29 May 2004

Property Investment – Is Now The Right Time?

We live in confusing times.

Politicians, the Reserve Bank, various interest groups and the media all having their input into the current property debate. But beneath all the emotive headlines, the property market is behaving fairly much as it always has – in a predictably cyclic fashion. Property has long been the trusted investment vehicle for Australians – for good reason. They key is in understanding both the long and short term fluctuations and investing accordingly.

Obviously there are various segments of the market that appear potentially oversupplied in the short term – with increasing vacancy rates and falling rental yields. These segments have been clearly identified for the past 2 – 3 years by the industry as problematic for investment in the short term – no surprises! They are not representative of the greater national market.

Putting it into context

Currently Melbourne and Sydney both have average vacancy rates of around 4%. In other words 96 out of 100 residential properties are needed – hardly cause for a major market correction. Melbourne’s previous worst vacancy factor was 5.2% n 1991 following the massive interest rate spike that precipitated “the recession we had to have”. Admittedly, capital growth was stagnant throughout the 1988-95 years, influenced in Victoria by a dreadful economic period, but the key issue is there was no bubble burst!

In fact over the past 30 years of recorded property values, neither Melbourne, Sydney nor Brisbane have recorded price falls of more than 10% for longer than 12 months. That is, the residential property market is remarkably resilient and self adjusting. At this stage, other than in a few already publicly noted exceptions (eg Docklands in Melbourne), there is no logical reason that the market should have anything other than either a plateau in price for a time of adjustment or ongoing price growth – in line with previous cycles. This entire market process is predicable and based on decades of similar behaviour. And it is the basis of our confidence into the future.

Property’s history as a wealth creator

Historical data (statistics) on Australia’s major capital city price movement is readily available for up to 40 years. Three facts are clear:

  • The property market is predictably cyclic.
  • While individual city markets enjoy similar growth over time, this growth occurs at different times within each city – creating a logical sequence of investment opportunities over any decade.
  • Residential property does not generally suffer from the “bust/bubble burst” problem that the media and various commentators would have us believe. Any market downturn is short-lived and minor in size.

Any investor who has taken a position in Sydney, Melbourne or Brisbane at any point over the past 30 years has done exceptionally well within 10 years. (The key is to hold over time and not to sell.)

During this period Australia has sustained recessions, interest rate peaks, widely-ranging CPI’s, hugely differing overseas migration patterns, the Asian economic meltdown and the world has been involved in a number of wars. The future looks little different. They key drivers to property price growth are supply and demand. The market is characterised by fluctuations around a permanently long term growth pattern. It is understanding these trends that underpins our property investment decision.

The keys to residential property investment

Most Australians understand 2 things:

1. We cannot hope to create any level of financial security by saving after-tax disposable income – hence we must invest.

2. Property is the universally understood and trusted investment vehicle. We know that it consistently grows in value over time. Rental yield and tax benefit largely enables us to service borrowings, and as a long-term investment it involves low risk.

Landscapes know that the simplest way to move a large rock is with a crowbar. It applies leverage and significantly increases the power of our muscles. A mortgage has the same effect – it significantly increases the power of our available funds to invest – hence enabling us to create significant capital growth over time from a small financial base.

In the past, all debt was seen to be bad. Increasingly Australians are coming to terms with the concept of “productive” and “non-productive” debt – the difference between borrowing for financially positive outcomes and normal consumer debt. And generally Australians are more comfortable borrowing against property than they are against any other form of asset, which is why property is for most of us the best investment vehicle to use. The key issues that concern us as investors are:

  • Vacancy
  • Interest rates
  • Yields
  • Capital growth

With vacancy, interest rates and yields the secret is to take into account both current rates and worst-case “what if” rates. This way we can analyse our likely worst situation and make provision for it. With all three, the issues are “how does it impact on our after-tax weekly holding cost and how can we make provision for this?”

We have two simple solutions – either be over conservative in the initial cashflow estimates or provide a contingency allowance within the investment loan adequate to meet any expected or potential downsides.

In the case of interest rates, we can fix either part or all the loan amount completely eliminating this as a potential problem. This entire solution methodology is related to the way in which we structure our funding.

Interestingly the Reserve Bank elected not to increase rates in February or March potentially indicating that the required activity slowdown may already be taking effect. Meantime, most economic commentators are suggesting that interest rates will continue to experience modest growth (through to possibly 9-10%) over the next 18 to 24 months.

The key with interest rates is to control any potential downside.

With capital growth, we have 2 options:

1. Either invest in relatively stable markets (Melbourne and Sydney) and hold for the next growth phase; or

2. Invest interstate in Queensland (both south east and far north) markets which are currently only entering their growth phase and have robust price growth forecasts for the next 2 to 3 years.

In either case the key is to hold. And to do this, we need to prepare for any likely change in the financial variables over the next 3 to 5 years (interest rates, vacancy levels and rental yields).

Selecting your property

Most of us are familiar with the “location, location, location” theory. But what if we have a property that doesn’t appeal to the market? What if it is out of reach of the average tenant? What if, when we come to sell, it doesn’t appeal to the discretional owner-occupier purchaser?

Obviously location is not enough. The 5 established keys to selecting a viable investment property are:

1. If you are keen on or need early capital growth, invest in markets that are entering their growth phase rather than those that are in the mature stage of the cycle.

2. Select properties that are well located and enhanced by neighbouring properties. Look for positive economic growth with the area, a social trend towards the particular location, easy access to major facilities including retail, education, recreation, entertainment and community facilities and “walk to” access to desirable elements like parks and cafes.

3. Invest in properties that will increasingly be sought after by the growth demographic (young professionals with no children, empty nesters, retirees and single parent families). Invariably these properties offer the best location at affordable prices, the appropriate accommodation, security, privacy and lifestyle. And ensure that it appeals to owner-occupiers. They are the key to your future capital growth.

4. Make sure that your property is affordable to the targeted rental market, is able to be funded to allow you adequate financial flexibility and, most importantly, has all the indications of long-term demand.

5. Usually it is desirable to invest in new property – it offers contemporary design, low maintenance and the highest tax effectiveness to investors.

So long as you are comfortable that you have selected appropriately and provided for any “what if” contingencies, the main issue is to take a position in the market. If you analyse the 3 key capital city markets over any decade in the past 30 years, investing at any stage of the cycle produced exceptional returns over 10 years – generally better than doubling in value. But only for those who were in the market. A simple way of rationalising investing in cities other than your own is to think about diversification. No one sensibly puts all their eggs in one basket. Property is no exception.

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