It is generally an accepted investment principal that diversification can reduce your risk and improve investment returns. The common vernacular is, spread your eggs amongst various baskets. I would agree with this principle, so long as it doesn’t result in deterioration of investment asset quality.
Sometimes property investors should not diversify. That’s because the quality of your investments, will determine your future investment returns. You cannot expect to invest in average quality assets and expect to generate above average quality returns. If you’re going to invest in property, you are much better off to buy one very high-quality property, than two average quality properties.
To be a successful investor, you must invest in the highest quality property that your budget allows.
It is also imperative to recognise that the dollar value appreciation of your property is an important metric which indicates whether you will enjoy a comfortable retirement.
In retirement, we pay for living expenses in dollars, not percentages
The value appreciation of property in dollar terms is an important metric. Whilst we can’t use capital growth to pay for living expenses, unless we sell the property, it still impacts our overall wealth. For example, if a retiree had $1,000,000 of super and wanted to spend $100,000 per year, they risk running out of super within 10 years (ignoring future investment earnings for simplicity). However, if at the same time, their property portfolio was appreciating by $200,000 per year, they are actually in a relatively strong financial position.
In 1991, 30 years ago, the median house price appreciated by around $10,000 per year – which is equivalent to $20,000 in today’s dollars (i.e., after adjusting for inflation). Since the average self-funded retiree spends circa $100,000 per year, this property appreciation ($20,000) is equivalent to 2.5 months of living expenses.
At the moment, the average median house price across Melbourne and Sydney is around $1,000,000. Assuming the median property appreciates by approximately 6% per annum (on average, over the long run), that equates to a dollar value rise of $60,000 (i.e., 6% of $1 million). That is equivalent to over 7 months of living expenses.
Annual property price appreciation in real dollar terms over the past 30 years
The chart below illustrates the historic change in median property price between 1991 and 2021, adjusted for inflation, that is, in today’s dollars. The chart also includes a projection of how the median property price might appreciate over the next 30 years, assuming a growth rate of 6.50% p.a. and an inflation rate of 1.50% p.a.
This chart suggests that the median property value might be appreciating at a rate of over a $100,000 per year by around year 2030-2033 in today’s dollars. And by 2045, the median property price may be appreciating by circa $200,000 in today’s dollars – equivalent to two years of living expenses.
Putting aside liquidity considerations, this suggests that if you’re at least 15 to 20 years away from retirement, that investing in one investment grade property could be sufficient to assist in funding your retirement.
What does this mean for investors?
When it comes to investing in property, quality matters a lot more than quantity. The above chart suggests that owning one investment property (worth $1m or more) might be sufficient.
Some investors are obsessed with acquiring a multi-property portfolio. They express their investment goals in terms of the number of properties, rather than their financial performance. Having such a goal does not encourage you to focus on the quality of the underlying assets, merely the number.
As I wrote about in this blog a few weeks ago, over the last three to four decades, the Australian property market has benefited from a rising tide. Almost anyone that bought a property in the 1970s or 1980s has probably done well, capital-growth wise. However, in that blog, I suggest that this rising tide has been stimulated by a handful of unique factors that probably won’t persist over the next three to four decades. As such, I suggested investors should develop their investment strategy with the underlying assumption that this rising tide will not continue. As such, asset selection (i.e., the quality of the property you invest in) is likely to be a more important factor over the next 30 years, than it was over the last 30 years. The chart above suggests that one high-quality, investment-grade property will do a lot of the heavy lifting in 20 to 30 years’ time with respect to funding retirement.
How do you put all your property eggs in one basket, safely?
The first thing I invite you to do is to examine any preconceived notions in regard to your maximum investment property budget (purchase price). Most investors will have a purchase price limit. Sometimes it’s wise to test these comfort levels, as long as it’s financially prudent to do so. Increasing your budget may allow you to buy a higher quality property.
If you’re going to invest over a million dollars into a property, it makes absolute sense to get professional advice in relation to which property to buy (i.e., use a buyers’ agent). The difference between an investment grade property and a property that has some impaired attributes in terms of investment performance, can be significant. For example, a 1% p.a. higher growth rate over 20 years will result in over $500,000 more equity in today’s dollars. Would you pay $20,000 to make $500,000? I would. Honest and professional investment property advice easily pays for itself in the long run.
If you have more than $2 million to invest, it may be wise to spread your money across two or more properties. Geographical diversifying your property portfolio, can serve you well on many fronts, which I discuss further below.
If you are going to put all your property eggs in one basket, then one factor that you’ll need to give a lot of consideration to, is any potential capital gains tax liabilities (when you sell the property). One of the downsides of property, is that it’s a lumpy asset, which means that you need to make a decision to sell all or none of the asset (unlike shares, which you can sell in smaller tranches). This means you could crystalize a significant capital gains tax liability in the future, particularly if you buy a high growth asset. It would be wise to consider various ownership structures that might help you minimise any future capital gains tax liabilities.
Of course, there are some risks
There are some risks associated with investing in one property as opposed to multiple properties. The first one is that you only have one tenant. If your property becomes vacant, you’ll have to rely on your own financial resources to pay all holding costs, including mortgage repayments.
The second risk of only holding one investment property is that you should expect periods of time where you won’t experience any value appreciation, as highlighted in this blog. Whilst practically, this has no financial implications, as we know we must hold property for the long-term to enjoy the financial benefits. However, it is something to consider from a risk profile perspective, to ensure you are comfortable with this potential outcome.
Finally, one of the benefits of investing in multiple properties, is that it gives you greater flexibility, particularly in retirement. For example, an investor that buys three investment properties when they’re 20 or so years away from retirement, can do so with the intention of potentially selling one property after they’ve retired, to allow them to substantially reduce their debt exposure at that time. Whereas if you only hold one property, you don’t have that flexibility.
Obsess about quality
The purpose of this blog is to make two important points.
Firstly, an investment grade house in most capital cities costs a million dollars or more these days. This is a lot more than what properties cost 30 years ago. As such, whilst the percentage capital growth rate is important to focus on, it is also important to understand the dollar value impact on our financial position. Put simply, one investment grade property will over a much greater impact on our financial position than it did 30 years ago.
Secondly, if you’re going to obsess about one thing with respect to property investing, it should be about quality. Quality is absolutely critical. You are much better to put all your money in the highest quality asset you can afford, than spreading your money across several average quality assets. And leveling up in terms of quality is the best way to reduce your investment risk. It’s a little bit like buying a pink diamond. A pink diamond is rarer than a normal white diamond, and as such, due to immutable laws of supply and demand, will always be more valuable than a white diamond. Therefore, you only want to invest in pink diamonds.
If you want above-average returns, you must invest in above-average quality property.