Should I invest extra cash in property or super?

So - now you're sitting pretty! Your home loan balance has been gradually ticking down and you now have a home loan outstanding of just under 50% of your home's value. You've found you have a little money left over each month and you know you should be investing it. Of course you could just let it build up in your bank account - though it would be better to keep paying off your home loan. It could also be useful to gradually pay money into a unit trust with exposure to property and/or share holdings. 

But if you're after some extra tax effectiveness, two strategies are worth considering;

• property investment and 

• topping up your superannuation. 

Which makes better sense - and over what time horizon?

The figures below examine these two options. In them we have assumed an individual has an amount of after tax income available for investment and either takes out a loan to buy property or places the equivalent money into their superannuation fund. The property investment example assumes the investor uses the equity in their home to take out an interest only loan for the entire purchasing costs of the property - over 105% of its value. It assumes conservatively that, after real estate agents fees and other costs, net annual rental return is 4% and annual capital growth is 3.5% (a total return of 7.5%) whilst the superannuation investment generates a 9% annual return. Interest is assumed to be the current basic variable rate of 6%. The purchase takes place in Victoria with the highest stamp duty in the country. 

During the first fourteen years of the loan, the investor must use some of her available after tax income to make up the difference between loan interest payments and the rental return from the property. This generates tax benefits as the excess costs are generally tax deductible. The property is negatively geared for this period. There are also some additional 'free kicks', as fixtures and building costs are depreciated over time generating a stream of valuable deductions over the years. After fourteen years the investor begins to receive more income from the investment than they spend paying interest and other costs - the property becomes 'positively geared'. 

In our comparison, the investor makes the same contribution to both property and superannuation strategies. Accordingly to ensure we are comparing like with like, the superannuation contribution falls over time to mirror the steadily falling contribution to property investment. (Of course in real life, once the contributions to property were falling substantially it may be time to invest in another property - or diversify with increased contributions to super.)

Here are some simple messages from the simulation that was done on fairly plausible and conservative assumptions. 

1. Geared property investment is extremely wealth effective and more so than superannuation - even with the tax advantages of super.

2. Because of high transaction costs (particularly in Victoria where we've done this simulation) it takes a while for these benefits to show. It takes between eight and ten years for the benefits to show, though better property can be expected to yield well over 7.5%. 

3. This benefit comes from higher gearing, which increases the short-term risk of the investment. This should be manageable if investment has a long time horizon - long enough to survive any property downturn. But it underlines the importance of a long term wealth building focus. 

4. One of the things which drives the success of gearing for property is that property is such a good form of collateral to underwrite borrowing. If one were borrowing unsecured one could expect to pay nearly double the interest rate. And even using shares or commercial property to invest, the gearing one can achieve is much lower, and the cost of the money - the interest rate - is a lot higher. One can borrow against 80% the value of residential property (or 90 or even 95% with mortgage insurance) at under 6% interest rates. Borrowing against shares or commercial property you're lucky to get away under 7.5% and you can only borrow around 60 odd percent of the value of the investment. 

On our scenario, an investor retiring in ten years will receive an after tax benefit of $81,000 from property investment or $70,505 from super. If retirement time is twenty years away the difference grows - property yields $210,000 compared with $147,000 for super. Along the way the property investment would allow generous tax deductions each year through negative gearing and after eight years the property would be earning additional income each year. 

Using the same conservative assumptions for property investment in states other than Victoria, the figures show an even better return for property investment because of lower transaction costs. In Queensland, where transaction costs are the lowest in the country it takes between six and nine years for property to outperform super and the benefit from property after 10 years is $85,000. 

What if the investor puts some effort into buying a good property with good scope for capital growth? With just 6% capital growth (our base case assumes 3.5%), the after tax benefit to the retiree after ten years is $156,684 and after twenty years is $460,318!

However, a word of caution when considering this analysis….property investment does not come without risks. The economy moves up and down affecting the growth in value of house prices. If a recession hit in the fourth year of the property investment the value of the property might drop say by 5%, and again drop 5% in year five. In this example, the property investor will make a loss on their investment unless she holds on to the property for at least eight years. Recognition of such risks and a long term view is necessary before making investment decisions. 

If an investor makes an additional contribution into their superannuation fund from their after tax income, they are under no obligation to make any other payments. On the other hand their money is locked away until retirement. Superannuation returns are also affected by recessions. Say during a recession in year four and year five, superannuation returns drop to 3%; if the investor retired after ten years her lump sum would be reduced from $70,505 to $67,337. Also, the rules governing super are constantly changing, creating an important risk for policy holders. 

Cheers,


AKA Nicholas Gruen
August 2002

Please note: The observations made here are general and indicative. They are not warranted as free from error in any respect whatsoever. You should not rely on any aspect of them without taking independent financial advice relating to your own specific circumstances. We suggest you obtain advice on a fee for service basis rather than from someone who earns either up-front or trailing commissions from investments they recommend. We would be happy to let you know of service providers whom we regard as reputable.