What are property investments?

Property investments include residential, commercial, industrial, retail, rural and other types of buildings. They also include trusts that purchase property, the latter being a good way to get a return related to commercial property, which is usually too expensive for a single investor to buy outright.

What drives property prices?

The biggest drivers of property prices are population growth and wage growth, which in turn is approximately the same as inflation. If you think about it, if all else stays the same property can't continue indefinitely to grow at a different rate to the rate of inflation, because if it grew faster than inflation it would become unaffordable. Unlike shares where you can still participate in the market by buying packets of shares which individually are cheap, if property prices all shot up at a faster rate than inflation it would soon be unaffordable.

A similar argument says that it is unlikely that property prices would lag inflation over an extended period of time, because if that happened it would become cheaper and cheaper in real terms over time. While prices could conceivably be cheaper than they are now, this would not continue for long because sooner or later it would become so cheap everyone could afford several houses, we just don't have the excess capacity to allow that to happen, building would stop until demand picked up. So between the limits of unaffordability and absurdly low prices there is an equilibrium, determined by supply of new housing and demand that keep prices in real terms roughly stable.

Population growth can allow prices to go up faster than inflation because as the population grows land gets more densely occupied. If lots are going to be subdivided you can maintain affordability by splitting an unaffordable large block into two affordable small blocks.

The capital gain primarily comes from the land component of the purchase, so don't expect too much capital growth if you are going to make a habit of buying densely packed units, if the land is occupied to maximum density there is little potential for growth exceeding the rate of inflation, presently estimated at 3%pa.

Of course over the short term there are other influences, interest rates might fall and then big mortgages become more affordable and hence prices climb, but some day interest rates will come right back up again and if that happens prices will have to either sit still for a long time while affordability catches up with historic prices, or prices will fall to more realistic levels.

As well as interest rate changes there are political factors (like the first home owner's grant) and various cyclical factors that are hard to predict.

What kind of return can I expect from property?

Historical data on property prices is hard to come by, and most measures in common use are flawed. For example many people use median house prices as a guide, but this is not a good estimate of profits because median house price tables don't take into account improvements over the years. It would be nice if we could have some sort of index of property prices that corrects for capital inputs like new driveways, swimming pools and other expenses, but there is no such thing. Therefore median house prices paint an overly optimistic picture of price growth.

Making crude corrections for such factors, and for interest rate moves, average prices do move at a similar rate over the long term to inflation, though as I have said when land can be subdivided there is potential for more growth.

Most of your return will probably come from rent, and rates here vary a lot. Residential property (the most popular form of property investment) has the lowest rental return and the highest management expenses. You would be doing very well to get a 6% yield from a residential property, but in practice might get a much lower yield, especially if you are talking about net yield, where you take off expenses.

The various commercial types of property, from inner city office towers to suburban shopping centres and industrial property tend to offer a significantly better rental return than residential property. If you don't have enough money to buy a Westfield shopping centre outright you can buy into a property trust instead. Professional property investors deal almost exclusively in commercial property, for very good reasons.

What are the main advantages and disadvantages of property?

Advantages:

• Property is a fairly secure investment, you probably don't need to diversify as much as for shares because only a nuclear disaster could reduce a property's value to zero.

• Banks just love property, and are willing to approve large loans to let you buy. This is a double edged sword though, the banks loan practices are designed to protect the bank from loss in the event of a foreclosure, you may lose tens of thousands of your initial deposit and home equity even if you invest no more than the bank will let you.

• As far as most people are concerned, property is easy to "understand". I take issue with this point, just because you understand a building does not mean you understand the real estate investment business, but most people nevertheless find it less technical than other investments.

• Returns are pretty good, particularly commercial and retail property. For best results there are low-cost index funds that buy a large number of property trusts that are traded on the stock market.

• Although not as tax efficient as shares, property is much more tax efficient as an investment than other asset classes.

• Property is a good inflation hedge.

Disadvantages:

• Real estate is a shonky industry, regulation is poor and many of the salesmen could only be described as sharks. Getting good advice in real estate is not easy. Two-tiered marketing organisations dominate the real estate seminar landscape. It is hard even finding a good book on the subject, because most of the best-sellers are populist garbage full of stuff that merely sounds good.

• A lot can go wrong. If you want to invest in direct property your expenses can be huge, especially if the neighbor's ficus tree has gone and messed up the plumbing and foundations. Tenants are a hassle, accounting is complicated, the place is subject to physical deterioration and if you are borrowing lots of money (as most property investors do) you are exposed to the risk of increased interest rates.

• Stable property values are as much a product of infrequent quotes as anything else. If you look at stock prices once a year they look more stable and less "risky" than if you get a quote every day, how much of the stability of property prices is simply due to infrequent quotes? Would the price be as stable if you auctioned your house once a week?

• Ok, so prices probably won't fall to zero, but a proper diversified shares portfolio isn't going to fall to zero either, although the shares will probably perform better. While really huge price falls are unlikely with property, the amount of potential fluctuations is still very high. Prices are not fixed, instead they "float" on the market, with prices set by supply and demand. Queensland is full of vast tracts of land covered in empty houses sold by property marketers, there are no tenants, rental yields are abysmal, nobody wants to buy your property and when places do trade hands they sell for prices much lower than the developer sold them to the investor for. Don't buy into this "residential property prices never fall" nonsense put out by salesmen.

• Liquidity is very poor. If the market is bad you won't be able to find a buyer at any price, so you could be locked in to a money losing investment for a very long time. Property trusts are better, but many have a waiting period of 6 months or more on redemptions.

• Costs are very high. You have real estate agent commissions, stamp duty, land taxes, rates, interest on the mortgage and various finance fees, and a whole lot more. The "round trip" of buying and selling a property can be 10% or more, which could be a couple of year's price growth!