Typically, you need a budget of circa $1.5 million to purchase an investment grade house (investment property) in Melbourne, less in Brisbane, and a lot more than $1.5 million in Sydney. Of course, not everyone can afford this budget, so I wanted to discuss how to buy the highest quality property possible within your budget.
This blog will still be useful even if you do have a budget of $1.5+ million, as it will help you understand what “investment-grade” property means.
What makes a property investable?
Regular readers of this blog will know that I always adopt an evidence-based approach when making investment decisions. An evidence-based approach typically means adopting a rule-based approach. That is, apply a set of objective rules to identify the asset/s that are most likely to generate the future investment returns that you desire.
The rules-based approach for investing in residential property involves ensuring a property has three important attributes. Properties that have these three attributes are typically considered investment-grade.
Attribute 1: A persistent imbalance between supply and demand
‘Supply and demand’ is a basic economic concept that explains how many investments work.
The goal with investing is to invest in assets that will generate good returns over very long periods of time. For example, an 8% p.a. return means your investment will be worth 10x in 30 years. Obviously, a 10x return will help you generate a huge amount of wealth.
The most likely way to generate strong capital growth over very long periods of time is to invest in properties that are in finite supply and benefit from growing and excessive demand. When the number of buyers exceeds sellers, prices will rise.
Finite supply means that there is no vacant land within close proximity, which is why well-established, blue-chip suburbs are typically great locations to invest in. A dwelling’s attributes can increase a property’s scarcity too. For example, no one is building art-deco properties anymore. Apartments blocks constructed in the 1960’s that only include 6 apartments are also very scarce – developers would probably build 20+ apartments on these blocks today.
Excessive demand can be achieved by investing in property that the wealthiest 20% of Australians desire, as their incomes and wealth position (and future inheritances) will assist in pushing property prices perpetually higher, for the reasons that I have previously explained here.
It is also very important that a property appeals to a variety of buyers such as families, professional couples, upgraders, downgrades, investors and so on. You must not invest in an asset that only appeals to one type of buyer. This will ensure demand remains consistently high.
Attribute 2: Evidence of past growth
There’s a common disclaimer used in financial services; past performance is not a reliable indicator of future performance. Whilst that might be true for some asset classes and investments, often past performance can be reliable indicator when analysing residential property. The reason for that is that the factors that have driven prices higher in the past tend to be static and factual, which means they will be responsible for driving future growth.
Static means that the positive attributes that make a property desirable tend to remain unchanged for many decades. For example, a property’s proximity to (private) schools, arterial roads, shopping strips, entertainment – these amenities tend to never move or change. Therefore, if these attributes have driven demand for property over the past 3 decades for example, then it’s likely they will drive demand over the next 3 decades.
Factual means these attributes are simply a question of fact, not opinion. Conversely, the value of a share on the stock market, for example, tend to be influenced by the market’s expectations. Expectations about a company’s profitability, growth, risk and so forth. These factors can be highly subjective. However, with property, it’s a question of fact. For example, the suburb East Melbourne is located close to the city so there are lots of entertainment options within walking distance. Its proximity to the city makes East Melbourne a desirable location.
Therefore, unless there is evidence to suggest otherwise, a properties historic capital growth rate tends to be a reliable indicator of what you can expect in the future e.g., will the growth be above or below median growth.
It is wise to therefore investigate a property’s historical growth rate i.e., what it’s been bought and sold for over the past few decades (you can use this calculator to calculate the compound annual growth rate). Often, you can find what a property has been sold for online, or your mortgage broker/advisor will probably have access to a database. You really want to see a growth history spanning 20 to 30 years i.e., a period that covers many growth cycles.
I also suggest reviewing the historic growth rate of comparable properties located close to your target property e.g., next door, assuming it’s a similar property. This data set should start painting a picture to help you assess whether it’s likely to be a good investment or not. If the historic growth rate is lower than expected, it’s a red flag.
Attribute 3: Strong land value component
A property’s total value comprises of its land value plus the dwellings value.
The land value drives the capital growth rate, as land in highly desirable locations appreciates in value over time.
To a large extent, the dwellings value drives rental income. For example, a brand-new property will generally generate a higher rental return than an older property.
As I wrote last year here, investing in property is all about maximising capital growth, not income.
Therefore, to maximise your capital growth rate, you must maximise the land value component of your property i.e., spend more of your money on the land as you can always make improvements (upgrade) to the dwelling in the future. This means avoiding newly constructed property. Typically, the older the dwelling, the higher the land value component will be.
Start in with investment-grade locations and work your way out
As I said at the beginning of the blog, you really need to have a budget of circa $1.5 million to buy an investment-grade house in Melbourne. If your budget is lower than this, then I would advise you to buy a property that has the three attributes discussed above in as close to a blue-chip location as possible. That is, start at the closest blue-chip suburb and investigate adjoining suburbs until you find a house in your budget.
Generally, you are better off to compromise on land and accommodation size before you compromise on location. Therefore, if your budget isn’t enough for a 3-bedroom house, then consider buying a villa unit, if it has the 3 attributes. Or even an apartment.
If you are buying for investment purposes and find that you budget isn’t enough to buy in a capital city, then you could consider investing in a major regional city. Just be careful with this as some regional cities have experienced a lot of growth during Covid and may not offer good investment prospects over the next 5 to 10 years.
Leapfrog into an investment-grade location
If your budget doesn’t allow you to buy directly into an investment-grade location, then perhaps you can consider buying a property in a secondary location which you can improve to manufacture equity. As soon as you have enough income and equity, you can then sell and upgrade into a superior location. This is called a steppingstone strategy which I discussed a couple of years ago here.
Professional advice pays for itself
The last bit of advice that I’ll leave you with, is if you’re going to spend a lot of money buying a property, then consider investing in professional advice i.e., a buyers’ agent. Only do that if you can find a buyers’ agent that is knowledgeable, and has plenty of experience in buying property in the location that you are interested in. I discuss some of the benefits of using a buyers’ agent here.
