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Why you shouldn’t listen to property market predictions – good or bad!

Property bubbles, the abolition of negative gearing, Australia’s housing affordability crisis, property market is on a brink of crashing, property cannot continue to appreciate in value at the same rate – all of these are headlines you regularly see in the newspapers. Bad news (read fear) sells more newspapers than good news. I have been a keen property observer and investor for over 20 years and participated in the property industry on a daily basis for 13 of them. Over that time the property market hysteria hasn’t changed much and I don’t expect it to either.

In this article, I’m going to share with you why most property market analysis and options are just not meaningful to investors like you and me.

What do you mean by “property”? This is the crux of this issue

People talk about the “property market” as if it’s just one big homogenous market. The truth however is that the Australian property market is made up of thousands of different market segments and locations and each has its own drivers. How mini-markets are very sensitive to interest rates for example and others are not. Therefore, to make an assessment or prediction about the Australian market as a whole you need to make extremely generalising statements. In fact, in many situations statements become so generalised that they become meaningless.

Maybe this point is better made using an analogy? Let’s assume you are a 45 year-old male and you go to your GP seeking advice on a medical issues, instead of the GP examining you, he chooses to make his diagnosis using health statistics relating to all 45 year-old males in Australia. Of course these statistics include data relating to very healthy men and some very unhealthy men. How useful do you think that approach would be? Listening to general property market commentary is probably just as useful to investors – the data and commentary is meaningless.

However, if a journalists or commentator is writing specifically about investment-grade property only, then I would be “all ears”. The problem is that this is almost always not the case.

Before going any further I should define what I mean when I say “investment-grade property”. Investment-grade property is property that has all the right fundamentals that will help the property double in value every 7 to 10 years. Investment-grade property has proven its ability to appreciate at this rate (i.e. the average compounding rate of historic appreciation over the past 20 to 30 years is above 7% p.a.). More about this below.

Beware of the self-interest

I think a healthy level of scepticism should always be welcome. Productive scepticism is an imperative attribute to become (and remain) a successful investor. Note that it needs to be productive which doesn’t mean not trusting anyone or anything – that’s not productive.

Most of the research and commentary that is conducted about the property market is funded by people with a vested interest (that includes me by the way). For example, the banks publish a lot of research. It is important to note that the vast majority of their profits are the result of lending (mortgages) which benefits from a healthy property market. The funds management industry has funded research in the past – guess what, espousing the property markets benefits won’t help them sell more managed funds will they?

Research and analysis is expensive and of course there needs to be a commercial reason for investing in it – so this conflict of interest exists in many industries, not just property. This doesn’t render all research useless. Just read it with the conflict of interest in mind and maintain a productive level of scepticism (e.g. I wouldn’t put much weight on a suburb research report given to me by an agent trying to sell me a property in that said suburb).

But don’t ignore it completely – it can add some value

The typical advice espoused by most investment experts is that if you invest in growth assets (e.g. property and shares), that there is a very high probability that those assets will fall in value significantly (e.g. 30%) in one year that at least one time during your lifetime. The Australian share market did exactly that in 2008 and I think it’s foolish to believe that the property market could never drop by a similar margin. Virtually anything is possible and the negative commentary about the property market can serve as a reminder to us to always protect our downside risk. Investing is about maximising your return for the absolutely lowest risk. You can use the negative commentary or doomsday predictions to stress-test your own investment strategy by asking yourself “what can I do to protect myself assuming that prediction comes reality”.

What makes investment-grade property?

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 it’s 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 (but not every) well-located two-bedroom, single-fronted houses in Prahran, South Yarra and Hawthorn in Victoria (for example) sold in the early to mid-1980’s for $75k to $80k. The same properties would be worth over $1 million today – that’s approximately 9% p.a. over a 30 year period.

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.

When putting the above three factors into practise most dentists would be well advised to seek independent advice from a trusted buyers’ agent. Knowledge without experience can be dangerous – think about what you were like when you left university and started practicing as a dentist compared to now. That why I’m a firm believer in getting some advice before investing hundreds and thousands of dollars.

Mitigating the risk of capital loss: 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. And the reverse is also true. That is, you cannot invest in average quality property or shares and expect good returns.

Therefore, to increase the probability of being a successful investor (or put differently, reduce the risk of being unsuccessful), you need to focus all your energy on only investing in quality assets. A quality property is often referred to as “investment-grade” property. If you own the best property in Australia and the whole market drops by 20%, chances are that your property’s value would have fallen by much less – if at all. Never compromising on quality is the best risk mitigation strategy.

 

 

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