So the answer is; our intuition is probably right but let’s prove it.

WHY DO WE INVEST IN HOUSING?

The simple answer is that we intuitively understand that housing is the lowest risk asset with the best returns around, but is this right?

Well the Reserve Bank and our lenders think this is right also. Our banks wouldn’t be prepared to be such aggressive lenders in this area if they didn’t agree. Further, the Reserve Bank wouldn’t require the banks to only set aside 50% of the capital for housing loans that they have to set aside for other categories of loans if they didn’t share the same view.

So the answer is; our intuition is probably right but let’s prove it.

The two most important considerations in capital investment in an asset are risk and return. You want to ensure that your capital is well-spent and will yield significant return. But given that the future is not always clear, you cannot be guaranteed any particular amount of return. There is risk, and you want to minimise this.

You will find that both risk and return vary depending on the asset class and the term of investment. All of these factors are closely related. Depending on the underlying volatility of the asset, the return can fluctuate wildly in the short-term, but will generally stabilise in the longer-term to be within a tight range. The volatility generates our risk as it may be such that we will have difficulty in picking or being able to, due to circumstance, to sell at a time when our return is best or we even worse our asset is worth what we paid for it.

The best way to judge an assets performance is to remove inflation as we want to be able to consider our constant spending power so in the following paragraph we consider a number of asset classes adjusting for volatility (risk) and inflation.

As each of us have different tax positions we will not consider tax in this discussion to keep it simple and likewise we will not include costs of holding, selling of buying any assets. Note that if you want of include the cost of property ownership then reduce the after inflation quoted returns quoted in this note by say 1.75% to 2%pa provided the asset is held for about 10 years.

We will use the average gross real (after adjusting for inflation) growth in a quarter, expressed as an annual figure, as our measure of return. This average is taken over all quarters where data is available (as far back as 1980), so is a very good indicator of long-term return.

The following table shows the return of our asset sectors over the last 10 years.

The following table shows the return of our asset sectors over the last 20 years.

Based on data from the last 20 years, the best returns have been seen in the Melbourne and Brisbane property markets; with up to 12% annually, while Sydney property is also providing high returns, it is some 3-4% less. The advantage of the property market investments is that these assets derive return from both intrinsic appreciation and rent.

The share market yields returns less than the levels of Sydney property, with the All Ordinaries in the order of 6% and the All Industrials at 5.5%. Investment in Property Trusts has seen returns lower than all house and share market asset sectors considered, at just under 4% pa. Since the Trust derives growth from property, it would be expected to show similar returns to our property sectors, but this is not the case because the Trust includes foreign properties, which are not so closely linked to the Australian market. Further, the global property meltdown has had a more significant impact on foreign property markets.

Investments in the Treasury assets (Bonds and T-Notes) have been shown to provide similar return to the share market averaging between 4% and 7% per year.

Note, the return figures as tabulated are for the broad asset class only and calculated as at 30/6/2009, and certainly do not apply to every constituent asset in the class. For example, the table is not saying that every single unit in Melbourne will grow at 12% pa. Some will over perform, while others will under perform, but the typical Melbourne unit should average the figure of 12% pa in the long-term. Likewise, shares in not every company listed in the All Ordinaries Index will grow at 7% pa, though the average one will.

Now lest consider the risk for each. We have indicated that risk can be measured in terms of volatility generally and one measure may be to consider its volatility in terms of its ability to keep constant pace with our spending power; grow at, at least the rate of inflation. The following table shows the short-term risk of our asset sectors in terms of that measure in any one quarter.

We can now combine our risk and return numbers and present in a chart which shows which are our best investments.

The graph has been divided in quadrants to make it easier to rate the assets. The bottom-right quadrant contains the most desirable assets, having high return at low risk. All of the property investments are either contained in this quadrant or are close to it, making them the most desirable. This is particularly true for long-term property investments; where the property is allowed time to achieve its expected return and expenses such as council rates and strata fees become insignificant.

The graph shows that our share investments, however, are highly volatile and do not generally match the expected returns seen in property. The return from shares is substantial though, and their volatility makes them ideal for short-term speculative investment, but only for the risk-taker. Remember, there is potential for large losses as well as large profits and timing is critical.

The low-risk low-return nature of T-Notes leaves them useful for countering the erosion effect of inflation in the short term. For longer terms, property provides much better return for just as low risk.

So it is clear, you intuition was right and the Banks and the Reserve Bank have good reason to take the stand they do and provide funds for housing.