The Business Times, Friday 16 January, 2004

The way to go in property investment

Prime freehold dwellings are worth considering if you're looking to buy a property

By JOSEPH CHONG AND CHONG KOK PENG

(For the full version of this article, please go to http://www.ni.com.sg/newsletters.asp "Property in financial planning")

FOR Singapore's property investors, it has been a cruel shakeout. Since 1997 - apart from a bounce after the Asian crisis - the market has been weak. Many are now suffering negative equity in their homes. The current market has also impaired the long-held belief that property can only appreciate given Singapore's scarcity of land.

Another myth that was prevalent then and still pitched to homebuyers by lenders and sales folk today is that 'any time is a good time to buy a property if you are buying to stay'. Generally, we are advocates of owning your residence but watch the price you pay. Overpaying by $100,000 on your property means other needs such as retirement or your children's education would be short by $100,000 plus the compounding effects of interest payments. So, do your sums, research and remember to bargain.

One question that we are often asked is whether this is a good time to buy property. We wish we knew for sure. Unfortunately, investment advisers can only work with the balance of probabilities based on statistics, fundamental analysis and judgment.

When using statistical correlations, it is important to ascertain causality. For example, there is a correlation between the size of ships and the age of their captains but the relationship is not causal! However, one correlation, which we believe is causal, is that of the Singapore stock market performance and the residential property market. It is causal as it is driven by the nation's economic performance. We re-based the STI to 100 points at end-1998 in order to compare with the URA residential properties index. The stock market apparently leads the URA residential properties index by six months. Hence, if the correlation holds true and the stock market bottomed in Q2 2003, then the forthcoming property market data should show a bottom in Q4 2003 or Q1 2004.

Most pundits agree that the stock market has bottomed but where is it going? This is important if we believe that the stock market leads the property market. We believe that global stock markets in the past nine months have appreciated primarily as a result of excess liquidity (courtesy of G3 central bankers) and a reduction in investors' risk aversion (observable declines in equity and credit risk premiums).

This is manifested by the expansion of price-earnings ratios globally. For example, the PER on the S&P 500 has expanded from 16 to 19 times in the past eight months. We believe that in 2004 both short and long-term interest rates will stay low because of outsourcing to China, among other things.

China is not only a prodigious supplier of cheap labour (driving inflation down) but also an indirect supplier of capital to global manufacturing through her high saving propensity (driving real rates down as well). This notwithstanding, we believe that excess liquidity will no longer be expanding as liquid balance sheets are converted into inventory and investments in new equipment, i.e, significant PER expansion is not likely. We believe that better corporate earnings will drive the markets forward in 2004.

Even if one believes that this is a good time to buy a property, what type should one opt for? Our preference is for prime freehold dwellings. Within the prime area, an older, but well-maintained dwelling with a low allowable plot ratio could very well preserve its value best going forward. We arrived at this conclusion from an explanatory model which we developed (details of the New Independent (NI) property model are published on www.ni.com.sg). We emphasise that this is an explanatory macro model and not a predictive micro model. Eventual appreciation of residential property is still very much subject to government land supply and zoning policy, the effects of adjacent developments and other dwelling-specific factors.

Essentially, when buying a residential property, one is purchasing two elements: the building and the land beneath. Generally the building would have a useful life of 30 to 50 years. That is, the value of the building will depreciate. On the other hand, (freehold) land tends to appreciate at a rate of nominal GDP growth per capita. Based on this assumption, our model delivers some interesting predictions. The value of a property compared to the value of land on which it sits is a good proxy as to how suburban it is. The bigger the ratio, the more suburban the property is likely to be.

In our scenario of where property values would be in relation to GDP growth, it is clear that, notwithstanding it being freehold, the most suburban dwelling is predicted to do least well.

Indeed, if economic performance is poor, say 2 per cent, one could suffer an actual decline in the value of one's property. This also possibly explains why deflation (when GDP growth per capita is less than zero) is so devastating to property values.

However, one new phenomenon which targets retail investors is 'land banking'. We understand that many retail investors have invested in 'undivided interests' in rural land in North America in the hope that it be re-zoned for productive use. But how many are aware that such investments are not regulated in Singapore? We believe it should be, especially when retail investors are targeted. Moreover, we believe that Singapore law does not apply in the event of a dispute - and how many retail investors are familiar with foreign statutes?

The ownership structure of land banking appears to be a hybrid of land ownership, real estate investment trust (Reit) and unit trust. Just because it does not fall clearly under one does not mean it should not be regulated. We believe that if this were regulated under the Financial Advisers Act and Securities and Futures Act, the disclosure and compliance regime would have made investors more careful. Indeed, in the case of one land-banking company they would have had to explicitly disclose that financing was being provided by a related mortgage company. Interestingly, rates charged by the captive financier appear relatively high.

Also, if regulated, could the land-banking company advertise the projections of high returns with buy-back capital guarantees? Especially if the capital guarantee is an unrated one? I wonder if the authorities would allow such an investment scheme to be marketed if someone tried this with raw land at the edges of Singapore?