There is one property investing golden rule that is more important than everything else. And if you nail this ‘one thing’, you are guaranteed to build wealth over the long run. This statement might sound sensationist, but I honestly cannot overstate this point.
The golden rule is that the quality of the property you invest in will determine your long-term investment returns.
If you invest in an average quality property, your long-term returns are likely to be average. Of course, if you want above average returns, you must invest in above-average quality property.
This golden rule applies to all other assets classes as well, including shares, bonds, commercial property and so on.
What does ‘quality’ mean?
A quality property has the necessary attributes that sustains a level of buyer-demand that perpetually exceeds supply. This imbalance of supply-demand results in appreciating value/prices in the long-run. A high-quality property is often referred to as investment-grade.
It is worth discussing the factors that impact supply and demand.
In investment-grade locations, supply is fixed or diminishing
Supply is probably the easier of the two factors to understand and ascertain. Supply refers to both land supply and dwelling type/style.
Regarding land, it is important that the supply of land is fixed and finite. Consider a well-established, blue-chip suburb. In these locations there is rarely any vacant land available, often within a 10km to 20km radius. And there is no way that any new land can by ‘released’ for sale. However, in outer suburbs, land supply can be abundant due to land releases within a 20km radius. The further a property’s location is away from available vacant land, the tighter supply will be.
Property type and style also affect supply. For example, in high land value locations, the supply of houses rarely changes, because its rarely economical to complete small sub-divisions in high-land-value locations, so the number of houses/townhouses remains unchanged. However, the supply of apartments can more readily change e.g. when a developer buys a commercial site and builds a residential tower. An example of a property type on the opposite end of the scale is Victorian houses. Virtually no one is building Victorian houses anymore, so their supply is finite. In fact, some probably get demolished every year, so supply is probably diminishing.
Buyer-demand perpetually exceeds supply
Buyer-demand refers to the size of the pool of potential buyers that desire to own property in a particular location and can afford to do so.
Demand substantially exceeds supply
When the number of buyers exceeds the number of sellers, property prices tend to rise. Of course, that’s because buyers must be willing to pay more to successfully purchase a property.
It is important that you invest in locations when buyer demand substantially exceeds supply. Notionally, there might be 10 buyers for every one seller. This level of imbalance in supply and demand will ensure that property prices will withstand changes in supply (e.g. an unusual number of properties for sale) or demand (e.g. an economic recession causes buyer demand to reduce). Despite what happens, it is likely that the number of buyers will always exceed the number of sellers and prices will be supported.
Demand is diversified
When considering a property investment, it is wise to consider who might like to own said property. It is important that the property appeals to a variety of types of buyers. Again, notionally, if you have 10 potential buyers (as mentioned above), 3 of them might be self-funded retirees, 3 investors, 3 owner-occupier upgraders and so forth. Ensuring that your property attracts a diversified pool of buyers will ensure it benefits from a sustainable and a robust level of demand.
Property that attracts buyers willing and able to pay more
Can property prices continue to rise forever? When considering this question, the media often compares average household incomes to average property prices and draws the conclusion that housing is becoming more unaffordable. Of course, this is a meaningful microeconomic analysis. However, its less important for property investors.
You must invest in a location that attracts higher income earners and wealthy people. The wealthiest 20% of Australians have almost 3.5 times more wealth than the average Australian. That is why its meaningless for investors to compare average incomes to average property prices and draw conclusions, unless you plan to invest in an “average” property. Instead, if you invest in locations that attract the wealthiest 20%, then it’s more likely that buyers will be able to continue to afford to drive property prices higher over time.
Factors that drive demand
Different locations are driven by different factors and rarely are two locations the same, so it’s important to understand the nuances of each market/location. That said, I’ve listed below some of the common factors that drive demand in investment-grade locations.
- Amenities. This includes necessities such as supermarkets, family doctor, dentist and so forth. Equally important is entertainment amenities including cafes and restaurants, entertainment venues, parkland including running and bike tracks and so on.
- Proximity to employment opportunities. Whilst we might believe this is less important post-Covid, I think the long-term impact has been overstated. There will always be substantially better employment opportunities in large capital cities for most industries.
- Schools. This can include sort after public school zones as well as desirable private schools. Proximity to schools can contribute a lot towards capital growth.
- Culture/community. It’s a positive attribute for a location to have a good community vibe/feel. This is often present in local shopping strips and the mixture of businesses adds a lot to this attribute. Some inner suburbs lack this and it’s to their detriment.
- Healthcare. Proximity to hospitals is important to some buyers, particularly older folk.
- Transport. This includes good public transport easily within walking distance as well as major arterial roads.
When doesn’t this rule apply?
A property’s quality might not be responsible for driving investment returns (capital growth) in the short-term. In the short-term, popularity can drive growth. This has been particularly evident over the past couple of years (through Covid) in many coastal locations. The popular trend has been that “since business will now be conducted online (Zoom), we can all move to the coast and enjoy a better lifestyle”. This thematic has driven unusually high levels of price growth in these markets.
If your investment decision is based on a trend, then you must have a well-defined exit strategy. Because if prices are not underpinned by sound fundamentals, prices will eventually correct i.e. either prices will fall or there will be zero growth for many years. This has been proven, yet again, in the share market over the past month. Therefore, you must exit the investment before a price correction occurs.
Don’t underestimate this golden rule
If you are going to obsess about one thing, it should be investment quality (applies to all investments including property). If you get the quality right, and everything else wrong, it is likely that you’ll still successfully build substantial wealth.
My advice is if you are going to direct any energy towards investing, it should be solely focused on asset quality, and all other matters (tax, borrowing, etc.) should be outsourced to your advisors.