I’m sure you have seen the glossy ads espousing various benefits such as stamp duty savings, rental guarantees, discounts and incentives, state-of-the-art gyms, beautiful kitchen appliances, a concierge and the list goes on. As the title of this blog suggests, I strongly believe that off-the-plan apartments do not make good investments. And I put new-build townhouses and houses in the same boat. I’ll tell you why…
The three fundamental problems
There are three fundamental problems with off-the-plan (OTP) apartments. The sheer existence of these problems means that these assets cannot provide good investment returns.
- Most people appreciate that land typically appreciates in value over time and buildings depreciate in value (due to wear and tear – a building cannot last forever without maintenance and refurbishment). Therefore, if you are investing in property primarily for capital growth (and you should), you need to invest in properties that have a strong land value component (i.e. > 50%). Even an apartment has an attributable land value component (I discuss this more below). OTP apartments tend to have a land value component of less than 10% of its overall value. So, in this situation, 90% of your property is depreciating and only 10% of your property is appreciating. There’s just not enough appreciation in value to offset the depreciation.
- The goal of investing is to achieve the highest return for the lowest risk. However, many people erroneously chase the highest return without any regard to risk – that’s just plain silly. Would you like to invest in a property that has a 90% probability of delivering 8% p.a. capital growth over the next 30 years or a property that has a 50% probability of delivering 10% growth? Most people would correctly opt for a lower growth rate to dramatically reduce their risk. This is the problem with OTP apartments; there’s no proven track record of performance. However, with an established property you can see what it’s been bought and sold for over say the past 30 years. This has two advantages. Firstly, you can assess its past growth rate – see this blog to find out why that’s important. Secondly, you can use this information to assess its current value. However, with an OTP apartment, you have nothing to compare it to. The developer sets the price and that price includes all the cost of marketing the property, providing rental guarantees, their profit and so on. Also, you have no reliable way of assessing the apartments future growth prospects.
- Why are red diamonds 150 times more valuable than normal diamonds? Simply because they are so rare. Scarcity is important with property too. The architectural style needs to be scarce – for example, no one is building Victorian cottages or art-deco apartments anymore. Also, land supply needs to be scarce too (i.e. the availability of vacant land within say a 20km vicinity of the property). OTP apartments have virtually no scarcity. They are typically in a block of hundreds of apartments that all look the same. In this situation, it is the vendor who drops their price first gets the sale!
In summary, OTP apartments have little land value, no proven performance or a way of assessing their market value and no scarcity. As such, their long-term capital growth prospects are minimal at best.
In addition to the above, some other concerns include the fact that you cannot inspect the completed property before you buy it. Walking through a property is a totally different experience than looking at plans and viewing a display suite. You can’t assess the size, level of natural light and so on. Secondly, construction contracts can give the builder the ability to change or substitute certain items or finishes – so you might not end up with the product that you thought you paid for. Thirdly, obtaining finance can be an issue if your situation changes, credit polices changes and/or the property is valued less than the purchase price by the bank (which is common).
The advantages won’t make you rich either!
The commonly promoted benefits associated with OTP apartments won’t make you independently wealthy:
- Stamp duty savings – this is a once off saving. Notwithstanding that you might end up overpaying for the asset when you purchase it, a once off saving won’t make you rich. What you need is perpetual compounding capital growth – see this blog for why.
- Depreciation – depreciation is a non-cash tax deduction. Depreciation is a measure of the reduction in value. Yes, your asset it worth less each year and you get a tax deduction for it – does that sound like a good investment to you? Secondly, you must eventually spend money on repairs and maintenance to maintain any depreciating asset (like an old car).
- Higher rental income – the higher rental income from an OTP apartment might sound great but how many properties like that do you need to own to retire? Three or four? And that’s only if you have no debt against them. Investing for income is the wrong approach – here’s why.
Why townhouses are probably not a good idea either
Townhouses typically consist of multiple free-standing dwellings constructed on one standard residential block – often there’s 2 to 5 dwellings on one block. They can either be attached or detached. They typically have two to three bedrooms and a garage.
The reason that townhouses typically do not make good investments is that they tend to be located in secondary land locations. That is, they don’t tend to be in blue-chip suburbs – or if they are, they are in impaired locations such as on a main road. The reason for this is that developers can only construct townhouses for a profit if the cost of land doesn’t exceed a certain value. For example, a townhouse development in the middle of Toorak won’t make economic sense because the developer would have to pay too much for the land and there wouldn’t be any profit for them.
Sometimes people think near enough is good enough. That is, a property in a secondary location might still enjoy a reasonable growth rate. That’s possibly true. However, why take the risk? Why not invest in a location that has the highest probability of growth? Secondly, in a rising tide, all ships rise. What happens if the tide stops rising and the property market struggles? Red diamonds will always be in demand because they are scarce. Invest in assets that have the fundamentals to do well in virtually any market condition.
Also, often the architectural style of townhouses tends to date i.e. it’s not timeless like Victorian cottages.
Finally, townhouses lack the other two fundamental prerequisites being scarcity and a sales/growth history.
Newly constructed houses
Newly constructed houses are typically located in areas where land supply is not scarce and that’s why they won’t generate long term capital growth. In fact, land supply is often abundant! Sometimes newly developed areas enjoy a once-off spurt of growth i.e. the land value increases between land release one and two. This occurs mainly because the area attracts some amenities such as shops, maybe schools, a doctor, etc. – but it’s not a perpetual driver.
Again, also there’s no historic growth performance either.
What apartments are worth investing in?
Not all apartments are created equal. Older style apartments can be classified as investment-grade if they tick all three boxes:
- More than 50% of its value is land: That is because they typically consist of a block of say 8 apartments on a very valuable parcel of land. The block of land might be worth $3 to $4 million – so each apartment’s land value is notionally worth $375k to $500k each. Investment-grade apartments are typically built between 1920’s and 1970’s – so the building’s value has depreciated to a base level (i.e. little in the way of future depreciation).
- They have a strong scarcity element: Older-style apartments tend to have no more than 10 on a block, their architectural style tends to be scarce and timeless and they are in locations where land is very scarce and in high demand.
- They have proven performance: Because they have been bought and sold many times over the past 30 to 40 years, we can calculate the property’s historic capital growth rate. This blog tells you why that’s important.
I discuss these three factors in this video.
Sometimes clients ask me whether the potential oversupply of new apartments will impact the returns on investment-grade, older-style apartments. The short answer is no. In the short term, there might be increased pressure on rental income (i.e. lower income). However, in the short to medium term the newer apartments will start to wear and lose their sparkle and be in less demand by tenants. They aren’t constructed as well as the older style apartments. In the long run, investment-grade apartments will perform very well due to the three factors mentioned above.
Get independent advice
If you are ever in doubt whether you should invest in a particular property or not, get independent advice i.e. advice from someone other than the sale agent/developer. We have a network of property advisors that we work with and trust so if you need a referral, contact us (of course we have no financial affiliations with these advisors and/or receive no benefits as a result of making the referral).
