How to avoid investing in the wrong property

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If you invest in residential property, how can you be sure that it’s going to work out for you?

The media talks about a property bubble, whether the government should abolish negative gearing, the RBA’s warning banks to not be too exuberant to lending money and so on. There’s lots of noise about property that puts doubt in people’s mind. [BTW, Seth Godin wrote a brilliant short blog about the media and why you shouldn’t pay any attention to them]

If you are going to borrow money to invest in property (and nearly all investors do), you must get a decent amount of capital growth (say 7%+ p.a.) to offset the cash flow cost of holding the property. If you cannot be confident of achieving this level of capital growth then my advice would be; invest in something else. So this begs the question: how can you be confident that an investment property will appreciate in value at 7%+ p.a. on average over the long term? The short answer is quality. The longer answer is contained in this article.

The quality of your assets will determine your success

Without a doubt, the quality of your assets will determine 80% of your financial outcomes (i.e. how much money you make). That is, if you invest in high quality assets, you should expect high quality returns. The reverse is also true. Therefore, to increase the probability of being a successful investor (or put differently, reduce the risk of being unsuccessful), you need to focus your energy on only investing in quality assets. A quality property is often referred to as “investment-grade” property.

What is investment-grade?

Investment-grade properties should double in value every 7 to 10 years on a perpetual basis (which equates to a 7% to 10% per annum compounding growth rate). There are a two important points to make about this definition:

  • Of all the properties that exist in Australia, probably less than 5% would be regarded as investment-grade – so I’m not talking about just any old property – just a select few; and
  • When I say “perpetual growth” I’m not necessarily suggesting that its never-ending. I’m really only talking about our lifetime. It is true that mathematically, property can’t double in value forever as eventually no one will be able to afford it. However, there are plenty of investment-grade properties that will double in value every 7 to 10 years over the next say 30 years – and probably even longer. The discussion about property eventually levelling out is a valid one but not relevant to this article.

There are thousands of examples of individual properties that I can point to that have appreciated in value at average rates of 7% to 12% p.a. (compounding) over the past 30 years. Many two-bedroom, single-fronted houses in Prahran, South Yarra and Hawthorn in Victoria (for example) sold in the early to mid-1980 for $75k to $80k. The same properties would be worth over $900k today – that’s close to 8.5% p.a. They do exist.

Focus 1: scarcity

Scarcity essentially means that demand will always be greater than supply (as the supply of scarce properties is typically fixed or in decline). Compare two examples: firstly an apartment in a block of 200 versus a Victorian-style, single-fronted, two-bedroom cottage. There’s very little scarcity with the apartment because there is literally hundreds and thousands just like it. There is scarcity with the Victorian cottage because no one is building period style cottages anymore and many are typically located on very (scarce) valuable land. Arguably, supply of these types of assets is in decline whilst at the same time there is increasing demand. Conversely, investing in a brand new house in a new residential estate doesn’t make a good investment because land supply isn’t scarce – it’s often abundant. Just like with diamonds, scarcity pushes prices up.

Focus 2: land value

Every established property’s value is made up of two components; land value and building value. It is commonly understood that buildings depreciate over time and land appreciates. Tenants will typically be attracted to properties with more building value (accommodation) whereas investors should be attracted to properties with more land value. That’s why newer properties tend to achieve a higher amount of rental income and lower capital growth.

Consider the example of a new apartment worth $550k that is located in a high-rise building. In this situation it would not be uncommon for the building value to be $500k and the attributable land value to be $50k. For this property to double in value over the next 10 years (value of $1.1m), what needs to happen? Well the building component will depreciate to say $400k at the very least (probably lower). Therefore, the land value needs to be $700k (being $1.1m less $400k) – so it needs to increase from $50k today to $700k in 10 years or 30% p.a. compounding over 10 years. I’m sure you agree that this almost certainly won’t happen.

Alternatively, consider a 2-bedroom 1930’s apartment that is worth say $600k. In this situation, the land value is likely to be $450k and the building value is therefore $150k. In the next 10 years the building won’t depreciate that much – maybe another $30k. Therefore, for the total property’s value to double, the land needs to increase from $450k to $1.08m or 9% p.a. compounding.

Of the above two examples above, which one do you think has the most chance of happening? That is why land value is very important and one of the reasons buying property off-the-plan doesn’t work.

Focus 3: proven performance

It is important to check the past sales history of potential investment property’s to assess their past performance (NB: we can provide you with this historic sales data at no cost – just contact us). The reason for this is that the fundamentals that drive property values tend to be objective (not subjective) and static – or if they do change they take many decades to change. Things like proximity to shopping strips, hospitals, the CBD, arterial roads, architectural style, land size and so forth rarely change. Therefore, if these characteristics have been responsible for driving the value of a property up over the past 30 years, then it’s likely that the same growth rate will occur for the next 30 years (assuming these fundamental factors don’t change). It’s about investing in a sure thing because you do not need to take the risk in investing in a property that hasn’t proven it can deliver investment-grade returns.

There are a number of fundamental characteristics that drive a property’s value, including:

  • Scarcity and land value component, as discussed above
  • Proximity to amenities such as shopping, medical services, parks, schools, public transport, arterial roads and so forth
  • The quality of the dwelling: good natural light especially in living rooms, privacy (visual and noise), security, logical floor plan, attractive architectural style (inside and out), car park on title if it’s an apartment, structurally sound building and so forth.

Therefore, before you invest, make sure that property has demonstrated strong performance in the past.

Learn from other peoples mistakes

As I said above, the quality of your investments will determine how successful/wealthy you will be. Therefore, if nothing else, your attention should be laser-focused on investing in only the highest quality assets you can find. To find these assets you should get some advice – or at the very minimum a second opinion. I don’t do my own dentistry – I go to my dentist. I didn’t write my will – my estate lawyer did that. And I don’t select the properties I invest in (even despite my personal knowledge and experience) – my trusted buyers’ agents do that for me.

Professional advice has two ingredients; knowledge and experience. Knowledge comes from training, reading books, education and so on. Experience comes only with time. One is not a substitute for the other. When you seek professional advice you are benefiting from these two components but arguably, the most valuable is experience. They say that most people learn from their own experiences, smart people learn from other people’s experiences and dumb people never learn!

When I meet with a new client I have an opportunity to share my experiences. The fact that I have been advising investors for over 12 years means I have seen a lot of it before. I probably haven’t seen it all but there are very few scenarios or situations that I haven’t come across. I have the benefit of hind sight too because I have witnessed the outcomes of both good and poor decisions clients have made. The same is true for a good buyer’s agent. They can share their experience with you.

Research shows that there are two common traits of extremely successful and experienced investors. Firstly, they are absolutely fanatical about risk, asking themselves; “what can go wrong?” and “can I lose any money doing this?” Once they are satisfied that the risk of losing money is remote to almost impossible (they never want to lose money), only then do they turn their attention to the potential upside being, return. Secondly, these investors only invest if they can exploit the risk-return equation. That is, they are looking to achieve very healthy returns for comparatively very little risk – they don’t accept that you need to accept higher risk if you want higher returns. The only way you can take this approach when it comes to property investment is if you pay for professional advice and not try and do it all yourself.

Please, please focus on quality

In summary, you must ensure that all your attention is focused on only ever investing in quality assets. All you need to do to become financial free is invest in quality assets as often as your circumstances allow it. It really is that simple.

We have lots of tools and resources at our disposal to help clients invest successfully (including a network of trusted advisers) so please don’t hesitate to ask for our help. That’s what we are here for!