Report: Performance review of investment-grade apartments

By October 27, 2020 Property Investing

It is my observation that investment-grade apartments in Melbourne have under-performed (from a capital growth perspective) compared to houses over the past 8 to 10 years.

That is, apartments have generated very little capital growth (sometimes none), whereas houses have grown in value by between 5% and 8% p.a. over the same period.

I have prepared a detailed report investigating the factors that have contributed towards this capital growth performance gap. Whilst I have focused my analysis on the Melbourne market, many of the factors identified and discussed have had an impact in Melbourne and to a lesser extent, Sydney.

I provide a brief executive summary below. I invite you to download a copy of the full report (link is at the bottom of this page).

We know that property growth tends to occur in cycles

The chart below sets out the distribution growth in the median price of apartments in Sydney, Melbourne and Brisbane over the past 40 years.

It is clear that growth cycles tend to last between 5 and 10 years (although Brisbane between 1980 and 2002 is the main exception). This is constant with what I have observed for houses, as previously charted here.

Distribution of capital growth rates

We need growth of circa 9% p.a. to make up for the under-performance

If you purchased an apartment 7 years ago for $600,000 in Melbourne, it may be worth $650,000 today. Most people would (and should) be disappointed with receiving only $50,000 of capital growth over 7 years. Applying the change in land values (as implied by the actual change in house prices) to apartments, one could argue that the intrinsic value of this apartment may be closer to $900,000. This intrinsic valuation is illustrated by the blue dotted line in the chart below.

I calculated that this apartment would need to generate an average capital growth rate of 9.2% p.a. over the next 10 years to “make up” for its past under-performance (i.e. to grow from value A to value B).

That is, the value of the apartment would need to increase from $650,000 to $1.55 million over the next 10 years. Whilst that might seem unrealistic, we note that apartments have delivered growth above 9.2% p.a. in the past, as illustrated in the chart above.

Intrinsic value of apartments

Dramatic increase in supply of new apartments between 2008 and 2018

It is likely that the increase in supply if new apartments (i.e. new construction) has been the main contributor to the low levels of capital growth. When supply equals demand, price growth does not occur. However, when demand exceeds supply (like it has in the housing market), this imbalance contributes towards price appreciation.

The chart below sets out the number of residential unit constructions commenced per quarter. This trend data is provided by the ABS and is seasonally adjusted. In the main, supply began increasing in 2008/9 but has started to taper off around 2017/8.

This increase in apartment supply is evidence in investment-grade suburbs too. The next chart below sets out the proportion of apartments listed for sale compared to houses in a selection of investment-grade, blue-chip Melbourne suburbs since 2011 (when the data series began).

As you can see, in 2011, on average, 60% of properties listed for sale in these suburbs were apartments. By 2017, that proportion increased to 78%. Importantly, the proportion of apartments for sale is slowly trending down and is now 75%.  

Tightening in credit

I have written a lot about the impact of credit tightening that has occurred since 2009 when ‘responsible lending’ regulations were first introduced. This tightening in regulation dramatically reduced everyone’s borrowing capacity. This affected first home buyers (FHB) to the greatest extent, as they tend to have relatively weak financial positions and borrowing capacities are tight.

This may have encouraged more FHB to be attracted to lower-priced, off the plan apartments – away from higher-priced, established, investment-grade apartments, thereby reducing demand for this investment-grade sector.

The Australian government has recently announced the relaxation of responsible lending rules (from 1 March 2021) which should materially improve FHB capacities.

Foreign buyers used to be dominant

In the past, most residential developers targeted non-resident buyers. They would have teams of salespeople on the ground in China and other Asian countries selling Australian apartments off-the-plan. Developers constructed buildings solely to fulfil this demand.

However, in 2015, the Australian government (its Foreign Investment Review Board or FIRB) started tightening rules governing the circumstances in which foreigners were able to purchase property in Australia. This has led to a dramatic fall in the volume of sales to foreigners.

In the 2014/15 financial year, the FIRB approved the acquisition of over $60 billion of residential real estate. By the 2018/19 financial year, the amount of residential real estate approved for purchase by foreigners had fallen to $14.8 billion.   

The foreign buyer market is now less than 25% of its previous size. In 2019, the government introduced a cap on foreign ownership of new developments. As such, the volume of new apartments constructed is likely to be significantly lower over the next ten years compared to the previous ten years.

Comparing apartments to houses is unfair

Comparing the performance of houses with apartments ignores that fact that the cost of an entry-level house is often more than double that of an entry level apartment. Not all investors are in a position to be able to invest in a house i.e. their financial budget doesn’t extend to this level. Therefore, in order to invest in an established, blue-chip suburb, they have to invest in an apartment.

From a practical perspective, a fairer comparison is probably to compare investing in an apartment in an investment grade suburb versus investing in a house in a middle or outer ring location i.e. further away from the CBD.

There’s a large body of evidence that demonstrates that average capital growth rates decline the further away a property is located from the CBD (e.g. this report – refer page 78 onwards). Therefore, typically, investors are better off investing in an apartment in an investment-grade suburb.

There’s more detail contained in the report

If you would like to learn more, I invite you to download a fully copy of the report but clicking the button below.