I am an analytical person by nature which is probably why I enjoy finance. I feel most comfortable when decisions can be made on numbers and logic alone. But the older I get, the more I appreciate that things are rarely ‘black and white’. Or put differently, if you treat things as ‘black and white’ you risk misreading situations.
An analytical approach to property
There are three fundamentals that a property must have to be classified as ‘investment-grade’ as discussed in this blog. One of these fundamentals is that the property must have demonstrated strong capital growth in the past. To obtain this information, we look at past sales data and calculate a compound annual growth rate. Let me demonstrate this using an example.
Consider the apartment located at 9/30 Denbigh Road, Armadale. It sold in March 2007 for $558,000. My client purchased it in June 2012 for $712,500. The growth rate over that 5-year period is only 4.8%. By comparison, the median property value in Melbourne increased by 6.8% p.a. over the same period ($380k in March 2007 versus $535k in June 2012). From this analysis, you would be excused for concluding that the property isn’t investment grade as you would prefer to see growth of approximately 7% to 10% p.a.
By the way, this apartment today is worth approximately $850,000 so the growth from 2007 to date is only 4.7% p.a. which is low for an investment-grade asset.
When the numbers lie to you…
Analysing past sales data typically only provides reliable evidence if it includes a number of sales over an extended period of time e.g. 20 to 30 years. The problem with the above analysis is we only have one past sale that occurred only 5 years prior to purchasing the property. Here are some issues that can impact the reliably of past sales data:
- Not enough data – if you cannot obtain enough data on the subject property then search for data relating to comparable properties that are located nearby. For example, I searched for sales data for all the other apartments located in the same block. I found that only 5 apartments had enough data on which to base a reliable assessment (click here for the assessment). I calculated that the average growth rate in the block is 8.3% p.a. over an average period of 25 years. This provides very strong evidence that the location and type of property are investment-grade.
- Not long enough time between transactions – as I noted above you really do need over 20 years of data that included 3 or more sales to provide an accurate assessment of past growth. The reason for this is that capital growth almost never occurs evenly each year. Instead, what is more likely is that in any decade you are likely to have 1 to 3 years of stellar growth, 5 to 7 years of average growth (maybe at CPI) and possibly 1 to 2 years of no or negative growth. You really need to hold the asset for long enough (i.e. a decade or more) to enjoy a few ‘boom’ years to propel the property’s value forward.
- Too hard to ascertain its current value – sometimes properties are so unique you really cannot accurately assess value without putting them on the market. We have assessed the current value of this property is circa $850,000. However, there have only been 6 sales in the last 10 years in this block. Also, this apartment occupies a superior position in the block. Since there are just not enough sales of comparable properties (yet), it is difficult to ascertain its value with a high degree of certainty.
- Past sale/s did not represent the fair market value at the time – The reason relying on one sale could be erroneous is that it might not fairly represent market value. Sometimes Purchasers over-pay for properties and sometimes Vendors sell for less than market value. If possible, it’s good to understand the past transaction and any motives of the Purchaser and/or Vendor – but often this is not possible. For example, a different client recently purchased a property for $1.87 million. The Vendor purchased this property back in 2009 for $2.1 million. Knowing this property well, I’d say that the Vendor significantly overpaid back in 2009 and the Purchaser (now) probably paid fair market value or possibly slighter under. In short, you cannot just assume all past sales are an accurate proxy for fair market value.
- You overpaid for the property when you purchased it – no one wants to overpay for a property. However, the good news is that overpaying won’t ruin the investment in the long run. However, it means that returns in the shorter term will be impaired. For example, remember that my client purchased this property in June 2012 for $712,500. Let’s assume that the client overpaid by say $70,000 (about 10%) – so the correct value of the property was $652,000 in 2012. That means that the growth between 2012 and 2016 is approximately 7% p.a. – which is closer to the longer term average in the block. If this property grows at the average rate in the block (being 8.3% p.a.), the property will be worth over $4.7 million after 25 years of ownership giving my client over $4 million in equity (and an average return of 7.9% p.a.). Overpaying for the “right” property only impacts returns in the short run, not the long run.
How reliable is your analytical data?
Taking the above considerations into account will allow you to make a judgement call on how reliable your property’s past growth assessment is. If your analytically data is very reliable then it can probably make up 70% or more of your overall assessment of the property’s quality. However, if its inherently unreliable like it is in this case (as we only have one past sale 5 years prior to our acquisition), then it should only make up around 10% of my assessment. The remaining 90% of my assessment will be based on the other two fundamentals that I mention in this blog being land value proportion and scarcity i.e. do you own enough land value in a highly desirable location? Here are my comments in respect to this:
Denbigh Rd is located in the blue chip suburb of Armadale. Armadale’s train station is located only 700 metres away and it’s a 12-minute ride into the city. The High Street shopping strip is less than 1 km walk and offers some of the best shopping and cafes in Melbourne. Chapel Street is nearby (2.4 kms away). The area is dominated by some of the best schools in Melbourne. The property is located close to two main arterial roads in Dandenong Rd and Monash Freeway. A major hospital (Alfred) is located within 4 kms. The street is very picturesque and quiet. Land supply is very scarce – there is no vacant land at all. The block of apartments was constructed in the 1970s so the building value would be less than 50% of the property’s overall value.
Another factor to consider is market cycles and trends. In the last few years, apartments haven’t performed as well as houses in the South-East of Melbourne. Anecdotal reasons for this could be that there are fewer first home buyers in the market, maybe people are opting to purchase newly constructed properties rather than established (there have been a lot of new apartment constructions in adjoining suburbs to Armadale), more money is flowing into home upgrades, etc. Irrespective of what is driving these differential growth rates, it is highly unlikely that this will be permanent. Everything moves in cycles. It is important to take this market performance into account.
My conclusion on this property (9/30 Denbigh Road, Armadale) is that I acknowledge that the growth has been less than desirable since 2012. However, I also acknowledge that the client has only held the property for four years which isn’t long enough to make a reliable assessment. The other apartments in the same block have demonstrated a strong capacity to appreciate at an acceptable rate over the long term. The property type (1970’s apartment) and location are perfect. Therefore, I conclude that the property’s short term performance has been impacted by one or all of the following:
- The short ownership period;
- It’s possible that the previous transaction in 2007 wasn’t fair market value;
- The short term trend of houses outperforming apartments; and/or
- It’s possible that my client paid too much for the property in 2012.
It is impossible, or at least very difficult, to ascertain with a high level of certainty which of the four factors above are to blame for the short term performance, because in this specific situation, property is more of an art than a science.
Either way, the above four possible factors are all short term and will not have an impact on the long term viability of this investment. Warren Buffett is quoted as saying that “The stock market has a very efficient way of transferring wealth from the impatient to the patient.” The same can be said for the property market too. If you buy the best quality assets (property) and hold them for 20 or more years you will be very well rewarded.
If you need any assistance with assessing the performance of your investments (be it shares, managed funds or directly property), don’t hesitate to reach out to us. We can offer an independent assessment and advice.