There is no such thing as free lunch, so beware of property investment incentives

Incentives! One of the key laws of economics. We act in a certain way because we are incentivised to do so.

Generally people don’t turn up to work purely for the enjoyment of so doing, although they might say that they do. Instead, the primary incentive is usually financial reward. Some older folk elect to keep working beyond the retirement age for the incentive of keeping active or sociable.

Coles and Woolies offer us shopper dockets in order to incentivise us to come back to their store instead of another outlet.

Incentives don’t only apply to financial and economic decisions. In almost every decision humans make we consciously or unconsciously weigh up the incentives of each of our options. This is the origin of the phrase "There's no such thing as a free lunch".

Let’s take the example of… well, why not the example of an actual free lunch?

Let’s say I’m 21 again (sigh) and I wander down to a pub in Sydney tomorrow (sigh!) and meet a beautiful lady whom I find funny and great company. I offer to buy her lunch next weekend. Obviously the lunch would not be free to me. Nope, certainly no free lunch there!

But would it be a free lunch for her? No. Her assumption would be that I would be expecting something in return as an incentive (even if that incentive was simply her time and company) and would intuitively weigh up her own incentives. She’d balance up the mediocre quality of the suggested restaurant, the inane nature of my moribund 21-year-old conversational skills and – the clincher – my woeful need of a haircut, before politely declining.

Whether we think about it or not, we weigh up incentives in this way all the time. Blokes spend more time getting ready to go out on a hot date than they do for a day at the footy due to the incentive of a potential romance.

Even when we are apparently giving something for free such as a charitable donation, we often expect to feel good in return as our incentive. This is why we choose charities that have a meaning to us and is why I donate to cancer charities in in preference to other deserving causes.

Governments use tax cuts and parking or speeding fines to incentivise us to behave in certain ways, and so on, but can we find a free lunch in investing?

Unfortunately, the law of "no free lunches" also applies to property investment.

Investors who gave money to Allen Stanford thought they’d found a free lunch. Consistent, high returns with remarkably little volatility! But they forgot to ask what the cost was. In this instance, sadly, the cost was one of the greatest frauds ever committed, a gigantic Ponzi scheme that ultimately collapsed. No free lunch – and the cost many investors suffered because they did not diversify was immense.

Incentives in property

In this recent article, Michael Yardney urges investors to be wary of property investment incentives such as discounts, which can distort the market. Similarly, be wary of rental guarantees. What is the cost of a guarantee? Is it that the developer wants to sell you a property based upon a multiple of the high rent? What happens when the rental guarantee ends?

What if you buy a property via a property investment club? Is the club helping you to buy just to be nice? Perhaps, but you need to fully understand the incentives. It may be 6% of the property purchase price. What of the developer’s incentive in this case? The developer may be selling via a club because it is a simple way to find buyers. At other times, developers may be offloading properties they simply can’t get rid of.

Does that mean that all properties bought via clubs are sub-standard? Of course not, some might be excellent investments. You simply need to understand the incentives and the costs and to always do your own due diligence.

 

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The incentive of yield

Property investors today are constantly being lured to invest in regional markets. The incentives are always listed as the same. Higher yield to lower your risk! Higher capital growth! More affordable and “room to grow”!

If anyone had designed a free lunch, this juicy trifecta must be the veritable entrée, main course and dessert. Might you get both positive cashflow and growth? Actually, you well might if you choose your market well.

But always ask, what is the cost? Go back to basics. A yield is high because the market value is low. Prices are usually low because demand is low. A property that is in low demand is a bad investment.

Be especially wary of investing in small cities or towns where there is vast acreage potentially available for new property development – if prices do go up it could become swamped with dwellings and prices may retrace. The best property investments are those you own forever.

Remember that by investing counter-cyclically in cities that are at the nadir of their cycle investors can get some pretty darned good yields anyway.

If you think you can outsmart the market in today’s climes by getting into and out of a mining town with expert timing (materially beating stamp duty, legal fees, sales costs and capital gains taxes) you're probably wrong.

Property cycles

The best benchmark I have for a property market which is at a different stage of the property cycle to that of Australia is the British market.

A great many investors opted to buy properties before 2007 in outer areas and remote markets tempted by yields of 7% or even above. The cost was that when the credit cycle reversed properties in low demand have been absolutely clobbered, in many cases by more than a quarter. And it’s now 2013, with little in the way of a recovery having taken place.

Those who invested in some city markets in the south-east of England, including in and around London, had previously paid a cost of a somewhat lower yield. But today, the incentive they are paid back is that by buying properties in the part of the country with a shortage of property and massive demand, their property portfolios are stronger than ever before.

Property in Australia has delivered outstanding returns over the past decade and a half which incentivises investors into the market.

The future is unknown, of course. Low interest rates in 2013 could well result in some reasonable growth this year. But what is the cost? My fear is that when we reach the end of the interest rate easing cycle and rates move upwards, some markets where property is in low demand will get clobbered.

Remember the law of incentives. There’s no such thing as a free lunch and always ask yourself: “what is the cost?”

Pete Wargent holds a range of finance and property qualifications and is the author of Get a Financial Grip – a simple plan for financial freedom.