4 capital growth myths you probably believe

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Some statistics regularly quoted as important for predicting future capital growth actually indicate the opposite, writes Jeremy Sheppard. He points out four commonly held beliefs that, while making sense on paper, don’t always stack up in real-life figures. 

Land appreciates, buildings depreciate

Many investors have heard that land appreciates while buildings depreciate. The theory is that you should buy investment properties with a high land component, namely houses. And if you’re in the hunt for a house they say you should maximise the block size with respect to the dwelling size. 

This can be misleading advice. I like to use extreme cases to prove a point, so imagine you have a block of land with no buildings on it that can depreciate. Is that a better investment than a block of land with a house on it? 

Since the land doesn’t generate any income, none of the expenses related to it like loan interest, land tax or council rates are tax deductible. Similarly, there’s no depreciation that can be claimed and no rental income to help cash-flow. Both houses and apartments have these advantages over vacant land. 

Another similar claim is that you should try to buy as much square metres for your dollar as possible. Again, taking an extreme example, you’d end up buying a big chunk of desert that wouldn’t experience capital growth for possibly decades.

Talking sense now, houses are generally better long term investments if the full development potential on which the house sits has not been realised yet. A house on a 300 square metre block may have just as much growth potential as a two bedroom apartment next door since it’s unlikely the block of land the house is on can be developed beyond the house that is already on it. A half acre block on the other hand has loads more potential. 

Make sure that if you’re spending the extra money to buy a house rather than an apartment, ensure that it has development potential, even if that is simply building a second storey or extending. And regardless of which dwelling type you chose make sure it suits your specific financial circumstances and suits the demand of the local rental market. 

High average annual growth indicates a future hotspot

The “average annual growth” or “long term growth” is the annualised growth over the last 10 years in percentage terms. 

For example, at the time of writing the long term growth for units in Erskine WA was over 30%. At the other end of the scale, houses in Crosslands NSW averaged growth of less than 2% per year for the last 10 years. 

Which of these two markets has more potential for capital growth in the immediate future? Many novice capital growth commentators would say that Erskine units have proved to be good long term performers while Crosslands houses are a total dud.

Without looking at any other figures apart from the average annual growth, it is actually Crosslands houses that have the most potential out of the two markets for capital growth in the future. To explain why, I need to go through a hypothetical example. 

Imagine 100 years ago apples were 1c each and oranges were also 1c each. But let’s say oranges outperformed apples in terms of growth over the next 100 years. Let’s say the average growth for oranges was 6% per annum over the 100 years and apples grew at only 4% per annum. That’s not much of a difference in rate of growth, but over 100 years the price difference is staggering. Today it would cost you $3.39 for a single orange and $0.50 for an apple.

Now imagine going shopping for fruit and you see a bag of 10 oranges for $40 or a bag of 10 apples for $5. Which would you buy? You would have to hate apples or be mad for oranges to justify buying oranges instead of apples. 

Long before oranges and apples got to such a huge price difference, the demand for oranges would subdue and people would instead start buying the much cheaper apples. Buyers won’t tolerate such a massive price difference for fruit that is very similar. That change in buying habit would decrease the growth rate of oranges and cause a spike in the growth rate for apples. 

Something has to happen to the nature of apples and oranges to affect their growth rates. Perhaps a new orange was introduced to the market that was sweeter or easier to peel. Or perhaps a new apple was engineered that lasted longer or had a shinier skin or was bigger. These types of changes cause spikes in the growth rates. But continual positive changes like these are needed in order to maintain a continually better growth rate. Long term, apples and oranges will grow at the same rate. A higher rate of growth can’t be maintained forever. 

If you were to look at the growth charts of property markets over a single year, you would see that they all have different looking charts. But if you look at them over 10 years, you can see many similarities. Stepping back even further to look at 20 years of growth and you’ll notice a common trend emerging in their growth rates. 

The further you step back to look at the bigger picture, the more property growth charts all start to look the same. They all start to match the really long term national average. Truly long term, all property markets grow at about the same rate. If they didn’t, there would be tremendous imbalance in prices that buyers simply wouldn’t tolerate. 

For every year of growth above the long term national average, you can expect a year of growth below the long term national average to follow. So the more years of above average growth that has stacked up in a market’s history, the more grim its future capital growth is likely to be. Similarly, the longer the stretch of below average growth in the past, the brighter the future will be to bring the long term growth rate back to normal. 

Markets are like homeostatic organisms that are always naturally moving towards a state of balance. As investors, some of the best opportunities can come from finding markets that are massively out of balance. That’s the whole idea of the demand to supply ratio (DSR), it measures the imbalance between demand and supply. 

