Some investors claim that holding a balanced property investment portfolio is the key to success, believing that you should never keep all your eggs in one basket. This leads to the obvious question – what constitutes a ‘balanced’ portfolio?
The logic of spreading the risk by balancing or diversifying your properties is that if the values (or prospective values) of one of your properties slumps, good continued performance in the others will still give you an acceptable overall result.
It is uncertainty that urges us to diversify, not the surety of high returns, because if we were really sure about the outcome, there would be no logic in diversifying at all.
Some investors spread their housing investments across several states, others own a mix of houses, townhouses and apartments, while still others balance their portfolio across capital cities, regional towns and rural centres.
The most common way that investors spread their risk is by investing in different areas, so let’s look first at capital city versus regional markets.
Capital city versus regional housing markets
Our growing urbanisation generates ever growing demand for housing in already heavily populated and over developed coastal areas and creates more or less continuous housing shortages in most of our capital cities.
This was not always the case, and in fact around the time of Federation in 1901 the price of regional and country housing was equal to and in some areas greater than the cost of equivalent city properties.
Since then there has been an almost continuous drain of people from rural areas to the cities, but a far more dramatic influence has been the arrival of overseas migrants, especially since the end of the Second World War who have overwhelmingly preferred to live in cities, especially Sydney and Melbourne.
Over time, this has resulted in city house prices being higher than those in country towns with country and regional housing prices declining to around 60% of capital city equivalents.
This is unlikely to change in coming years, with no significant or serious decentralised housing initiatives forthcoming from governments at any level.
It does not mean that country prices are falling in real terms, but that their rate of growth is less than that of capital city housing markets.
The annual average growth rate of capital city housing markets is around 2% more than country areas on average, which means that investors seeking a balanced portfolio should only invest in capital cities, unless there is strong evidence that a particular regional or rural market is about to boom.
One State versus another
Some investors believe that a balance is achieved by spreading their property investment portfolio across several different States.
This can lead a huge mistake being made, if the properties are all located in the same type of market.
For example, consider the extremely high long-term price growth that took place in Newman, Port Hedland, Gladstone and Moranbah in the ten years leading up to the end of 2011, with average annual price growth of 15% and more.
The causes of this growth were housing shortages for rental accommodation generated by workers in the coal and iron ore mining booms associated with these towns.
It was the subsequent competition between investors seeking a piece of the action which then led to dramatic rises in house prices.
Although it seemed to some experts that the mining house price boom would last forever, it was not to be and the slowing of the mining boom led to dramatic falls in prices as investors now competed with each other to sell their vacant properties.
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Some investors in these towns suffered catastrophic losses because they thought a balanced portfolio meant that they should hold properties in several different States.
They failed to see that the relevant factor was that all these towns had the same types of markets, and were therefore driven by the same dynamics.
Diversify by different types of housing markets
Irrespective of where we decide to invest, we need to look at the single most important fact about housing investment.
Housing is about people, not places and the best investments will always be where the demand for housing is so great that it leads to housing shortages.
This demand will then translate into rent or price rises and if the demand slows or stops, it will take the housing market down as well.
Seventy percent of dwellings are owner-occupied and thirty per cent are rented, so the two most basic types of housing markets are those where renters are in the majority, and those where owner/occupiers predominate.
Rental markets are far more volatile than owner-occupier markets, because the people who live in the dwellings don’t own them, while the people who own them don’t live in them.
This volatility provides opportunity as well as risk.
Rental markets can offer the highest positive cash flow and this is where housing markets can boom, with property prices doubling in just a few years – something unheard of in owner-occupier areas.
On the other hand, the risk is that these markets can also crash when rental demand slows down and investors all try to get out at the same time.
We can break up the rental markets into six types of markets with similar types of renters, such as permanent renter suburbs, new inner urban precincts favoured by younger households, established suburbs where overseas arrivals rent, student localities near tertiary institutions, tourist towns or remote construction zones.
Each of the housing markets in those areas will boom or bust according to the rent demand the renters generate and each behaves according to the same demand dynamics.
The three owner/occupier markets are easier to identify.
They are first home buyer markets located in urban growth corridors and outer suburbs, upsizing upgrader markets situated in well-established upper socio-economic areas and downsizing retiree markets located in regional retirement destinations along our coastlines, rivers and lakes.
Every one of our 15,000 suburbs and towns can be identified as one of more of these nine types of markets, so if you are certain that one of them is about to boom, it makes sense not to diversify and rather, to concentrate all your properties in that one type of market.
But because so many of the macro dynamics such as interest rates, economic conditions, population change, lending rules and finance availability can change, it becomes very difficult to accurately pick the type of market where price growth is most probable.
This is why it is best to limit the diversification of your portfolio to a combination of those types of markets where growth is most likely, such as localities with regional transport infrastructure projects which will generate rental demand from construction workers and then become thriving tourism boom areas and retiree destinations when the work is complete.
Achieving such a sensible balance means that while all of your investments may prosper, it is highly unlikely that none of them will, because the dynamics of each of these markets is different and they all have good potential.