Last week, I highlighted some evidence that indicates investment-grade apartments in Melbourne are perhaps intrinsically undervalued. The topic of this week’s blog is all about whether a house or apartment makes a better investment, specially:
- If your investment budget is $1.3 million or more, should you invest in one house or two apartments?
- If your investment budget is in the range of $700k and 800k, should you invest in an investment-grade apartment in a blue-chip suburb or a house further away from the CDB (or in a regional town)?
Of course, my commentary and suggestions below are general in nature and may not apply to your financial situation. Therefore, it is important to obtain independent financial advice. Here are a few considerations that you must take into account:
Apartments are susceptible to the impact of future development
The number of houses in a blue-chip suburb are somewhat fixed. That is, typically, there is no more than one house per block (excluding the odd townhouse development which is rarer in high land value, blue-chip locations). However, the number of apartments in a geographical location can change significantly over several years. All you need is one or two large developments and that can dramatically impact the supply of apartments. Whilst new-build apartments are vastly inferior assets from an investment perspective, their existence can retard capital growth.
The advantage of investing in a house is that supply is relatively fixed. This ensures that the imbalance between supply and demand (in an investment-grade location) remains in the investors favour. That is, if supply is fixed and demand is increasing, you will typically benefit from price appreciation.
If you have multiple assets, you have more flexibility
The advantage of investing in two apartments as opposed to one house is that you have greater flexibility in the future, particularly as you get closer to retirement. For example, if you invest in two apartments at age 45 (which might be 15 years prior to your planned retirement) then you will be able to sell one apartment after you have retired and use the cash proceeds to repay the debt on the other apartment. This may result in you retaining one apartment with no (or very little) debt thereby generating a good income stream to supplement your super.
Spread your eggs across many baskets
Another advantage of owning two apartments as opposed to one house is that you can diversify geographically. Different geographical locations and micro-markets will perform differently at different times. Tying a lot of your wealth up in one asset creates a lot of concentration risk which might not be a prudent thing to do.
One of the greatest advantages of direct property is control
One downside to investing in an apartment is that you have less control over the asset. That is, common areas are managed by an Owners Corporation. The Owners Corporation makes important decisions by vote at an annual general meeting. Some motions require a unanimous resolution meaning all owners must agree – which can be difficult to obtain. Some examples of challenges that investors have endured include not being able to maximise the value/use of the land (surplus car parking could have been sold but agreement could not be reached), updating the title type to improve the property’s marketability and value but agreement could not be reached, etc.
The best way to mitigate this risk is to undertake good due-diligence prior to investing and ensure the Owners Corporation is functioning effectively and the property is in an optimal state (i.e. nothing needs to be changed).
Different levels of income
Housing will generally have a lower rental yield than apartments. In Melbourne, houses will attract a yield of between 2% and 3% of the property’s value – depending on condition. Apartments however will generally attract a yield of 3% and 4%. Therefore, you could maximise your investment income by investing in two apartments as opposed to one house. The difference could amount to approximately $300 to $400 per week (e.g. a house might rent for $600-700 p/week versus two apartments for $400-500 p/week each).
Capital growth differential
Compounding capital growth is a very powerful investment attribute and is the simplest and easiest way to build wealth. Therefore, investing in assets that provide the highest amount of long-term capital growth will help you build substantial wealth.
When we prepare financial plans, we assume that investment-grade property will appreciate at an average long-term rate of 7.5% p.a. (assuming the inflation rate is 2.5% p.a. – so the growth rate excluding inflation is 5% p.a.). However, the observed growth rate over the past 30-40 years is often a lot higher than that (we’re being conservative).
I picked a few houses that have sold recently at random. I compared an investment-grade house in a great street of Prahran (Melbourne) with a couple of houses in a well-established part of Geelong (Newtown is arguably the most “investable” suburb in Geelong – I know the area well as I grew up there – Go Cats!). Essentially, I wanted to see if there was evidence that a regional city provided lower growth than a capital city.
Donald St, Prahran
Based on sales data, the property at 59 Donald St, Prahran has appreciated in value by 10.4% p.a. over the last 37 years. Over this time, we have seen many changes including interest rates, governments, tax rules (CGT, GST, negative gearing), population, housing supply and so on. Given the population growth rate, the demand for this location will be higher in the coming 40 years than it has in the past 40 years – so, arguably, growth should repeat itself.
Buckingham Rd & Cairns Ave, Newtown
Again, based on sales data, 69 Buckingham Rd has appreciated at a rate of 7.8% p.a. over a period of 13 years and 37 Cairns Ave (superior location) has appreciated at a rate of 8.8% p.a. over a period of 30 years. Both houses are older-style (so mostly land value) properties located in quiet streets.
Conclusion
Anecdotally, it makes sense that a house in prime, blue-chip suburbs of Melbourne will appreciate at a higher rate than a house in a regional city – mainly due to higher sustained levels of demand. From my basic observation above (acknowledging that the sample size is statistically unreliable), it appears the growth gap is in the range of 1.5% and 2.5% per annum. Based on my experience and observation over the past 15 years, this is what I expected to see.
Apartments may perform like regional houses but…
It would be reasonable to assume that investment-grade apartments will not generate the same level of capital growth as houses (although you are partially compensated with a higher rental income as discussed above). The reason for this is that houses tend to have a greater land value proportion.
Intuitively, I think it is reasonable to assume that capital growth cap between investment-grade houses and apartments to be in the range of 1.0% and 2.5% per annum depending on the quality of the apartment. Of course, there are exceptions and some apartments demonstrate similar growth rates.
Ostensibly, an investment-grade apartment in Melbourne and a well-located house in an excellent street in Geelong for example might have similar investment return attributes (i.e. similar rental yields and growth rates) in the long run. The main difference is that an apartment in Melbourne is a much less risky investment because demand is more robust and sustainable. Melbourne’s population is close to 5 million compared to circa 200k in Geelong. Why take the risk when investing several hundred of thousand of dollars?
What other investments do you have?
How much do you have in super? What other investment assets do you have? If you already have accumulated wealth across various asset classes, then investing in a house might be acceptable (because you will still have reasonable diversification). However, if you have little investment assets then investing in a house might result in too much concentration risk (all your eggs in one basket) and you might be better off spreading your investment dollars across a few assets.
Investing in adjoining suburbs
People ask me whether it’s worth moving further out to get a house. For example, a $800k budget won’t buy an investment-grade house in Melbourne (but will be enough for an apartment). However, if you consider non-investment-grade suburbs that are 20-30kms out from the CBD, it might allow you to buy a house.
In this situation, at best – if your execution is perfect, you may achieve similar investment returns as an investment-grade apartment, but it is unreasonable to assume that you could achieve the same growth as an investment-grade house. Therefore, taking this approach might achieve the same results but you are taking a higher risk (again, demand in outer suburbs is less then inner suburbs – similar to the Geelong example).
In short, moving further out just to get a house is a higher risk strategy. It’s not to say that it can’t work (or hasn’t worked in the past) but we cannot fool ourselves into thinking the investment is of equal quality. And quality will determine your investment returns.
Sorry. There’s no simple answer
As you can appreciate from the above discussion, there is no ‘one-size-fits-all” answer. It really depends on your personal financial situation, risk profile, goals, budget and overall financial plan. However, hopefully the above has highlighted some of the issues you need to consider.
If you need advice, make sure you seek it from a financial advisor that is completely independent and has the requisite knowledge and experience in property investment (and all investment asset classes for that matter).
