Is residential property Super?

The retirement plans of working families may soon succumb to Australia's residential property mania. If Chris Joye had his way, Australian super funds would invest in the emerging residential equity market to diversify their portfolios against highly correlated domestic and global equities markets. The argument for this move is summarised below.

Investors, such as super funds, get extremely low-cost, highly enhanced and very long-dated exposures to what has, during the past three decades (including the recent calamity) been the largest and best performing of all investment classes: residential real estate. Historically, investors have only been able to access highly concentrated, risky development-style holdings comprising small parcels of properties that incur heinous transaction costs of about 12.5 per cent. By investing in a portfolio of thousands of shared equity interests, super funds could avoid all of these costs and secure the low risk diversification that they have never had before. Independent actuarial analysis suggests that about 15 to 30 per cent of all super fund capital should, in theory, be allocated to housing, in part because its returns are so unrelated to the performance of other investments. Compare the 50 per cent plus losses in shares and listed property trusts in the past year with the fact that the RP Data-Rismark Australian House Price Index has tapered by only -0.8 per cent. (emphasise added)

Is this idea worth embracing? Or to put it another way, how many people would actively choose to invest superannuation in the residential property market?

Super funds investing in residential property equity face a couple major of problems in my view:

1. decreasing the diversity of investor portfolios, and
2. moral hazard associated with residential equity finance.

To begin a proper analysis we need to take think in terms of investor portfolios, not super fund portfolios. Outside of their super fund, Australians have other investments - mainly in residential property. Already we see that most (70% home ownership) households have plenty of exposure to this apparently superbly stable market, particularly those close to retirement age.

But Joye's argument also rests on the fact that typical investments in housing are lumpy - people own just a single house rather than a share of the housing market. An individual home can be high risk due to its location, but the housing market is much more diverse and is thus far less risky. If super funds invest in residential equity schemes they are reducing risk against not only other equities markets, but from households' own lumpy property investment. It sounds almost too good to be true.

Opponents of this idea also have some fair points to make. Directing more investment at the housing market will increase market risk and fuel speculation.

There may also be severe moral hazard in the market for residential equity. Only people who view their property as below average, and whose money management is rather poor (since they are negating part of the investment benefits of property ownership yet still leveraging wildly), may take up equity finance, thus reducing the diversification benefits that were the initial selling point. Equity finance is an easy way to hedge against a falling property market.

While the residential property index has low volatility (and therefore low risk if you believe in that type of thing) it also has very low returns. Although equity finance is structured to take twice the capital gains (if you take out 10% equity finance when you buy, you owe 20% of capital gains when you sell), it misses all the 'dividend' of rent. Sellers have less incentive to hold on through a market downturn if losses are shared. They also have less incentive to maintain the property, since they take a smaller share of capital gains.

Further, those who are willing to take the risk can already invest in property via a self-managed super fund - further exposing them to residential markets.

All I see from residential equity investment is a small upside with a potentially huge downside. If, from this point on, house prices track wages, which slightly edge ahead of CPI, the best outcome for a residential equity investor is about two to three times CPI, or 6-9%. The downside is all there in the event of a residential price bubble deflating, and it may be many years before positive returns eventuate.

Because an equity mortgage typically supplements a debt-leveraged purchase, they are second in line for cash upon sale. People taking out equity finance will probably not fully understand the downside risks of having this funding arrangement.

For example, if you borrow 60%, equity finance 20% and put up 20% of your own, in the event of a 40% drop in the value of the home which forces you to sell, you will still owe the equity financier 12% of the home purchase price and the mortgagee 60%. The equity mortgage is not real equity – it does not share in leveraged losses. The possibility that a proportion of equity mortgage holders will default on the balance owed, was not recovered from the sale price under such a scenario, adds to the downside risks.

In the end, if owning an equity share in the housing market as a whole provides such benefits, why would anyone buy their own home in the first place? Wouldn’t they simply want to lend to others under this fantastic scheme? Some people may, and some people do. But the significant moral hazard problems may mean that the diversification benefits so loudly promoted are not all there. Furthermore, super fund investments in residential equity will divert an even greater proportion of the typical retiree’s funds into the housing market, negating the apparent diversity benefits.