When I first got involved in property investing, I wrote a little program that scoured the real estate websites for details of properties that were in areas interesting to me. One of the stats that it tried to calculate was the average rental yield (the rent divided by the purchase price) for different areas. Unfortunately, the values I was getting back were utter rubbish.

After looking closer at the data, I realised that I’d fallen for a classic beginner’s mistake: I had tried to compare median values.

The median is an “average” measure of a set of values where there are just as many values smaller than it as there are larger than it. If there are five houses worth \$100k, \$120k, \$125k, \$190k and \$250k, then the median house value is \$125k (the middle one).

Medians are widely used by real estate agents because they are easy to calculate, aren’t skewed by the effect of a really expensive or really cheap property coming onto the market, and provide a simple message to buyers. They state how affordable an area is – if you can afford the median, then you can afford the majority of homes for sale in an area.

However, my mistake was comparing two median values in an area: 1) the median rent  and 2) the median sales price. The set of properties available for rent was composed of completely different dwellings to the set of properties available for sale. For example, the median rent might have come from a 2 bedroom unit, while the median sale might have come from a 3 bedroom unit. As a result, the yields being calculated were much too low.

My mistake in comparing medians is repeated by many in the media every week in calculating property growth by comparing the median from one period with the median from another period. To be fair, it’s not entirely their fault, as they get their data from real estate agents.

Statisticians are aware of the problems with using the median for calculating growth rates and have come up with three improvements. Christopher Joye has written a detailed overview, but I’ll provide my potted summary.

### Stratified Median

The Australian Bureau of Statistics (ABS) and Australian Property Monitors (APM) both use an approach of grouping properties into related sets (stratifying the data) prior to computing medians. If the groupings are done properly, then any skewing in one group will not affect another group too much, so data from different periods should be more comparable. However, it doesn’t eliminate the problem that properties sold in different periods might not be comparable in the first place.

### Repeat Sales

The main approach used by Residex is based on calculating the growth rate of properties sold in a given period based on how much they sold for last time. Comparing a property with itself clearly doesn’t have the same level of issue as comparing medians. However, a property might have been renovated (or even completely demolished and rebuilt) since its last sale, which adds a wrinkle to the calculation. Also, sales of new buildings cannot be included since there isn’t a prior sale to compare them with.

### Hedonic Method

The hedonic method is less interesting than it sounds, but is the main approach used by RP Data. In this method, sale data is combined with data on the nature of each property, e.g. precise location, land size, number of bedrooms, number of bathrooms, etc. In this way, like can really be compared with like, and more accurate growth rates can be calculated for properties in different areas. However, this approach is only as good as its data, and we need to trust that the statisticians at RP Data have gotten the good stuff. Also, historical data for all of these additional details are hard to find, so it’s not possible to do comparisons as far back as with the other approaches.

In conclusion, it is clear that the three improved approaches all have their strengths and weaknesses, but all are superior to the plain median. I was never able to update my little property stats program to collect enough data to make proper comparisons, but at least I learned the pitfalls of comparing medians.

I recently got back from a short holiday in Canberra, our nation’s capital. Amongst other touristy things, we visited Old Parliament House, where there is an Australian Democracy Museum. One of the displays is on the past Prime Ministers, and when you see them all together, you realise that we’ve had a lot of them, in the century and a bit that we’ve run our own parliament.

In fact, from 1901 to 2010, we’ve had 31 changes of government. For those not doing the math as we go along, that’s one every three and a half years.

And for someone who is, say, 35 years old, and facing 25 years before they can get access to the money in their superannuation, there’s an expected 7 or so new governments that will have a chance to meddle with it in the mean time.

The risk of current and future governments impacting the performance of an investment through passing laws is called Legislative Risk. Unfortunately, laws that affect superannuation have been prime candidates in the past for government fiddling. In the future, given the rumours about the Henry Tax Review, it will almost certainly get further tweaking still.

If you’re an employee, participation in superannuation is compulsory, where 9% of the total salary package (or thereabouts) is locked away in the system. Unless employees are willing to go to the expense and effort of setting up a Self Managed Super Fund, their money is generally invested in Australian stocks and bonds. So, if you want to invest in say fine art, residential property, a family company or venture-capital backed start ups, you aren’t going to get any joy with super.

Despite the limited investment options and the long period that you can’t directly benefit from it, an investment in your superannuation gets beneficial tax treatment. This is its key advantage, and the very thing that is vulnerable to legislative risk – a risk that is real, based on past actions and rumoured future actions of our governments.

