Why the next property you buy is the most important one

By August 26, 2020 Property Investing
buying the right property

This blog’s title is a bit deceptive, because every property you buy is important, for either lifestyle or financial reasons.

I contemplated using the title: “why the first property you buy is the most important one”. But the reality is, if you have made a mistake on your first property, you can always start again.

The general theme of this blog is to demonstrate that the compounding impact of buying the right property is critical to understand.

Why is it so important?

Let me explain using an example:

Rick and Karen are buying their first home and are comparing two properties. Property A is considered to be investment grade and has great growth prospects i.e. 6% p.a. growth rate. Property B is a newer property but has inferior growth prospects and barely keeps up with inflation – growing at 1% p.a. Both properties cost $750,000. Rick and Karen need to borrow $700,000.

After 5 years of principal and interest home loan repayments, the balance of Rick and Karen’s loan would have reduced from $700,000 to approximately $622,000. The value of Property A would be approximately $1 million, and Property B would be $790,000. If Rick and Karen purchased Property A, they would have $378,000 of equity. However, if they purchased Property B, would have less than half the equity i.e. $168,000. That is a substantial difference of $210,000!

But it’s how this difference compounds that’s most important

If in 5 years’ time, Rick and Karen were contemplating upgrading their property to buy a larger family home, the differential in equity will have a substantial impact on their budget.

Assuming that they want to borrow a maximum of 80% of the new home’s value, a deposit of $378,000 will allow Rick and Karen to spend up to $1.45 million (allowing for 6% for costs including stamp duty).

However, a $168,000 deposit will only allow Rick and Karen to spend $650,000, which is less than their current property value! If they buy for $1 million, they will have to borrow 90% of the value and pay for mortgage insurance (which will cost over $35,000!).

Therefore, using this example, the difference between buying the right versus wrong property could be the difference between being able to take the next step (and buy a family home), or not.

It should be noted that this equity gap will continue to grow. If Rick and Karen purchased Property B, they may be forced to buy their larger family home in a suburb further away from the CBD (due to budgetary constraints). This will mean they will have a lower value asset that attracts a lower growth rate – the equity differential could be massive, as charted below.

buying the right property

And you can put that equity to work

To make matters worse, not only will buying the right property help Rick and Karen build more equity in their home, but they will be able to leverage that equity to build an investment portfolio. This could include borrowing to buy an investment property or invest in the share market.

Should you buy a property purely to make a quick profit?

No. In order to minimise your risk, it’s important to buy an investment-grade property that has sound long term fundamentals. A property that is well positioned to generate an above average capital growth rate over the long term. That must never be compromised.

However, if your goal is to upgrade or invest in the shorter term, then it does make sense to pick a property type or location that is expected to deliver a reasonable amount of growth in the shorter term.

This could include a number of things:

  1. Picking a property type that you expect to out-perform e.g. buying a villa unit rather than an apartment (this is only an example – I’m not suggesting villa units will in fact out-perform, although they might in some locations);
  2. Picking a location that already has above average growth momentum. This can be more difficult to accurately pick, so be careful. Some investment-grade locations are more popular or trendy than others, and riding that momentum can be helpful; and/or
  3. Buying a property that would benefit from cosmetic improvements. Economically upgrading the kitchen and bathrooms; a coat of paint and new carpets can substantially improve a property’s value and ‘create’ equity.

However, the above strategies are not mutually exclusive. You MUST still ensure that the property has sound, long-term fundamentals. That way, if you mess up the abovementioned tactics, at least you will still enjoy decent growth in the long run. Plus, if you buy a quality asset, the chances of losing money are substantially reduced.

Buying the right property is particularly pertinent for first home buyers

The understanding that is it important to buy well is particularly important for first home buyers. The reason is that first home buyers tend to have a relatively weak asset base and therefore have more to gain from creating as much equity as quick as possible. Also, they tend to have lower incomes which makes building equity via debt repayment all the more difficult.

As such, making an astute decision with respect to your first property (i.e. buying well) could create a substantial amount of equity, in dollar terms, compared to their starting deposit and/or income. That is, a first home buyer with a $40,000 deposit and a modest income could amass well over $100,000 of equity in a relatively short amount of time.

This ‘financial kick start’ could catapult a young adult’s financial position dramatically.

What if you currently own the ‘wrong’ property?

Of course, we all make mistakes in life and that sometimes to extends to buying the wrong property. But all is not lost. The most important step is recognising you have made a mistake and develop a plan to fix it.

The next step is to divest of your dud property whilst still maximising its sale value. That means you don’t want to give it away. But you also don’t want to wait 10 years before selling it either. Be realistic about its current value and pick the best time within the next 1 to 3 years to sell it.

Once you have done that, you can apply some of the ideas I discuss above to ensure you do not repeat same mistakes.

This applies to homes and investment properties

Where practical, I counsel my clients to apply an investment lens when selecting an owner-occupier home. Buying your home well, will improve your asset base, and therefore your ability to invest to build wealth.

I hope this blog goes some way to demonstrating how generating equity relatively quickly can catapult your investment plans. Good luck.