With share markets at an all-time high and sentiment in the property market recovering, it is a great opportunity to divest of any underperforming (dud) investments.
Not all investments perform as expected. Therefore, it’s important you regularly review them. This review should be completed without any influence of emotion – it’s all about the numbers.
Let’s first discuss why now might be a good time to do this and then I’ll share some considerations.
Why is it time to sell?
The US share market is high, very high
Over the past 11 years, the US share market has increased by an annual compounding rate of over 14.5% and is now trading at an all-time high. To put that in context, $50,000 invested in 2009 (in the S&P 500 index) would be worth over $220,000 today!
The chart below (click to enlarge) which has been produced by Advisor Perspective records four commonly used valuation metrics for the US share market since 1900. This chart doesn’t need any commentary from me – it is obvious valuations are high! Probably, too high! In fact, the last time they were this high was in the early 2000’s during the dot-com bubble. Most of us know how that turned out – the market fell by around 40% between 2001 and 2003.
The Australian market is high too
The Australian market hasn’t risen anywhere near as much as the US market. It has increased by a compounding average of 6.9% p.a. since 2009 (compared to 14.5% p.a. for the US market). Looking at the CAPE Ratio valuation measure, the Australian market looks slightly overvalued (CAPE is currently 19.3 compared to presumed fair value of 17.6), but certainly to a much less extent than the US market.
In a rising tide, all ships rise
The rising domestic and international share markets tend to drag all stocks with them, good and bad ones alike. Irrationally exuberant markets tend to ignore investment fundamentals.
US electronic car manufacture, Tesla is a case in point. Its share price has risen from $450 per share to over $1,150 per share in the past year. Its market capitalisation is now nearly $200 billion yet it has never recorded a profit. In fact, it burns through more than $1 billion of cash per year! But, despite that, the market suggests Tesla is worth 1.6 times more than Ford and General Motors combined! Ford and GM sell approximately 13 million cars per year. Tesla sells circa 370,000. Where is the common sense?
Property market sentiment is strengthening
We have certainly noticed an improvement in sentiment towards investing in property over the past year. This has also been reflected in auction clearance rates – which are now in the mid-70’s – which is a signal that there are more buyers than there are sellers. According to CBA Economics, lending to owner-occupiers has lifted by 26% from its low point in May 2019 and by 15.5% for investors.
That said, there isn’t a lot of stock around, as the market doesn’t really return to ‘normal’ until late February.
Probably a good time to dispose of a dud property
If you have an investment property that is less-than-perfect, then competition is not your friend. That is, it is best to sell an impaired asset when stock levels are lower, and buyers have fewer options. If we agree that demand for property is increasing, and stock levels are definitely well below normal, then now might be a perfect time to sell.
Considerations before you sell
There are a few important matters to consider before you dispose of any underperforming assets. I have listed these below in no particular order.
Minimise capital gains tax
If you expect to make a capital gain, then it is best to consider if there are any other assets you can (or should) sell that will crystallise a capital loss to offset some or all of the gain. Or sell assets that will create a capital loss first, before you sell ones that create capital gains.
If you are selling a property and you have previously claimed a deduction for depreciation, then the amount of your deduction will reduce its cost base. For example, James purchased a property for $200,000 and owned it for 5 years. Each year James claimed $2,000 of depreciation. James eventually sold the property for $198,000. In this situation, James will record a gross capital gain of $8,000 (because the cost base is $200,000 less $2,000 for 5 years = $190,000).
Be careful to avoid a “wash sale”. This involves selling investments solely to crystallise a capital loss (to offset a gain) and then buying back those same assets.
Consider selling in tranches, not all at once (with shares)
The challenging thing is that no one can predict what the share market will do this year. It could rise by another 20%. Or it could crash. Therefore, I typically advise my clients to spread their timing risk. This means if they own a stock that they want to sell, I usually suggest they sell it in 2 to 4 equal tranches, three to four months apart, rather than selling it all at once.
Borrowing capacity is just as important as cash flow
A common mistake that people make when assessing an investment property is that they assume that just because the property’s income covers all of its expenses, that holding onto the property is a costless exercise. They say “well, it’s not costing me anything cash flow wise, so I may as well hang onto it”.
However, that is incorrect. There is an opportunity cost – both with respect to borrowing capacity and equity.
Everyone has a limit to the amount they can or should borrow. Borrowing capacity is a scarce resource and should be allocated in the most efficient manner. If a property is using some of your borrowing capacity, you must ensure its working hard for you. How you allocate your borrowing capacity is just as an important decision as to how you allocate your cash flow.
The same is true with respect to equity. If you have a certain amount of equity tied up in a property that is not performing, you must ask yourself what else you can do with that equity. That is your opportunity cost.
If it hasn’t performed in this market… well
As I said above, in a rising tide, all ships rise. Therefore, if most of your investments within your portfolio haven’t performed over the past few years, then you are probably doing something wrong.
Sell to reduce concentration risk
If you have too much of your portfolio invested in one stock, sector or fund manager, now might be a good time to sell some of your investment and reinvest these monies in a more diversified, lower-risk manner.
Good reasons not to sell
Be careful to not be too hasty with your decision to dispose of an investment. There are a few reasons why you might decide to retain an asset, even if its performance hasn’t met your expectations:
- You haven’t held the asset long enough so it’s too soon to make a reliable decision.
- Investment returns have been driven by market-wide phenomena, not something specific with your asset. Investment-grade apartments are a good example, which I discussed last week.
- The methodology hasn’t had a chance to work yet. For example, a valued-based share methodology won’t work as well in a bull market. So, if you adopted a valued-based methodology, its unreasonable to expect it to have worked (yet).
Spring cleaning is an important activity
Reviewing performance and taking appropriate action is a very important investment activity. It must be completed regularly with discipline and free of any emotional influences – that is, focus only on the data and stick to sound fundamentals. If done properly, over time you will reduce your portfolio risk and maximise your investment returns. Of course, if you need help, don’t hesitate to reach out.