Should investors buy property, property stocks or both?

Broadly speaking there are two ways to invest and participate in the Hong Kong real estate market.

There is the direct approach - you buy a property (be it residential, office, retail, industrial, or whatever one fancies) or become a real estate developer, and one not only benefits from rising prices, but also from adding to the value of land, for example by changing its use or development density.

Alternatively there is the indirect approach - you buy a related stock, for example Sun Hung Kai Properties; or buy into a reit (real estate investment trust), for example The Link.

Naturally, there are other, more complicated approaches involving complex finances, but these are beyond the scope of this article.

From time to time, one may read debates in news media among investors and commentators about which of the above approaches offer better returns. Real estate agents tend to favour investing in bricks and mortar, while stocks traders would say equities offer better expense ratios, especially if all the stamp duties are taken into account.

Out of curiosity, we have done a quick comparison between the two asset types, that is, bricks-and-mortar real estate holdings versus paper equity real estate holdings.

For our data on bricks and mortar we have turned to the various residential indexes published by Centaline Property Agency; and the real estate stock performances are abstracted from www.Webb-Site.com, where the total return of each stock can now be found.

The time period we have chosen, somewhat arbitrarily is December 30, 2007 to January 20, this year, or roughly five years.

This is not exactly comparing apples with apples. Note that the bricks-and-mortar data are averages of the residential real estate sector and the stock performances are based on selected real estate stocks and reits.

While real estate rentals have been taken into account, they are not factored back into the property, because unlike stocks one either buys a whole unit or nothing, that is, one cannot use the net rents collected in a year to acquire a few more square feet of property.

The stock performances assume the dividends are to be reinvested to buy more of a stock.

Another caveat is comparing total returns with compounded annual returns. Total returns for bricks and mortar take rental yields into account, and for simplicity we have assumed the average rental yield for the period and for all geographical regions to be 4 per cent a year, that is, roughly 20 per cent in total for the five-year period.

For stocks (including reits), total returns include dividend yields. Likewise, the compounded annual returns for both bricks and mortar and paper equity have taken into account the rental yield and dividend yield respectively.

In the resulting table, CCL represents the overall Hong Kong residential real estate sector.

It is clear from the data that New Territories West offered the best total return over the period we have selected, and Hong Kong Island performed the worst.

In the case of paper equities, Cheung Kong (Holdings) and Sun Hung Kai Properties are among the most popular and sizeable property development stocks. The rest are reits, which invest mostly if not exclusively in commercial properties; one should also note that Yuexiu Reit invests in properties on the mainland, and not in Hong Kong.

From the data it is clear that reits offer better or more competitive returns.

As a group they offer some of the best total and annual compounded returns.

So does this suggest you should focus on investing in reits?

The simple answer is no, because these results may apply only to the period and the items studied. There is no proof beyond any doubt that reits will, at any time in any place, outperform their bricks-and-mortar equivalents, or vice versa.

Timing and reasoned selection of assets are more crucial.

Also, if one takes financing into the equation, then bricks and mortar generally offers better terms, as mortgages are usually less expensive than, say, a personal loan.

Given that the reits lean heavily toward commercial properties, and given that the typical bricks-and-mortar investor would find the residential sector easier to comprehend and participate in, it makes sense, then, to participate in both.

There are several issues to consider in setting up a well-balanced property investment portfolio including asset type (residential, office, retail, and so on) and diversification (note: there is no market risk diversification by investing in both residential and commercial properties in Hong Kong because the price correlations between them are high).

Also to be taken into account is recurrent income (rentals, dividends) and diversification not only in terms of sources but also in aspects of taxation. For example, rental incomes involve taxes while stock dividends do not for a Hong Kong resident.

Buying is one thing, selling another. What flexibility do you have in your portfolio? In this respect, property stocks and reits are easier to buy and sell (the latter action being especially vital if the market goes down).

Stephen Chung is managing director of Zeppelin Real Estate Analysis