I think that most Australians would benefit from having some level of investment outside of superannuation (even if it’s just their home), in order to reduce their exposure to this risk.

I’ve written about it before (“I am not a nutter” and “Thatâs not a Housing Affordability Crisis”), and I’m about to write about it again. Today I received a letter from my accountant (who, admittedly, is more savvy than the average accountant when it comes to property) confirming, and even encouraging purchase of geared property in a super fund. I quote:

If you have over \$120,000 sitting in Superannuation you can now buy property through your superannuation fund … the SMSF makes the first installment of 20% deposit plus stamp duty/ legal costs plus the first year’s interest repayment.

And I have also come across a company called the Quantum Group that is setting up a similar structure for superannuation funds, calling them property warrants. So, there’s also an option for people whose accountants aren’t quite as savvy.

The residential property market has been performing quite well recently. For example, the average annual growth of median residential property prices in Melbourne over the last ten years has been 10.65% (according to this article, reporting Residex figures). If a property purchased at \$450,000 (the current Melbourne median property price) grows at the average figure of 10.65% annually, and is purchased at a gearing level of 80% (as in the example from my accountant), then the growth is considerably higher. Ignoring tax, rents and interest payments, the \$90,000 invested would become equity of around \$880,000 after ten years – that’s about 25% annual growth. Not bad, and will be hard for super fund investors to ignore.

I would expect that once superannuation funds start investing directly in residential property, the big players in Australian superannuation will want to address the demand by packaging up property so that it is easy to invest in, i.e. indirect investment in residential property, or funds of geared residential property which a SMSF can buy units in. The catch will be that while the SMSF area is regulated by the ATO, the wider superannuation funds industry is regulated by APRA, and they are not going to want to see superannuation funds gearing up and putting people’s pensions at risk. The gearing cat is already out of the bag, so perhaps all they can do is cap it at a more conservative level, of say 60% (this would have produced a return of around 18% in the example above).

It is worth considering what sort of property funds the industry would be looking to set up. Generally they look to the blue-chip end of the market, so in property this would be houses or whole apartment blocks (rather than individual apartments) and in well-established suburbs such as Hawthorn, Toorak and South Yarra in Melbourne, and their equivalents in Sydney and possibly Brisbane. Such property typically goes for multiple millions of dollars, but I would expect that people living in such houses would prefer not to rent it. I don’t really know – I’ve never been in that position myself! Innovation in rental / purchase contracts will probably be required to give residents in such houses the certainty, control, or capital gains that they require. However, where there’s money, there’s incentive to fix such problems.

So, initially, I expect to see the big funds going after apartment blocks, then eventually houses, then when supply is exhausted in the blue-chip areas, moving into neighbouring areas or the other cities in Australia. A side-effect of this staggered buy-up is that these funds may not be particularly diversified. There could be a “Toorak houses” fund, or a “South Yarra apartments” fund. It may not be a bad thing – it doesn’t matter if a particular fund is not diversified as long as someone’s overall portfolio is diversified. And it could enable people buying that type of property in that type of area to invest in something that tracked the investment performance of their dwelling without having to invest in (i.e. renovate) the dwelling itself.

Is this complete speculation, or have similar things happened overseas? Well, to be honest, no. Real-estate Investment Trusts (REITs), as they are often known overseas, tend to invest in hotels, office blocks, shopping centres, and sometimes apartment blocks. Although I’m no expert, I’m not aware of big REITs buying up houses. So, this is all in the realm of speculation. But the fact that it hasn’t happened overseas should not be an indicator that it won’t happen here, as Australia tends to lead the world when it comes to putting real estate into retail funds. According to Wikipedia, the first real-estate trust was launched in Australia in 1971.

Anyway, for the everyday investor, who can’t pony-up a few million to buy a house in Toorak, the impact of competition for real-estate from the major fund managers is likely to be limited. You’re more likely to be bidding against someone running a SMSF. Unfortunately, the number of SMSFs is growing rapidly.

Finally, one thing to watch out for will be unscrupulous operators. There are already dodgey property marketers who prey upon interstate investors, e.g. Perth people buying overpriced property in Melbourne, or Melbourne people buying overpriced property in Brisbane. This will give them one more tool to exploit: that vulnerable people can invest their super into a dodgey scheme, and possibly not realise for many years that the property that they’ve bought was massively overpriced because the whole thing is so hands-off. Hopefully people know not to invest in something they don’t fully understand. It’s a vain hope, I know.