Here’s a basic guide to help potential property investors understand their options and make informed decisions when comparing direct property versus listed property.
Direct property versus listed property: what makes them different?
The main difference between direct and listed properties has to do with ownership and access to the structure.
Simply put, direct property investment is when the investor is the actual owner of a brick-and-mortar structure. The investor has full control over most controllable aspects of property ownership and is directly exposed to its risks.
Listed property, on the other hand, is a type of indirect property investment. A listed property investor is not the owner of a brick-and-mortar structure and their claim is limited to their share of the income collected from the property, whether from rent or profits.
Owning a direct property investment
As mentioned earlier, direct property means the investor actually owns the structure they selected—or the bank owns it until they fully pay off the mortgage. This popular retirement investment strategy is also known as ‘buying to rent out’.
There are many cases of investors getting duped by investment property spruikers, but there are also other cases where the investor failed to account for the different risks the real estate market presents.
How direct property can be advantageous
Direct property investment gives the investor a greater degree of control over their property, including determining the terms of the lease, who to accept as a tenant and how much rent to charge, among other things.
If the property is in a prime location and they price the rent just right, the investor may have a steady income stream to pay off their mortgage faster, if there is one, while enjoying a gradual increase in value as long as economic conditions allow.
Direct property owners also avoid market volatility that other asset classes are exposed to, mostly because they only need to have an annual valuation. This is unlike the volatility of company shares whose value can increase or decrease multiple times within the trading day.
The owner can also take advantage of available tax benefits, such as turning the property into a negatively geared investment in order to claim it as capital loss come tax season. If they hold on to the property for at least 12 months before selling, they also get a 50 per cent discount on capital gains tax (CGT) if it increased in value.
The dark side of direct property ownership
Investors can either search for their own investment property or employ the services of a professional to find a property for them. However, simply locating the ‘perfect’ property is not an assurance that their investment will kick off.
Why? Attention to investment properties does not end with signing the contract of sale and paying the agreed amount nor does it necessarily lead to a steady income stream from rent.
Since direct property purchases require investment, the investor can usually only pay off the 20 per cent deposit and take out a loan to pay for the property—these loans amount to hundreds of thousands or even millions of dollars.
This means they would willingly incur a huge debt for potential gain. Unless they chose the right property in the right market, they have to consider the following risks:
- The possibility of the mortgage defaulting and losing the property if they suffer financial hardship
- The real estate conditions if their property’s location crashes
- Property value decreases
- Future real estate developments cutting off income or devaluing their property
- Their expected income from a positively geared property falling below expectations
- Attracting tenants is more difficult than expected
- They’re not cut out as a landlord/landlady
Direct property owners must have enough time and money in their hands to address potential problems within the property, such as minor repairs to major renovations. Likewise, it is up to the owner to market their property, assess and choose the potential tenant and pay fees and taxes related to the property.
The typical costs for direct property investors include:
- Stamp duty (purchase and/or sale)
- Conveyance fees
- Legal costs (documents, etc.)
- Search fees (if they will hire an agent to find their properties for them)
- Building reports
- Insurance premium (whether for structure only or along with contents)
- Management expenses (repair, maintenance, renovations, etc.)
If they decide to hire a professional to manage the property and tenants, the owner would still have to pay fees and/or commissions in addition to repairs or renovations. Let’s not forget about insurance—who knows what accidental or deliberate tragedy could happen to a property while someone else is using it.
Investing in listed property
Listed property is, usually, more affordable than direct property investments since they come in the form of trusts or funds traded in the share market. They are less stressful because investors can leave the selection and management of properties to professionals.
To better illustrate, think of listed property as shares without ownership or voting rights. Legitimate listed property investments involve actual real estate properties that the investor visits and assesses for themselves prior to investment.
Investors simply inject their money into a real estate investment that funds the development and/or maintenance of selected properties. In return, the property managers share their income and profits with the investors.
Professionals handle the selection and management of properties and all an investor does is to invest their money and wait to receive the benefits. Since listed properties don’t involve the purchase of brick-and-mortar properties, investors can purchase them without needing a huge loan.
However, investors do not receive any tax benefits from listed property, unlike direct property investments.
