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 boom or even a 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 minds. property market

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 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 insufficient value 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 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 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). property investment

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 are 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, the 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.property market

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.

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