Risky as Houses

Adjusting asset returns for risk.

Common wisdom in Australia is that an investment property beats shares because:

 

1. You get access to cheap finance (notwithstanding that margin loans exist), and:
2. The housing market is not subject to the same volatility as the share market.

Most shares-versus-property comparisons focus on carrying and transaction costs, with historical market averages as a baseline for returns. 

However, individual shares swing more than does a passive global fund.

And the value of a single house swings more than does an aggregate market.

How can an individual investment property go wrong? Let me count the ways. Dodgy builders, deadbeat tenants, storm damage, the list goes on. And that's before we get to the risk of financial conditions rendering your debt un-serviceable.

It is this idiosyncratic risk that we will try to price in...

via GIPHY

Shares vs Leveraged Property Round 2!

Shares: DHHF

DHHF is a mega-blend ETF of thousands of shares with an Australian bias of about 37%. The rest accords roughly with a global allocation.

It has an annual volatility of about 15%, acutely felt when some orange idiot plays funny buggers with tariffs.

There is no idiosyncratic risk. Your DHHF holding will perform the same as another DHHF holder's.

Leveraged Property

Suburban single-family rental. 

Market risk corrected for appraisal smoothing is around 8%. (Hoesli, Lizieri 2007)

Idiosyncratic risk is 7.9% - 10.55%. Note that this goes both ways. You could be the only one among your peers to have a water heater explode, but you could also reap excess rewards on a tasteful kitchen reno. (Cheung, Galimberti, Jaqueson, Vermeulen, 2025)

Borrowing is 80% LVR. Go hard or go home, right? 😉 

This multiplies the return on your deposit by 5x (Leverage Multiplier) and multiplies your costs by 4x (Debt-to-equity Multiplier), assuming debt is used for carrying and transaction costs.

Step A: Calculate Total Volatility 

Total volatility (optimistic) is then:

Total = √(Market^2 + Idiosyncratic^2) , or:

Total = √(0.08^2 + 0.079^2) = 11%

Step B: Apply Leverage

An 80% LVR means a 5x Leverage multiplier.

Annual volatility = 5 x 11% = 55% volatility. 

Step C: Convert Volatility into a Percentage Return "Drag"

To convert volatility into a direct percentage penalty which can be subtracted from expected returns alongside transaction costs, we use a Mean-Variance Optimization Risk Penalty Utility formula:

Risk Penalty = ½ x A x volatility^2

Where "A" is a Risk Aversion Coefficient. Standard investors usually fall between 2 (less risk-averse) and 4 (more risk averse). Let's use A = 3.

DHHF's Risk Penalty = 0.5 x 3 x (0.15)^2 = 3.38%

Leveraged Property's Risk Penalty =  0.5 x 3 x (0.55)^2 = 45%

The Showdown

Metric	Passive Fund (DHHF)	Leveraged Direct Property
Gross Expected Return	~9.0%	~6.0% capital growth + ~4% gross rent = 10.0% With 5x leverage, 50%
Transaction Cost Drag	~0.0% (Brokerage negligible, MER 0.19%)	-1.5% (Amortized stamp duty, agent fees, legal entry/exit)
Carrying Cost Drag	0.0%	-4.5% (Mortgage interest at ~6% on 5x leverage, property tax, maintenance) With 4x debt-to-equity, total cost drag = 4 x (-1.5% - 4.5%) = -24%
Net Nominal Return	~8.8%	~4.0% nominal. Net return on equity = 50% - 24% = 26% 😀
Risk Penalty	-3.38% (diversified)	-55% (concentration + 5x leverage)
Certainty Equivalent Return	5.42%	-29%

Final Words

There is a lot of room for subjectivity in the risk penalty formula, as in, "How much risk are you comfortable with?" 

For expected risk-adjusted returns on leveraged property to equal that of a passive equity fund, to the point where you would have difficulty choosing between the two, you would need to be far more risk-seeking than the standard investor.

Over long periods of time you would expect returns to approach expected nominal returns. That is, unless catastrophe risk actualised and forced you out of the market. 

Perhaps that's why governments support home ownership and property investment with all manner of concessions.

Only the boldest would invest in property otherwise.