Why This Common Investment Strategy Now Might Not Work
Purchase a property, rent it out, watch the market do its work, pull out some equity, repeat. When the market is booming, it's happy days, but what happens when the market is flat? What happens when prices go down?
Purchase a property, rent it out, watch the market do its work… Once its value has increased enough, pull some of the equity out… Purchase another property, rent it out, watch the market do its work…Repeat.
When the market is booming, it’s happy days, but what happens when the market is flat? What happens when prices go down?
That’s what we’ll explain here with actual client case studies.
Melbourne’s last price growth cycle ran from 2012 to 2018, during which time Median $ House Prices increased by an average of +74% across Inner & Middle Melbourne. Property investment was pretty easy. But, since the peak in 2018, prices have decreased by an average of -11%.
The typical investor with one or two rental properties, with a strong debt-equity position, and with a long-term perspective, wouldn’t be bothered too much. More active investors (often supported by ‘property investment experts’) with a large portfolio of highly leveraged properties purchased with a speculative approach should be rethinking their strategy in a serious way right now.
Without strong medium-term price growth, property investors need to get smarter.
Recent events will help the market stabilise: federal election results, interest rate drops, APRA lending requirements, etc. And, a number of indicators suggest that the market is bottoming out: increased attendees at open for inspections, improved auction clearance rates, shortening days on market.
But – and this is very important – no serious analyst is predicting a return to the double-digit per annum price growth that we saw from 2012-2018.
The following 3 real-life examples will demonstrate why a more sophisticated and proactive approach will be necessary to succeed in the real estate market in the coming years.
In 2015, we supported three very different clients in purchasing properties that suited their objectives and parameters:
- Linda: First-time investor with a limited budget, looking for a set-and-forget property that she could rent out. Aiming to secure a long-term asset, with no dramas.
- Rob: Intermediate investor with a slightly bigger budget, looking for a property with development potential that he could rent out. Aiming to manufacture equity through permits and to create options (e.g. leverage to purchase again, sell with permits, proceed to build).
- Mick: Experienced investor with a similar budget, looking for a property to develop ASAP. Aiming to manufacture equity through permits and construction, with an eye towards retaining the completed dwellings over the medium-term, primarily for tax benefits (e.g. negative gearing and depreciation).
Over the following 30 months, the market performed pretty well, driving the value of each property up by about +21%.
Linda bought a lovely little detached house on a modest block, close to shops, transport, parks and schools. It netted her a typical yield of 3.2%, and it rose in value by $135k over the period, from $645k to $780k. Her total equity contribution (including 20% purchase, stamp duty, mortgage payments less rental income, and outgoings) was $191k.
By investing $191k and watching the market do its work, Linda grew her equity by +52%.
Rob bought an older house on a corner block of about 1000m2, in a reasonably progressive residential zone. Due to the dwelling’s condition and the large block size, the property netted him a smaller yield of 2.2%. A golden rule in real estate is that it’s the land that appreciates in value, not the house; the property rose in value by $189k over the period, from $900k to $1.089m.
Rob took his time working through a very tasteful development concept, and eventually attained planning permits for 3 detached houses, at the cost of $25k. His total equity contribution amounted to $318k.
By investing $318k, and proactively adding value by attaining a planning permit, Rob grew his equity by +78%.
Mick bought a shocker of a house on about 650m2 in a great suburb. The house was in terrible condition, and he rightly determined that it would cost him more to make it rentable than he’d get back in rent. With no rent coming in, he saw the land value rise by $194k over the period, from $925k to $1.120m.
Mick immediately got stuck into the design, and secured a planning permit for 2 high quality detached houses, each with its own street frontage. Once he attained the permit, he completed all documents necessary for construction: architectural, engineering, landscape, drainage, traffic. Together with build specifications, he tendered the job to a few local builders and landed on a fixed price build contract of $920k.
His total equity contribution, including a modest $20k required by the bank for construction finance, amounted to $530k. Upon completion, the new dwellings were valued at $2.660m combined.
By investing $530k, and proactively adding value through development, Mick grew his equity by +142%.
All three of these clients did really well, but, how would they fair in this current market, where very little price growth is expected over the next 30 months?
Assuming Median $ House Prices rise by a modest +7% over the next 30 months…
If Linda deployed the same strategy today, she’d build her equity by just +4%. She might as well just keep her money in the bank instead of purchasing a set-and-forget rental property.
Rob would be far better off than Linda. By proactively attaining planning permits (while sacrificing on rental yield), he would grow his equity by +34%. Importantly as well, he’d create options for himself – now and into the future.
Mick’s expected return in a flat market would still be far greater than what Linda achieved in a hot market. By seeing a development through from start to finish over 30 months, he’d achieve a Return on Equity of +85%.
Perhaps the most powerful lessons are learned in a falling market. How would each client fair in the market we’re just coming out of, where property prices fell by -11%?
Linda would likely be forced to sell, seeing her equity in the property shrink by -56%, from $191k to $84k. If the banks came knocking, she’d be hard-pressed to maintain the required LVR.
Rob would be slightly better off, but he’d still be fuming by a loss in equity of -22%. His equity position would shrink from $318k to $248k. Not good, but he’d live to fight another day.
And, Mick? He’d be the only one to make money. Even with the market crumbling around him, he’d end up growing his equity by +10%, from $530k to $582k. Sure, nowhere near what he was hoping to achieve, but by hiring good professionals and working hard to add value proactively, he’d ultimately be in a better position.
Skeptical about Mick’s – or any other developer’s ability to make money during a market downturn?
Consider another client of ours, who purchased at the top of the market 16 months ago. With construction now commenced, and against conservative resell valuations, he will achieve +14% ROE upon completion. Did we want more for him at the time of purchase? Of course, we did. But, he’s a positive and highly experienced businessman who appreciates that we’re all at the mercy of the market to some degree. That’s why he takes it upon himself to hire good people and rip into ventures with enthusiasm.
Real estate investment will not be the same in the future as it has been in the past.