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Is property about to outperform ASX shares in this rate cut environment?

This could be time for property to shine after underperforming shares for more than a year. Is this the time to rotate out of equities and into residential property?

It’s hard not to be tempted by the light at the end of the property tunnel as the declines in house prices are easing at a time when experts have flagged concerns about stock valuations with the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) index hitting a fresh 11-year high on Tuesday.

This financial year has been particularly good for shares and you only need to look at some of the stellar gains made by large cap ASX shares to get an appreciation of the performance of the asset class with the Fortescue Metals Group Limited (ASX: FMG) share price leading the group higher with a more than 70% capital gain over the year.

The Goodman Group (ASX: GMG) share price is not far behind with 53% increase while Mirvac Group (ASX: MRG) took the third spot with a 45% gain.

Is the tide is turning for property?

In contrast, Sydney and Melbourne home prices have fallen 15% and 10%, respectively, although property bulls are emerging from hibernation after being awoken by falling interest rates and the federal election results.

The thinking here is that the Reserve Bank of Australia (RBA) will be forced to cut rates to new record lows of 1%, or even 0.75%, and that would open the floodgates that were holding back pent-up demand for property.

The argument certainly sounds logical to me and I did some work over the long weekend to see if I too should be jumping on this bandwagon. What I found is that it wasn’t a comfortable ride.

Cracks in the property investment story

Even though property prices have eased and borrowing costs are at the lowest I’ve ever seen it, it’s still very hard to be positively geared in property.

I made some assumptions about the “typical investor”, even though I acknowledge there’s no such thing as one, who is looking to purchase a home for $450,000 to $500,000 and will borrow half that.

Even in the “bull case” calculations, he/she could make $130 a month versus a loss of $211 a month if there was a change in tenants in that financial year. Replacing a tenant is an expensive exercise in terms of lost income and other associated costs.

I’ll ignore negative gearing as I suspect most will still be losing money even with the tax benefit and I don’t like putting money into something that will be bleeding cash.

The economics improves significantly if all cash was used, but even then, the capitalisation rate (which is your net operating yield before tax) inches up to just under 3% in the bull case. That may be better than inflation but hardly worth the effort in my view given the risks and large capital outlay (the size of the outlay is a risk factor as it impacts on your ability to diversify).

Foolish takeaway

The only way to justify rotating into property is if you are convinced that house prices will increase significantly. Stranger things have happened so it’s a possibility.

But if you look at the key drivers behind the very enduring property boom of yesteryears – easy availability of debt and strong migration – you might think history will not repeat.

Don’t get me wrong, property prices are more likely to rise than fall over the longer term and it should increase by inflation at least, but there’s nothing to suggest to me that property will outperform shares over that period.

Throw in the fact that most investors won’t need to borrow money to invest in a portfolio of blue-chip shares, the stronger yield, low transaction costs and ease to move part of their capital out of the asset class, and I think property bulls have yet to mount a convincing argument.

Of course, this doesn’t mean you shouldn’t be looking at property as I have made some very general assumptions that may not apply to everyone. But no matter what investment decision you make, you should do so with your eyes wide open and I hope this article has given you somthing to mull over.

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Motley Fool contributor Brendon Lau has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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