Be careful looking at long term growth in isolation. You may think 10 years is a long time, but it could easily take another 5 years for a depressed regional market to recover. City markets are much more uniform and will balance out in a shorter period. Even waiting two years is a waste of loan repayments. Make sure there is some sign of growth before jumping in. 

New developments in a suburb are good news

Many people will consider the start of a new development or the opening of a new estate as a positive for a property market. There are circumstances where this is the case, but more often than not, these events represent a stifling of capital growth. 

Prices change according to changes in supply and demand. If demand exceeds supply, prices will go up. The more demand exceeds supply, the more rapidly prices will rise. So we want to know of those locations that have the highest demand and the lowest supply. We want the highest demand to supply ratio (DSR). 

How does the release of a new development or estate affect supply and demand? It’s simple: the supply is increased. This is something we don’t want as property investors. Instead, we want the supply to be as low as possible. Yes, that’s right, strange as it may seem, developers are actually the enemy of investors seeking out capital growth. 

The opening of new housing estates can often represent a boost to the local economy. The sale of land boosts the business of local real estate agents and solicitors. And then the ensuing building activity increases the economy even further. 

This increased economic activity requires more workers and they need accommodation. Workers in turn need food, petrol, clothes and entertainment. A host of unrelated businesses can benefit from the opening of a new estate in the years that follow, but that initial spike in supply has to be distant history for capital growth to start up. So as a general rule, avoid markets where there are a large number of new developments. 

High population growth always indicates an emerging hotspot

The most over-rated indicator of capital growth is the oft-quoted population growth figures from 2006 census data. Not only is this data more than 5 years old, but it is so infrequently sampled that it’s almost useless.

People don’t move into an area and live on the streets waiting for their new dwelling to become available. Instead, they move into an already vacant dwelling. Then the population growth figures are updated and then you and I hear about it. 

In other words, the data is behind the eight ball. We want to know ahead of time where people want to move to and then supply that demand. Once people have moved, the demand has already been met by supply. 

Population growth data is a lag indicator. The event occurs and it’s too late to take advantage of it – unless you can establish a trend and assume that trend will continue. 

To establish a trend you need frequent sampling rates for the data. Once every 5 years is way too infrequent. Census data on population growth is of little help. 

The Australian Bureau of Statistics (ABS) also publishes a figure called the ERP which stands for: estimated resident population. The ERP figures are a combination of census data and local council data. The ERP is sampled quarterly, which is frequent enough to establish a trend. However, the data is inaccurate geographically. 

The ERP is for a local government area or LGA. An LGA may contain numerous post codes and a post code may contain numerous suburbs. There are some post codes in Australia that contain a single suburb and others that contain more than 100. 

Having the population growth figures for an LGA is simply too wide an area for an investor to know which suburb to buy in. How do you know if the growth is evenly distributed amongst all post codes and all suburbs within all post codes? What if there are a handful of suburbs in one post code where the majority of new residents are moving to? 

Another problem with population growth figures is that there is no break-down of what the figures are comprised of. Four variables are needed:

  1. Number of deaths
  2. Number of births
  3. Number of people moving out
  4. Number of people moving in 

For example, assume there was a suburb that experienced 10% growth over the last 12 months. That’s an extraordinary increase. But what if all 10% was due to births? Here’s a hot tip for novice investors: babies don’t buy properties. You’d be better off opening a store that sells prams in such a location. 

Some will argue that bigger families require bigger housing. That’s true, but the new property they move into will be balanced with a vacant one they leave behind. So the extra births don’t increase the demand for additional dwellings they just change the nature of dwellings required. 

And what if the market that experienced this 10% population growth by births was 100% apartments? It’s possible the parents of those babies will make a decision to raise their child in a house rather than an apartment. Perhaps they now need four bedrooms and there are no apartments with three let alone four. Given that there is no suitable accommodation, young families may decide to move away. Suddenly there is a mass exodus leaving many vacant properties just after the positive population growth figures were published. This highlights how important it is to know the cause of the change in population. And the population data available in this country simply isn’t that detailed.

This is an extract from the article False, over-rated and secret indicators, appearing in Your Investment Property's March 2012 edition. To grab a copy or sign up for a subscription, click here

 

 

 

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Comments
  • Jason says on 02/04/2013 10:28:53 PM

    Great article. I love trying to explain things to people by going to the extreme scenario to show how silly the fact could be. Like anything that comes from data you need to understand what it means and not just take it on face value. Also that past stats don't always indicate the future prospects.

  • andrew says on 17/10/2013 12:33:25 PM

    Thanks for that bro.

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