How the Power of Gearing makes Property a Better Investment than Stocks and Shares
Debating the pros and cons of investing in stocks and shares versus investing in property is a popular subject amongst analysts, brokers and investors. This debate is often conducted under the guise of comparing traditional pensions versus property investment, as most traditional pensions are invested in global stock markets.
Stock market analysts will often accept that property is the better investment in a given year compared to stocks and shares. However they will often fail to take into account some of the major advantages that property investment has over stocks and shares when declaring that stocks and shares have ouperformed property in another year.
For example, a stock market analyst might attempt to promote investments in stocks and shares by stating something like this:
“Last year average property prices increased 7% and the stock market was up 10% so stocks and shares performed better and represent a better investment.”
While the facts as stated, in terms of percentage gains, are entirely true, to claim that this automatically makes stocks and shares a better investment is very misleading. It is understandable that, after giving such figures a cursory glance, you would believe that in the‘last year’ you should haave been investing in stocks and shares . Indeed that is exactly the conclusion the analyst might want you to reach.
Gearing and the Return on Capital Employed
The Return On Capital Employed (ROCE) from property in this case will have easily been far higher. Why? Because you can borrow money from a bank or other lending institution to buy property and secure the loan against the property that is being purchased. This means that you only need to invest the amount of your own money required to pay the deposit on the purchase rather than the full price of the property. This is often referred to as Gearing or Leverage and it is not something that can easily be achieved when investing in shares.
Banks will generally not accept shares as security since they are considered highly volatile .Not only can they go down in value as well as up but, they can in certain instances lose almost all their value in a very short space of time. Companies can quickly hit huge difficulties due to factors such as poor management, strong competition and unfavourable market conditions. For example, shares in the HBOS group were trading at around £12 each before the credit crunch hit Britain, only to fall to be values at just a few pence during the height of the crisis. Such volatility simply does not occur in property markets. Despite all the media talk of a crash of epic and unprecdented proportions in the UK property market between 2007 and 2009, the average house price decline amounted to around 15% at it’s worse.
The power of Leverage can be seen in this simple example:
In order to buy £100,000 worth of shares you need £100,000 in cash, but to be able to buy a £100,000 property you would typically need £20,000 because you are able borrow the rest from a bank. Banks are happy to secure the £80,000 loan against the property being purchased, safe in the knowledge that people will always need somewhere to live ensuring that demand for the property, and long term price rises, will almost certainly guarantee the safety of their loan in the event of default
After a property is purchased and a mortgage isput in place you are then able to rent the property out to service the cost of the loan and other expenses and in many cases provide extra profit.
Using the above example we can examine the ROCE in 2 scenarios, one in a year where percentage gains were higher in property and another in a year in which percentage returns were higher in shares.
| Year 1 | Capital Invested | Asset Value at Start of Year | % Increase Over Year | Profit |
| Stocks & Shares |
£20,000
|
£20,000 | 7% | £1,400 |
| Property |
£20,000 |
£100,000 | 10% | £10,000 |
| Year 2 | Capital Invested | Asset Value at Start of Year | % Increase Over Year | Profit |
| Stocks & Shares |
£20,000
|
£20,000 | 10% | £2,000 |
| Property |
£20,000
|
£100,000 | 7% | £7,000 |
As you would expect property provides the better return in the year when property prices rose higher than share prices – delivering a massive 50% ROCE with just at 10% rise in prices. However, due to the power of gearing, property also provides a far superior return to stocks and shares (2.5 to1) in the year that share prices rose higher than property prices.
As you can see, the Return on Caital Employed (ROCE) is a far better inidciator of profitablility than the headline percentage return for an asset class.
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