Commonwealth Bank’s share price has recently increased above $75 which is well above its pre-GFC high of $60 (and massively above its GFC low of less than $30! It is amazing to reflect back to September 1991 when it first traded at $6.81… which means the share price has increased by an annual compounding rate of 11.5% p.a. over the past 22 years). Most would agree that CBA is a quality, blue chip stock that has proven to perform well over the long term. With that in mind I was thinking; I wonder who would be better off. A CBA share investor or a property investor?
The CBA investor
I took the year 2000 as my starting point – for no particular reason. I assumed that the share investor started with $10,000 and invested a further $10,000 per year (i.e. bought more shares). I also assumed that all dividends were re-invested (net of tax and imputation credits).
The property investor
I assumed that in the year 2000 the property investor purchased a property worth $500,000 because at that stage (mortgage interest rate was 7.20%) such a property would cost approximately $10,000 p.a. after tax (so same assumption as the share investor). As the property’s rental income increases over time, the cash flow cost of the property reduces – i.e. it’s not going to cost $10,000 p.a. forever. Therefore, I assumed that any cash flow left over from $10,000 p.a. would go into repaying the loan. I assumed the property would increase in value at an average of 8% p.a. over the period. I used actual interest rates over the period.
The CBA investor ‘s portfolio would be worth a bit over $500,000 today… which I am sure you’ll agree is a good result. However, the property investor’s net equity is a whopping $1.1 million – more than twice the return. If I had have compared the return over a longer period (say from 1991 when CBA listed), the result would be even more stark.
Why is it so?
Is it because property is better than shares? No! The reason for the difference is the power of gearing (i.e. borrowing money to invest). The CBA investor invested small amounts each year from after tax savings. That is a slow strategy. Whereas the property investor invested a large amount upfront in one go.
The chart below demonstrates the power of compounding annual growth. The left hand vertical axis shows how a $500,000 property’s value increases at 8% p.a. growth over a 20 year period. The right hand vertical axis shows the percentage growth over each 5 year period. You will see that a property worth $500,000 today will be worth $2.15 million in 20 years (assuming an 8% p.a. growth rate). However, after the first 5 years, whilst you are already 25% into the 20 year period, you have only enjoyed 11% of the growth (property is worth $680k after 5 years). In the next 5 year period (year 6 to 10) you enjoy 19% growth, then 28% growth (between years 11 and 15) and finally the last quarter is the most spectacular with 42% growth occurring in the years 16 to 20 (where the property increases in value from $1.45 million to $2.15 million). This is the power of compounding returns and why all good investment strategies need “time”.
The quality of your investments determine the outcomes
Without a doubt, the most important thing is to ensure you only invest in quality assets. The quality of your assets will determine your investment outcomes. CBA’s share price growth over the past 22 years has been spectacular and it’s been a great investment. You would have been much better off investing in CBA than investing in a poor quality investment property. This article isn’t about property versus shares or CBA versus property. This article is about the power of compounding growth. But compounding works both ways – it magnifies good and poor performance. So please make sure that you only invest in quality assets first and foremost. Secondly, if appropriate to your circumstances, consider the power of gearing (borrowings). Ignoring loan to value ratios, margin calls and interest rate differentials, if I had have compared gearing CBA shares (using the same assumptions) to gearing property, CBA shares would have won. But many people won’t be comfortable gearing into shares to the same extent as property. Food for thought.