The Slippery Slope of Capital Growth


It is a commonly held belief that those who are shrewd when they buy do the best from property, no matter where it is. The reality is that this can be far from the truth and usually is. Why? Because where you buy plays a large part in the longevity of growth.

The very first rule any property investor needs to learn and do properly is research. The next two rules are to repeat rule one until you fully understand it and do it as second nature. Research can be a tedious and time consuming task, but when you are investing hundreds of thousands (in some cases millions) of dollars, research is king. Property research is often undertaken in different ways, but there clearly is a right and wrong way.

Some individuals try to attend as many seminars as they can, spending thousands of dollars to have other people tell them what they probably could have found out for themselves by reading the right research reports and surfing the multitude of property web forums.  These people rarely make a decision because they procrastinate.

Other people will do too little research, and then go straight out and buy the first thing they see. These people will read the papers, rely on research published by major selling agencies and act on median house prices statistics or what is called "unclean data." This is data that has not had transactions involving family members, large development sites, etc., removed from the normal house price data.

Researching the right way

To gain the true growth statistics of an area over 12 months, ideally we would need to take a core sample of properties that sell in one year and then find a near identical set of properties in the same area the following year. This would then allow a measurement of the difference of those two samples to arrive at an average growth statistic for the area. Of course this type of data collection is extremely labour intensive, but the accuracy it would provide on which areas are growing and which are not would be invaluable.

Researching price growth statistics and rental figures should not be the only statistical research that is carried out. The second tier statistical data should also be considered, such as:

• Unemployment data
• Number of properties sold in the last 12 months
• Income spread for the suburb or postcode
• Number of properties on the market now and over the past year
• Demographic structure and information
• Percentage of owners to investors

To achieve good capital growth from a property, it does not need to be bought for a cheap or bargain price, nor does it need to be necessarily bought at the right price or market value. Many astute investors, and in my experience, particularly high net-worth investors look to secure high quality or prime property at what they consider a fair price. They do this in the knowledge that the property will see excellent growth over the years based on where it is and the attributes it exhibits. Purchasing a property like above, coupled with paying a lower end value range for it, supported by your research, then it's a no-brainer!

Lower priced properties have all received strong percentage growth in recent years, due to the fact they were starting at a very low base. It could be argued that some of these areas have grown too fast and made it difficult for the incumbent demographic to afford to buy in. Due to income restraints and tighter lending policies by the banks, these traditionally lower priced areas may see price ceilings reached and low or minimal growth occurring in the short to medium term.

Reviewing markets closer to a major capital, the supply and demand equation continues to drive growth. Although there are cases in the current market where sellers are accepting less than what they possibly could have achieved 12-18 months ago, these are generally isolated and the market fundamentally remains strong for quality property.

Finding the right goal

The first question I often ask an investor buyer when I meet them is, "What is your goal with wanting to buy property?" Put basically, I want to know why are they buying property. Do they want to diversify or add to their investment portfolio? Do they have a focus on accelerated wealth creation through buying high growth property? Or, do they want a passive income from a high yielding property? And finally, they heard from someone at a BBQ that property was a good thing to buy but they don't know much else! The need to assess where you sit in all of the above can have a large impact on the type of property you buy and a massive impact on the outcome from that.

The more people I speak to in this market, the more I realise that everyone is hanging out for that once-in-a-lifetime bargain buy that they can talk about for years to come. The fact is that a good quality property bought at a below average price will always outperform the majority of properties bought at "bargain" prices. That's because more often than not, the quality is lacking in bargain buys. Why is that the case?

Firstly you need to ask the question, if a property is advertised as a bargain, why is it being advertised at all? Because 99.9% of real estate agents these days have a very large database and any 'bargain properties' have the real potential to be bought by those people on the database.

Secondly, if you have an opportunity to buy a property at a bargain price and that has been on the market for some time, there is usually a catch. It can be said that the properties that are easy to buy are always the hardest to sell, and visa versa.

Obviously there are exceptions to that in good and bad markets, but usually I find it is true. Those home buyers or investors that hold out for the bargain buy will undoubtedly miss out on the opportunities for good quality property that present themselves nearly every week.

As indicated, you only have to look at some of the wealthiest people in Australia; they have made the vast amount of their fortune through property. I think you could assume the property they bought was good quality at a good price (not necessarily a bargain), and thus it achieved fantastic capital growth, making it look like a bargain in the long run!