Advantages and risks
As with all types of investments, listed properties have their pros and cons. One of its biggest advantage of listed properties is that they can be traded in the Australian Securities Exchange (ASX).
Listed properties also allow some diversification in terms of property types, because fund managers can select any scale of real estate investment. The fund’s underlying property or properties can be anything from a small residential apartment building, medium or large-scale office buildings, commercial and leisure properties to industrial parks and warehouses, among others.
Listed properties open up more opportunities and choices for local investors because they offer real estate located overseas. However, there’s also the risk that the type of property being funded is not fit for the overseas economy.
If the investor is not careful with the selection, they also risk losing much, if not all, of their investment.
Types of listed property
Listed properties are fixed-term investments that can be purchased in the ASX. Like bonds, listed property investments typically lock in investors to a fund anywhere between six months to five years. Lock-in periods depend on the fund chosen by the investor.
Since listed property investments are managed funds, investors should expect to be charged fees in connection with their investments.
Listed property investments may come in any of the following forms:
- Real estate investment trusts (REITs)
These are funds composed of investment properties selected and managed by professionals. REITs may be composed of local and overseas properties for residential, commercial or industrial use. This provides opportunities for diversification within one fund.
REITs that are limited to local properties are called Australian real estate investment trusts (A-REITs) and their main difference is market exposure.
- Exchange-traded funds (ETFs)
Property investments may also come in the form of managed ETFs. Instead of following a diversified market, its portfolio is focused on the real estate sector.
- Property trusts
Property trusts, also called syndicates, are managed funds where a professional investment manager selects the individual properties to invest in and the trust purchases them. The manager takes care of all the duties in managing the properties while investors receive their share of income and profits from the fund.
Note that trusts are required to distribute 90 to 100 per cent of its income from the underlying investments—as long as there is income from the properties and the trust exists, investors will receive a payout.
Schemes and scams
If there are people willing to spend money on a good investment, then there are also spruikers very much willing to dupe them and take the money.
Overseas direct properties
One of the more common scams are offers to own cheap direct property overseas—in the United States, for instance—but many of these offerings are dud investments.
The Australian Securities and Investments Commission (ASIC) recommends doing due diligence before considering overseas property investments.
This is actually sound advice because an investor who is willing to get into a huge debt to purchase a property on the other side of the world shouldn’t hold back on spending a few thousand dollars to assess the property in person to assess risks.
ASIC also advises potential investors to ask themselves: if the cheap property is really a good catch, then why aren’t the locals investing in it? Why do they have to entice someone halfway around the world to make the investment?
Land banking schemes
The government also warns about scams on property investments, such as land banking schemes. These schemes involve offering potential investors either options to buy parcels of land or actual plots of land with the promise that the company would purchase them back at a higher price once it is developed.
In some cases, the developers do not actually receive approval from local councils or have the capacity to develop the land. This leads the plan to collapse and leaves investors with ownership of a useless plot of land they likely can’t sell, profit from or develop with their own money.
The government and professionals also advise against purchasing properties based on advertisements and testimonials from ‘successful property moguls’ in property seminars. In many cases, people who bought into expensive lessons and limited-offer property investments only ended up drowning in debt, instead of the high income they were promised.
Even after all the benefits and advantages that property investments present, one of the most important attributes to look for in an investment is its liquidity. Most experienced investors know that real estate assets are some of the most, if not the most, illiquid investments available in the market.
Real estate properties are generally illiquid because there is usually a waiting period from the time the property is put up for sale to the time the property is actually sold. This is mostly true for direct property investments, but there are some exceptions.
For direct property, the exception would be if the property is in a prime location and there is an actual demand for it. It won’t magically turn the property to cash, but it helps hasten the process.
Listed investments tend to be more liquid because REITs are traded in the ASX, however, the trade-off is exposure to market volatility.
Which property investment is better for a portfolio?
Experts recommend having some form of investment property in investment portfolios as a long-term investment. If investors can manage it, it is advisable to have both direct and listed property in their portfolio. However, those who cannot afford a physical property can start with listed properties.
It is also important to learn about the underlying properties in the investment, the same way one should be acquainted with a business when purchasing company shares.
This information has been sourced from ASIC’s Moneysmart, Property Funds Association, ASX and the Australian Investors Association.