leading Australian market analyst.

"I've been investing for over 40 years & read nearly every investment book ever written yet I still learned new concepts in his books. Pete Wargent is one of Australia's finest young financial commentators." - Michael Yardney, Australia's leading property expert, Amazon #1 best-selling author.

"The most knowledgeable person on Aussie real estate markets - Pete's work is great, loads of good data and charts, the most comprehensive analyst I follow in Australia. If you follow Australia, follow Pete Wargent" - Jonathan Tepper, Variant Perception, Global Macroeconomic Research, and author of the New York Times bestsellers 'End Game' and 'Code Red'.

"Pete's daily analysis is unputdownable" - Dr. Chris Caton, Chief Economist, BT Financial.

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Friday, 17 August 2012

The Yield Trap

The Yield Trap
People often tell me they have found a good investment because of its high yield or income. Today I explode a few myths about why yield can be a very misleading indicator of the quality of an investment.
We need to understand the dimensions of yield and growth and how they interact with each other. This is beautifully illustrated by Peter Thornhill in his share investment book Motivated Money.
Back in 1980, he notes, term deposits were paying around 10% interest, so on the face of it were far more attractive investments than, for example, a portfolio of industrial shares, which were yielding only around half of this percentage. High yield (and supposedly low risk) investments tend to attract retirees who seek certainty of income.
There is a hidden trap, however, and it is this: a high yield is not the same thing as a high income.
High yield does not mean high income
A yield is simply a spot figure calculated at a point in time. Income of $100 on an investment of $1,000 gives a yield of 10%. Superficially attractive. Income is the dollar figure that the investment pays you over time.
Suppose a retiree invested $100,000 in term deposits in 1980. Income of $10,000 in the first year may seem more attractive than the lower dividend yield of shares.
By 1993, however, an initial $100,000 portfolio of industrial shares, whilst still paying a ‘weaker’ dividend yield of around 5%, was paying income of closer to $20,000, and by 2006 a huge dividend income of around $75,000 on a portfolio value of a massive $1.75 million.
What happens to the capital value and income of a term deposit over that time? Oh dear.

So much for the high yield!
Investing in high yielding investments upon retirement such as term deposits might only be a good investment if you plan on dying quickly. What we actually want, rather than high yield, is high income over time.
The percentage yields on shares over the long term tends to fluctuate with prevailing sentiment and prices, so yields do become comparatively higher when share prices crash (and lower when prices boom). Thus a stock market meltdown is a great time to buy both for yield and future capital growth.
The yield trap in property
There is much talk of the benefits of investing in properties which generate a high yield too. We do need to note, however, that high yields tend to exist where capital growth has been restricted due to uninspiring levels of demand.
Very similar principles apply to property as they do to shares. When prices are high, yields tend to be lower (and vice versa), but over a long time horizon we might expect rental yields to revert to a mean or average, and therefore what we actually want is properties which experience great capital growth. The rental yields will generally follow over time.
Counter-cyclical property investors get great yields anyway!
If you elect to invest counter-cyclically in property when sentiment is low, you can attain excellent yields on prime location property – just as share investors who invest after a crash get great dividend yields on blue chip shares.
The chart shows the phenomenal increase in dwelling prices in Melbourne experienced since 2007 as compared to other capital cities.
Obtaining higher yields counter-cyclically
Depending upon which provider you source the data from, the average rental yields you might expect to see on apartments range from a mediocre 4.5% for Melbourne to somewhere around 5%-5.4% for Sydney, and higher still for Brisbane at 5.5%.
In other words, by electing to invest in property which has recently experienced sharply rising rents but not capital growth, just like share investors, counter-cyclical property investors expect to receive both future capital growth and a solid yield too.
Smart investors look for rental yields above the quoted average and manufacture higher yields too by adding value to properties through cosmetic renovation.
Thus if average properties in prestige suburbs can easily attain 5.5% yields we should question how much value  there may be in seeking out yields of 6% if this involves investing in an area which over the long term will not experience as great a level of demand?
Apartments in the inner suburbs of Sydney, for example, will over the coming decades experience a phenomenal increase in demand due to population growth, while construction remains inadequate and costly.
What does this mean in real life?
OK, so I may have bored you with the theory. What does it mean in practice? What can growth do for us as investors?
Being an Anglo-Aussie I frequently refer back to what is happening in England for clues, as some of the property markets there are more developed. While many property investors in the UK regions who bought in the period after 2005 are owners of property with negative equity, prices in London continue to surge to the highest they have ever been.
Ask people who bought a house back in the 1980s and 1990s in Britain how they've fared and they say: “I have done well”. Why? Because the property is worth more in dollar terms than they paid for it.
Buy have they really done well? Most likely they have no idea because mostly they have few other investments and no worthwhile benchmark against which to measure performance.
Typically, house prices moved upwards through the inflationary 1980s and somewhat further as credit growth expanded in the 1990s, but have tailed off in most areas outside London over recent years.
The winners
I know of people, though, including some Aussies, who many years ago bought only one or two properties in prestige areas of London such as Mayfair and the West End, who now have little interest in paid employment because the price of their properties has increased so substantially.

As you might expect, whilst their yields remain relatively low on a spot figure percentage of property price, their rental income is staggering. A 3 bedroom flat in Mayfair today tends to rent for somewhere between £125,000 and £350,000 per annum (≃$200,000-$500,000).

So much for those lower yields!
Expect to see similar trends unfolding in Australia, with properties in prestige suburbs of the major capital cities over time being massive outperformers both in terms of rental income and capital growth. Lower yields, maybe, but far, far higher income. Understand this fundamental difference and you can be a winner too.