Should you sell an underperforming apartment? Part 1

Apartments have underperformed compared to houses for the past 13 to 14 years in Melbourne and Brisbane and the past 6 years in Sydney.  

Melbourne has been the weakest market. Over the past 13 years since 2011, the median apartment price in Melbourne has only increased by 2.6% p.a. Interestingly, this matches the inflation rate over the same period (2.6% p.a.), indicating that, in real terms, the median apartment price in Melbourne has experienced no change for the past 13 years, which is a very poor outcome for investors.  

Naturally, many investors are rightly disappointed with investment returns and are considering selling underperforming apartments.   

Is the problem asset-specific or market-wide?  

If you have an underperforming apartment, it might not be because the property itself is impaired. Instead, the underperformance could be attributed to the overall poor performance of the entire apartment market. 

The chart below sets out median apartment price growth rates since 1980. You will note that all property markets experience two cycles – a flat cycle followed by a growth cycle.  

It is important to consider what factors have contributed to this underperformance. I discussed these in detail in a report published in November 2021. I summarise these factors below.  

Apartments were expensive compared to houses  

The median price of apartments in Melbourne appreciated at a rate of 9.1% p.a. between 1980 and 2010. Therefore, by 2010, apartments were relatively expensive, as long-term growth rates should normally range between 6% and 7% p.a.  

Too many new apartments 

After 2010, the supply of new apartments increased substantially – more than tripled in many cases (refer to the chart in Section 1.4 of this report). Many property developers were selling a large volume of apartments off-the-plan to non-resident, Chinese buyers. These buyers are nowhere near as active in the market today, due to the tightening of foreign ownership laws.  

Clamp down on borrowing rules  

The banking regulator began clamping down on borrowing rules in 2014. The most substantial change was to stop using benchmarks for borrowers’ living expenses, which were unreasonably low, to a verification process based on the actual spending reported by borrowers. Borrowers now must declare their expenditure across various categories and banks will take steps to verify this information by reviewing bank statements. Apartment buyers tend to be financially weaker than house buyers and are therefore a lot more sensitive to changes in borrowing capacity.  

What could the future hold?  

There are several factors that could stimulate the apartment market to begin a new growth cycle.  

Supply of new apartments is lower 

New dwelling starts in the September 2023 quarter were the lowest they have been for more than a decade as discussed by Pete Wargent here. Considering the huge uplift in population growth due to immigration, Australia is not building enough dwellings, including apartments. Apartment prices will push higher due to the lack of supply.  

Construction companies, building costs and quality… 

It’s widely reported that numerous construction companies, including those involved in residential and high-rise buildings, have gone bust, impairing future supply.  

With construction costs escalating by over 30% in recent years, developers must increase prices for new apartments.  

The well-documented concerns about build quality, exemplified by issues such as cracking in Mascot Towers and cladding problems, are pushing builders to improve the overall quality of apartments. Additionally, as these apartments primarily target Australian buyers, developers can no longer compromise on the quality they may have offered a decade ago to non-resident buyers.  

These factors will contribute to a rise in the cost of new apartments, making older-style apartments a more favourable comparison in terms of pricing. 

Apartments are relatively cheap!  

The chart below demonstrates that apartments are relatively cheap compared to houses. In Sydney, the median house price is now almost double the median apartment, which is much higher than the long-term average of 1.4. In Melbourne and Brisbane, the median house price is over 1.5 times higher than the median apartment price. The long-term average in these markets is 1.3 and 1.2, respectively.  

Apartments are the cheapest that have been relative to houses since 1980.  

Cost to rent versus cost to own  

Many older-style apartments currently yield gross rental returns of over 4% p.a. Given that owner-occupier interest rates are around 6.5% p.a., the gap of 2.5% is relatively modest compared to history. However, rents are anticipated to continue to increase, and if interest rates decrease, this gap is expected to shrink further. Consequently, there may come a point where more renters, potentially influenced or helped by their parents, opt to purchase rather than continue renting.

Part 2…

In Part 2 of this blog, I will discuss when apartments might enter into the next growth cycle and share a 4-question decision matrix to help you work out whether the divest of your underperforming apartment. See here.