The Comparison Challenge – Super, Shares, Property

I received a question recently for my Ask an Expert column where the reader was comparing the annual income they received from their investment property, against the growth in the value of this superannuation fund. Their conclusion, looking at the numbers, was that they should sell the investment property and shift all the money to super.

But their comparison was flawed on multiple levels. So this week I thought I’d talk you through the differences across the main investment options to help you consider what the best path might be in your particular situation.

The first thing that we should make clear is that whilst it is true that for most of us with a lump of money to invest, we would consider the options of super, shares, and property, this is a little erroneous because superannuation is simply a tax structure. When you invest your money in super, it may be that the money is then flowing into shares or property. Whereas shares and property are asset classes, super is just an investment structure with concessional tax treatment.

Having covered that reservation off however, let’s now get on with the comparison because in a practical sense, this is the juggling act many of us would weigh up.

The first important thing to be mindful of, which was very relevant in this reader question, is that investment returns are the combination of income generated and capital growth. With the share fund for instance you will get some dividend income and then on average some capital growth. It could be for instance that you get 3.5% income, and 4.5% growth, so your total return is 8%.

The reader was comparing the return of his Super fund to the income he generated from the property, but this is not a fair comparison. The income return on the property is only a part of its total return. To make anything like a fair comparison you would also need to include the capital appreciation on that property. Now of course that’s quite challenging. Until we actually sell the property, we don’t know exactly what it’s worth. We can look up broad property data, but that will be inflated by the money people have spent doing renovations and improvements to their properties. It’s also very imprecise and doesn’t necessarily reflect the position of your particular property. Nevertheless, if you do want to make a fair comparison, capital growth needs to be considered.

So here we arrive at our first challenge. What growth rate to apply to your investment property?

The next challenge though is the biggest. That is allowing for tax.

Firstly, when you see the return on your superannuation fund, it is important to recognise that this is an after-tax return. Super funds pay 15% tax on income, and 10% tax on capital gains. The return shown on your annual super statement is after this tax is paid.

In comparison, your investment portfolio outside of superannuation will quote returns before tax. Depending on your taxable income, the actual return you end up with will be quite different. To really make a fair comparison between your non super investment portfolio, and your superannuation investment portfolio, you really need to get the non super portfolio return adjusted down to the after-tax result. This is certainly not easy to do.

For starters we operate on a marginal tax system meaning that as your income moves through certain thresholds your tax rate increases. As you generate more income there is an increasing likelihood of you pushing into the next tax bracket, and whilst this doesn’t impact the income generated up to that threshold point, it does mean a higher rate of tax for the income at this higher level. For that reason it’s difficult to apply a blanket tax rate to your investment return, for instance 30%.

On top of this you have franking credits. Assuming your investment portfolio holds Australian shares, you will receive some tax credits reflecting the Australian tax that has been paid by the companies that you own shares in. If you are on a low marginal tax rate, it may be that the franking credits cover the tax liability on your investment income entirely. Indeed it could be that they are in excess of the tax liability, in which case you will be entitled to a refund.

The after-tax return on your investment property will likely also require a bit of spreadsheet crunching. To begin with you may have some depreciation claimable, which will have a significant impact on your after tax return. Now in theory the depreciation should reflect the value of your property declining. Depreciation exists to recognise the fact that properties wear out. But whilst the physical property might wear out, the value of the land that the property sits on tends to rise over time given Australia’s growing population. It’s therefore possible that the value of your property in total will have risen, even whilst you’re able to claim depreciation to reduce your tax liability.

Investment property owners have further deductions of course, such as council rates and insurances. All of these need to be accounted for so that you can arrive at a true after tax return.

As you can see, endeavoring to make a simple return comparison between placing savings in super, versus a share portfolio in your personal name, versus an investment property, is not easy. I suggest then that you make your decision as to where to direct your savings based on other factors.

We know that superannuation will provide tax free income when we retire, which is pretty hard to beat. The trade off though is that we lose access to our money until we are at least 60 years of age. In deciding whether you want your savings to go into superannuation then, you need to determine whether these preservation rules are compatible with your life plans. A 59 year old who plans to retire at 60 would likely be quite comfortable dropping some surplus savings into their super. But a 40 year old who plans on a career change and lots of travel, would likely conclude that superannuation is not the best vehicle for her savings.

Investment properties hold the primary attraction of being easy to leverage. Borrowing magnifies returns both positive and negative. Property is something banks are comfortable lending against at quite high ratios. You need to put down a fairly minimal deposit. Indeed if you already have considerable equity in your home, it may be possible for you to buy an investment property without putting down any deposit at all. By using borrowings to acquire the property, increases in the property’s value can produce disproportionate increases in your wealth. As a highly simplified example, imagine you purchased $1,000,000 property with a 10% deposit, so chipped in $100,000. Some years down the track, that property increases in value and is now worth $1.1 million. This looks pretty good, 10% growth. But consider what’s happened to the $100,000 that you chipped in. You borrowed $900,000 and for this simplistic example let’s assume that debt remains at $900,000. With the property having increased in value by 10% your portion has doubled from $100,000 to $200,000. A return of 100%. This is the power of leverage. It’s not something that is specific to property, but property very much lends itself to the use of leverage.

Leverage is risk though. If instead of increasing in value, the property dropped in value to $900,000 your initial deposit is completely wiped out. Even worse, if the property fell to $800,000 you’d have to find another $100,000 to repay the bank.

As always, there’s no such thing as a free lunch.

So property’s great draw is it’s ability to be leveraged. The counterweight though is that investment properties entail a lot of costs, both upon acquisition, and during the ownership period. In addition, many people find that being a landlord is a major headache. Investment property ownership is certainly more hands on than your superannuation or share portfolio options.

With regards to the share portfolio, its attraction is that it’s highly liquid. That works great for someone looking to add a certain amount each month and build the portfolio over time. It also permits partial withdrawals, something the other two options don’t allow for, at least until retired in the case of superannuation. The biggest challenge with share portfolios can be deciding what to buy, and avoiding getting distracted by the price volatility.

In summary then, trying to decide where to place your savings based on a simple look at the return differential between super, shares, and investment property is challenging and has many flaws. A better approach is likely to consider your investment time frame, need for cash flow, tax position, and appetite for risk, and develop your strategy from there. It’s also worth keeping in mind that choosing between these options need not be binary. In particular, you could easily direct some of your savings to superannuation and some to a share portfolio.