Monday, April 17, 2006

Retirement portfolio components - property

The previous post summarised the case for shares being one of the key components of a retirement portfolio. The second key component is property.

The rational for including shares in a retirement portfolio is that they produce a stream of income (dividends) that has the potential to increase over time compensating for the effects of inflation. Similar reasoning applies to property - it is an asset class that produces a stream of income (net rental) which has the potential to grow over time.

Property differs from shares in several respects. The first is that historically banks were more willing to lend against the security of property than against the security of shares. While the willingness of banks to lend against shares has improved noticably, the terms offered are generally less favourable in several respects. The interest rate on loans used to purchase shares will be higher, the maximum amount that can be borrowed is usually lower and margin calls are a distinct possibility. All of which makes property much more suitable as a levergaed investment.

Another issue is that property requires more management than shares which can either be viewed as a pain or as part of the challenge. There are outgings to be paid in addition to the mortgage - rates, maintenance costs and so on. There is also the risk of vacancies disrupting the flow of rental income.

The last point to bear in mind is that because of the relatively large sums involved, it is harder to achieve diversification with property than with shares.

Acquiring a property using debt finance set at a level where payments on a prinicple and interest mortgage will be serviced from the rental income can result in an end position where the amount of capital invested at the time of acquisition effectively matures into a debt free property producing an attractive stream of income on retirement. Of course it is necessary to allow for outgoings and the occasional vacancy when doing the maths.

Certainly, there are risks involved. We could experience deflation. Interest rates could rise faster than rentals (or rentals may not rise at all). Still, if an inflationary environment is expected, property remains for me an attractive proposition over the longer term.

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