Since the start of 2020, property prices in relatively affordable regional markets have risen strongly compared to capital cities, partly driven by Covid lockdowns and higher interest rates.
I have come across numerous posts from buyer’s agents on social media showcasing the strong short-term gains their clients have made. For example, “Bought this property four years ago for $550,000, and it’s worth $850,000 today.”
While this is great news for their clients, it’s important to remember that a short-term profit does not necessarily drive long-term value.
What is hotspotting and how does it work?
Hotspotting is a property investing strategy where you identify areas, usually suburbs, that are expected to enjoy above-average demand for housing, which in turn drives property prices through a significant growth cycle. These areas are typically in regional locations or outer suburbs of capital cities. Properties in these areas are often more affordable, with prices ranging from $400,000 to $600,000, and they tend to offer higher rental yields.
The challenge with hotspotting is pinpointing the locations where property prices are on the brink of taking off. Buyers’ agents typically rely on demographic data such as household income, population growth, and migration patterns as potential indicators of future property price growth. They also look at growth drivers like new infrastructure projects, economic development, and government initiatives.
However, there are two key challenges with using a data-driven approach for making investment decisions. First, it’s often hard to find reliable, up-to-date demographic data. Much of the data available is over a year old, which means it tends to reflect past trends (lagging data) rather than predicting future developments (leading data). Second, because many buyers’ agents and analytical firms have access to the same data sets, it can be difficult to gain a competitive edge.
Data driven decisions and the self-fulfilling prophecy
One of the biggest concerns with a hotspotting strategy is that it can become a self-fulfilling prophecy. I am aware of buyers’ agents purchasing properties in Perth’s outer suburbs, sight unseen, over the past couple of years. Local real estate agents quickly caught on that these buyers’ agents would snap up properties with little due diligence, making it incredibly easy to sell to them. Naturally, the next seller in the area wanted a higher price, and the buyers’ agent, who had already committed to the area, had to keep paying more with each transaction.
The problem? These same buyers’ agents then used the price growth they had created with their clients’ money as “evidence” to convince other investors that the location was booming. But was the growth real and sustainable, or was it just artificial demand driven by a handful of buyers?
As an investor, how do you know if a location is genuinely in demand from a broad buyer pool, or if price growth is being propped up by just a few sources of demand? That’s a critical assessment to make.
The same issue applies to hotspotting reports. If they become widely followed, they can fuel price increases simply because so many investors rush in based on the same data and advice.
The key is to invest in locations with genuine, multifaceted demand, where both owner-occupiers and investors, particularly those who live in the state, are driving the market. Areas dominated by interstate investors, for example, can be vulnerable to exaggerated price movements that are not backed by long-term fundamentals.
What is the biggest downside to hotspotting?
The core issue with hotspotting is that secondary locations simply cannot sustain above-average price growth over the long run. The reason is straightforward: household incomes in these areas will not grow fast enough to support ongoing price appreciation, unless buyers have access to other sources of wealth. In addition, these locations typically have more available vacant land, which limits long-term capital growth.
While some of these areas might experience a short-lived surge in prices (if you are lucky), they will almost certainly fall behind blue-chip suburbs, where the wealthiest 20% desire to live.
At the end of the day, the maths is simple: the best property investment strategy is the one that delivers the highest average capital growth rate over multiple decades because it benefits from compounding capital growth.
Here’s an important example: a $1 million property that appreciates at an average rate of 6.5% p.a. over 30 years. In 30 years, the property will be worth $6.6 million, meaning it has gained $5.6 million in equity. Here’s how that growth breaks down:
- Only 16% of the total equity growth happened in the first decade ($880k).
- 26% of the growth occurred in the second decade ($1.65 million).
- The biggest chunk – over half (55%) – came in the third decade ($3 million).
This highlights an important strategy point: you must invest in locations that will deliver solid growth across the entire 30-year period, not just in the first few years!
The numbers: Hotspotting versus buy-and-hold
You know I’m a numbers guy, so you should expect I have prepared a financial analysis.
