Why do some locations outperform blue-chip suburbs?

I was motivated to write this blog for two main reasons.  

Firstly, I observed several buyers’ agents on social media proudly advertising short-term capital gains. One instance caught my attention, where a buyers’ agent claimed to have purchased a property for a client 18 months ago for $435,000, asserting its current value at $510,000, implying 19% capital growth. However, the actual growth is 17.2% over 18 months or, more accurately, 11.2% p.a. annualised growth. However, this calculation excludes purchasing costs, making the true annualised growth rate less than 7% p.a.! Misleading advertising?  

Unfortunately, there are few regulations to protect property investors against such misinformation, unlike with share market investments (heavily regulated), highlighting the importance of conducting thorough due diligence. 

Secondly, I received an email from a reader, Stephen, asking me to explore the recent boom in regional towns over the past three years, largely attributed to Covid-related factors. This theme aligns with another topic I’ve been contemplating – how seemingly secondary suburbs at times outperform blue-chip suburbs.  

This raises the pertinent question: How crucial is it to exclusively invest in blue-chip suburbs? 

Short-term performance data isn’t very meaningful   

Investors and their advisors cannot control short-term market performance. In the short term, market performance is volatile and unpredictable, with no reliable methodology for predicting it. However, over extended periods, market cycles tend to even out, making performance more predictable. Short-term performance is susceptible to unsustainable factors like popularity, while long-term performance is mainly influenced by investment fundamentals. 

Investors have control over fundamentals, meaning they can choose to only invest in assets with strong fundamentals, knowing that these attributes determine long-term returns. While one might experience above-average growth in the initial years of owning an asset, it’s crucial to recognise it as luck, which is not a dependable investment strategy. 

Conversely, one can also face a scenario of investing in a fundamentally sound asset and having to endure below-average investment returns for an extended period. Markets may underperform for longer than anyone might expect, but not indefinitely. 

This is why I approach businesses that advertise short-term returns with scepticism, as it often reflects their marketing prowess rather than genuine investment acumen.  

On the other hand, highlighting long-term returns is very valuable and compelling. 

There will always be locations that out-perform blue-chip suburbs  

The reality is that some geographical locations will outperform blue-chip suburbs over the next few years. However, pinpointing these outperforming locations with a high level of certainty is challenging – neigh on impossible.  

Short-term outperformance can be driven by various factors, including promotion by property spruikers, shifts in lifestyle preferences like tree/sea changes, new infrastructure developments, or periods of low-interest rates. 

The late founder of Vanguard, Jack Bogle, was famous for saying “Reversion to the mean is the iron rule of the financial markets”. This refers to the undeniable concept that periods of above-average growth are inevitably followed by periods of below-average growth, resulting in average performance aligning with long-term average returns. 

In the grand scheme, a location’s fundamentals play a crucial role in long-term performance. This means that locations experiencing strong buyer demand but limited property supply, such as blue-chip suburbs, are likely to enjoy higher long-term capital growth rates. 

Tried-and-tested versus growth suburb 

The below chart illustrates the performance of two properties over time. The blue line represents a property that experiences rapid capital growth – the value doubles in the initial 7 years but then stabilises in line with inflation for 17 years and grows again. This is compared with the green line, representing an investment-grade property with a consistent average growth rate of 7% per annum in the long run. While the first property initially accumulates more equity in the first 10 years, the investment-grade property surpasses it with 44% more equity after 20 years. Remarkably, after 40 years, the investment-grade property is worth more than double the value of the first property. 

Selecting the next potential high-growth location carries inherent risks. There’s a possibility of being incorrect, with prices not increasing as anticipated. Even if your prediction is accurate, sustained outperformance is unlikely unless the chosen location possesses robust investment-grade fundamentals. This is why an asset of high quality, backed by strong fundamentals, is more likely to consistently outperform in the long run. 

But some secondary suburbs have performed just as well as traditional blue-chip suburbs…  

Over the years, I’ve observed that some suburbs, which are not typically classified as investment-grade, have demonstrated strong capital growth over several decades. Take, for instance, the suburb where I purchased my first property, Moorabbin. Over the past 25 years, it has exhibited an impressive average annual growth rate of over 8%. For example, the property I bought for $150k in 1998 would now be worth more than $1.3 million.   

Similarly, neighbouring suburbs like Bentleigh and McKinnon have also performed exceptionally well, if not better. Despite being around 20 km from the city and considered secondary suburbs, these areas have thrived. The question then arises: why have these secondary suburbs performed so well? Are these locations as good as traditional investment-grade locations? Will these suburbs grow at this pace indefinitely?   

Why?

Firstly, it’s crucial to recognise the impact of the property ‘affordability ripple effect’. As property prices soar in suburbs near the city, becoming unaffordable for many buyers, demand shifts to adjacent suburbs. This heightened demand pushes prices higher until they reach an affordability threshold, prompting the ripple effect to extend further.

Secondly, some of the increase in property prices can be attributed to property owners investing in renovating or rebuilding their homes. Three to four decades ago, the suburbs mentioned above were dominated by post-war, brick veneer, 2 and 3 bedroom homes of relatively modest size. Today, many of these residences have been replaced with spacious family homes or multiple townhouses through gentrification, attracting a different demographic.

The critical question is: which is more likely to achieve a capital growth rate exceeding 7% per annum – a secondary suburb or a traditional blue-chip suburb? The answer lies in investing in locations where price appreciation is less dependent on household income and borrowing capacity, such as blue-chip suburbs, as discussed in previous blogs here and here.

Top 5% of properties have outperformed

According to research conducted by Ray White’s Chief Economist, Nerida Conisbee, the most expensive 5% of houses and apartments in Australia have exhibited superior higher rates of capital growth compared to the rest of the market. Over the past decade, luxury properties have appreciated by more than 13% when compared to median-priced properties. In certain locations, premium properties have even surpassed this, achieving growth rates exceeding 30%.

This data reinforces the intuitive notion that highly sought-after properties typically possess robust fundamentals, making them more likely to outperform in the long run.

What does this mean for investors?

To sum up this analysis, I draw three conclusions.

Firstly, while there will always be some suburbs that will outperform blue-chip, investment-grade locations over the short to medium term, identifying them is inherently challenging. Therefore, this is a higher risk strategy.

Secondly, even if you can pinpoint such an outperforming location, it’s crucial to consider the growth potential over several decades. Properties with weaker fundamentals are likely to underperform compared to investment-grade locations.

Finally, blue-chip, investment-grade locations carry the least investment risk because they rely less on household incomes and are less affected by changes in borrowing capacity to stimulate capital growth when compared to secondary suburbs.