Making the most of your purchase
Returning then to that cliché of "You make your money when you buy", it can be proven both ways that money can be made on buying any property under market value. Similarly money can be made by buying a quality property in short supply that is generally sought after and will achieve the desired accelerated capital growth over other properties in the surrounding area.

Auctions are certainly a form of sale and purchase that can swing both ways, but there is usually only one winner. If an auction is conducted in a market where there is a high demand and low supply, the competition for a property can drive the price high, maybe higher than what it is really worth. The question then is if the same property was put on the market the next day and listed for sale at what it achieved at the auction, would it sell? Possibly, but from my experience in those sort of markets, I'd say people get carried away in the moment and usually pay more than what they would have if the property had been offered for a private treaty sale.

An auction from a purchaser's perspective can be a completely beneficial experience if the market is depressed or supply is in excess of demand. Or buyers may have exited the market like we have seen from time to time over recent years due to an economic event. Really successful auctions require competition and to create competition you ideally need more than one buyer, otherwise the seller may as well have marketed the property for private treaty. Lack of buyers and competition at an auction plays right into the hands of a buyer, particularly if the seller is committed to selling on the day of auction or shortly there after. Buyers take note - this is a time when quality property can be purchased well below its true value!

The power of compounding growth

Unless you pay the correct price or market value for a property in the first instance, you're not going to achieve the best capital growth for the property you purchased. The exception would obviously be if you sold the property for a high enough amount to make up for the lost growth, but highly unlikely.

Let's make some assumptions.
Firstly, that you have chosen an area to invest where the projected growth rate is 15% per annum for the next five years. The property you purchase for $100,000 in that area was actually only worth $90,000 at the time. So on the face of it you think, "What's $10,000....I will make that up in capital growth over time." The reality is that the power of compounding growth is a very strong one, and that which needs to be given serious consideration when researching a property and an area. 

The initial equation of purchase for $100,000 with projected 15% per annum growth over five years shows an end estimated value for the property of approximately $201,000 at the end of year five, a doubling of value. In contrast if the actual original value for the property was the $90,000. When you go to sell it 5 years later, you'll find that a valuation or sale price would come in around $173,000. So your initial 15% growth rate has actually been reduced to fewer than 12% due to your original $10,000 mistake in overpaying.

Being 10% out on your original purchase price at the $100,000 level is bad enough, but what if you where out 10% on $500,000 taking into account the same set of assumptions?

The equation then becomes an initial purchase for $500,000, with projected 15% per annum growth over five years. This shows an end estimated value for the property of approximately $1,006,000 at the end of year five, a little over double in value. In contrast if the actual original value for the property was the $450,000. When you go to sell it 5 years later, you'll find that a valuation or sale price would come in around $905,000. So the amount of your lost equity is magnified five fold.

So as you can see the principle remains the same for whatever dollar amounts, or growth rates for that matter, you use. The greater the initial mistake, the greater the impact on your eventual outcome and return. If you never intend to sell the property, you may put yourself in a better position, as the longer you hold the property, the less impact your mistake has (in average growth per annum terms). And, of course, it is all reliant on the rate of growth in the area to begin with.

The cost of overpaying

There are other issues with paying too much for a property, none particularly heart-warming. A higher purchase price then necessary can lead to such things as higher taxes and stamp duty, and a higher loan amount with correspondingly higher repayments.

So it's clearly critical to pay the right amount for your property in the first place and avoid all these higher costs and lower returns. How do you ensure you pay the right price? What is the 'right' price anyway?

The 'right' price is a price that reflects the value of the property. That is, a price such that if you put the property back on the market again the day after it is purchased, you could be confident of receiving a similar kind of price again.

To ensure the price you pay is right, you fundamentally must know your market. And if you don't know your market, don't buy property until you do know your market. If you don't feel confident, consult a professional. Money spent before buying could make you tens of thousands when selling.

But most of all ensure that you are going into the transaction with your eyes open. You don't need to be an expert, but you should feel comfortable with what you are buying. Be knowledgeable enough to know that what you are paying is fair and reasonable, and that you have completed sufficient research on the area and the property you are purchasing.

Buying property is without doubt the largest monetary expense most of us will ever experience. By equipping yourself with the knowledge of where and how to gather information about an area or a property in particular it can be a rewarding experience that has a lasting impact on your future wealth and lifestyle.

Scott McGeever is the director of Property Searchers, a buyer's agency in Brisbane. He is also a founding member and chairman of the Buyer's Agent Interest Group (Part of REIQ), and has been recently elected to the Vice President position of The Real Estate Buyer's Agents Association of Australia (REBAA).All views expressed are his own.

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