“Never make forecasts, especially about the future”
If only all advisors adhered to this piece of advice when talking to clients about what they can expect from their investment. There are lots of salespeople out there who like to dazzle people with future returns, especially when it comes to property. Who wouldn’t have their head turned by someone telling them they will get 10% a year.
Property returns given tend to be the rental yield, which is an indicator of how long it will take you to make your money back. Say you bought a property for €500,000 and the rent is €3,500 a month. The rental yield on this property is 8.4% and you will get your €500,000 investment back in 12 years through rental income.
Of course, this rental income is taxed each year (unless held in a pension) and the calculation doesn’t include the cost of purchasing the property, fitting it out, periods of vacancy, cost of debt, renovation costs. Over the long term, it is unlikely that the actual return, when all these extra costs are taken into account will be 8.4%. It also does not take capital appreciation into account, which can go up and down in value, but should yield a positive return over the long term.
When people look at investing in equities, they tend to look at past performance, even though those gains have already happened and you will not be able to enjoy them if you aren’t already invested. You rarely hear someone selling equities in the same way as property. In fact, a lot of advisors downplay the returns, looking at long term averages, which include crash periods. If we look at long term returns, the S&P 500 has annualised returns of 14.84% and 8.61% over 10 and 20 years respectively. But most advisors use an annualised return of 6%.
When looking at the returns of equities, it would be foolish to just look at the dividend (rental) yield. Lots of the top performing companies don’t pay dividends at all so your dividend is 0%. Warren Buffett’s company, Berkshire Hathaway, has paid a dividend just once, in 1967. Since 1965, their share price has increased by 2,810,536%, so you wouldn’t have done that badly from them. The reason that Buffett and others like Amazon don’t pay a dividend is they believe they can use the money better than you can, using it to grow the business with you benefitting from a higher share price. It would be like buying a terraced house, receiving no rent and being given back a detached house at the end.
And as there is no distribution from the company, there is no tax liability until you sell your shares (dividends, like rent are subject to income tax in the year they are received).
It is easy to get distracted by headline returns but you need to look at whether that is the real return you are going to get and what are the risks associated with it because risk and return are related. Can you get a better return from an asset for the same level of risk? It is important to compare what is available for the same risk.
Steven Barrett
19 July 2021