Regarding analysing a hotspotting strategy, I have made the following key assumptions based on outcomes I have seen advertised: Buy a hotspotting property for $650,000.
- Initially, the gross rental yield starts at 4.5%, generating $560 per week.
- Mortgage interest rate of 6.5% p.a., with 30% of gross rent allocated for costs.
- Investor is in the 39% income tax bracket.
- After 7 years, the property’s value is expected to double. The investor sells the property and reinvest the net after-tax cash into an ETF portfolio earning 7% p.a. before tax, and then buys another hotspotting property within 12 months.
If the investor stops after selling their third hotspotting property and leaves all the funds in the ETF portfolio, my projections show they could accumulate approximately $1.45 million in today’s dollars after 30 years (around $3 million in future dollars). This consists of $265,000 of original capital invested (property holding costs) plus $1.185 million of after-tax investment returns.
Alternatively, if the investor had purchased an investment-grade property with a 2.5% p.a. gross rental yield and 7% p.a. capital growth, and sold it after 30 years, they would realise cash proceeds after-tax exceeding $2.35 million in today’s dollars (circa $5 million in future dollars) – this is almost an extra $1 million more than the hotspotting strategy (65% more)! This total return consists of $555,000 of original capital invested (property holding costs) plus $1.8 million of after-tax investment returns.
Of course, it’s important to note that the cash flow requirements (capital invested) differ significantly between holding an investment-grade property versus a hotspotting property. The investment-grade asset costs twice as much to hold after tax. I will address this shortly.
Adjust for inaccuracy risk with hotspotting investments
In my financial analysis above, I assumed that the investor buys three consecutive hotspotting properties, each doubling in value after seven years. But let’s be clear; this requires perfect asset selection and perfect market timing. As I have discussed, that’s incredibly difficult because the data used to identify potential hotspots is often unreliable or outdated.
I remember sitting on a panel years ago alongside a well-known advocate of the hotspotting strategy. She admitted that her accuracy rate for her personal property portfolio was around 70–80%. At the time, I could not help but think: why would you base your investment strategy on something with such a low success rate?
Therefore, to test a more realistic scenario, I modelled what happens if the first and third hotspot properties perform as expected but the second one underperforms, appreciating by just 23% over 7 years. That’s not a complete failure, but it falls well short of the investor’s goal. In this case, instead of accumulating $1.45 million, the investor would end up with just over $1 million, comprising $265,000 of original capital invested and $786,000 in after-tax investment returns.
This analysis demonstrates that for this strategy to be successful, the investor needs to time the market perfectly, hold through the full growth cycle, and repeat the process with consistent accuracy – every single time. That’s a big ask.
Adjusting for higher cash flow – compare apples with apples
As I mentioned earlier, an investment-grade property requires twice as much cash flow to hold compared to a hotspotting strategy. So, if we theoretically compare owning 50% of an investment-grade property with a hotspotting strategy, here’s how the numbers stack up:
- Perfect hotspotting strategy: $1.45 million of wealth ($265k of capital + $1.185 million of after-tax investment returns)
- Semi-perfect hotspotting strategy: $1 million of wealth ($265k of capital + $786k of after-tax investment returns)
- 50% of buy and hold: $1.17 million of wealth ($278k of capital + $894k of after-tax investment returns)
The key takeaway? If you can afford to invest in an investment-grade property, that is likely to be the superior long-term strategy. But if the holding costs are beyond your means, then a hotspotting approach might be a viable alternative – if you can consistently pick the right properties at the right time – it’s certainly a higher risk strategy.
However, if you agree a hotspotting property is not going to deliver strong capital growth over many decades, then it’s probably best to sell it after the growth cycle ends and reinvest the capital elsewhere.
Will regional locations underperform over the next decade?
One additional risk with the hotspotting strategy is regional property performance. As I pointed out at the start of this blog, regional prices have outpaced many capital cities since 2020. This was largely driven by Covid, and affordability pressures due to higher interest rates and reduced borrowing capacity.
But markets move in cycles, and this trend will eventually reverse. That means investors in regional locations could be exposed to additional downside risk over the next decade.
