Here speaks an equity man, just don't do this at home

I had an interesting debate with my brother in law the other day. He was considering going to go the bank borrow a sum of money and invest in a house, rent it out, using the income to pay the loan, in 25 years time he hopes to own an asset that has held its value in real terms. The bank manger will probably say yes, my brother in law is a hard working man who has never failed on a debt to my knowledge. There is nothing unusual in his idea, plenty of people do it. I wondered what the reaction would be if he went into the bank and asked the bank manager to borrow money and invest it an FTSE 100 ETF, I think the response would not be so favourable. I imagine he would have been shown the door in pretty short order. Why? The FTSE100 offers you an income, as does a house, that grows generally above the rate of inflation, that should you wish can be offset against the cost of a loan. You may be subject to one company failing to pay its dividend, but extremely unlikely to see all 100 companies fail to pay. With a property your risk is concentrated to one tenant, if he does not pay, you have to evict him get solicitors involved and then find a new tenant. If all that fails in extremes you have to find a buyer for the property. It can be a costly business.

If you think back to 2007, part of the problem for the banks was to have lent money on property assets that the owner could no longer afford and the bank could not sell. Even worse they were lending money on the future value of a property. When the collapse came, the banks were unsure how to value the asset, and the way out was probably to lend someone else the money to buy the asset from them at a deeply discounted price.

Imagine if the asset was not a house or piece of land but the FTSE 100 ETF. The bank would know the value of the asset, could liquidate at any moment in time. Suppose interest rates moved sharply higher, the buy to let sums soon do not work so easily. The owner of the ETF could at any moment in time sell the asset if he wished, and repay the outstanding loan and walk away with no further costs or hassle. The FTSE 100 ETF does not need a lick of paint every few years, does not suffer damp or requires re-pointing, as some properties do. The FTSE 100 ETF is diversified, the risk is spread across many assets. One of the problems with the FTSE 100 is investors are keen to register gains and take losses, unlike a property.

The FTSE 100 started almost 30 years ago today. I am in no way advocating to borrow money to stick in the stock market, and I know a bank manger will never lend to buy equities but I thought it would be a thought provoking way to compare the two asset classes.You ask what have the returns been on the two asset classes? Since 1984 compound annual growth rate of the average house price in the UK has been 6.14%, and the FTSE 100 6.5%. Despite this I still think you will get shown the door by the bank manager.

 

House price data

Market data

Posted on January 7, 2014 .