Let’s look at a story from Zen Buddhism: The wind was flapping a temple flag. Two monks were arguing about it. One said the flag was moving; the other said the wind was moving. Arguing back and forth they could come to no agreement.
Finally the Master said, “It is neither the wind nor the flag that is moving. It is your mind that is moving.”
Similarly, we are seeing property prices moving up and down, most of us get so confused as to what is the true measurement of their values. The question is whether there is something else that is moving.
When we talk about the true value of an investment property, there is an underlying assumption that a property can be valued objectively (being independent of personal opinions) regardless of the subjective (being dependent of personal opinions) views of the buyers and sellers. But is this true?
Before we can understand whether there is a true value of an investment property and how to measure it, we need to go back to some basics of economics.
A classic definition of economics is the study of the use of scarce resources which have alternative uses.
- From an individual standpoint, because resources (such as properties, money & time, etc) are limited for all of us and they all have alternative uses, each one of us is ‘forced’ to look at the efficiency of our resource allocation.
- From the standpoint of the economy as a whole, resources tend to flow to their most valued uses when there is price competition in the marketplace.
- Prices help allocate scarce resources to their most valued use from their alternative uses in a market economy like Australia.
The fact that property prices fluctuate over time, and occasionally have a sharp rise or a steep drop, misleads some people into concluding that prices are deviating from their “true” values. But their “normal” level under “normal” conditions is no more real or valid than their much higher or much lower levels under different conditions.
In fact, there is no such thing as an objective or “true” value of a property. Or even if there is one, no one would know what it is and nor would anyone care in a real transaction. Let me explain why.
Let’s say you pay $500k for a property, obviously the only reason you do so is that the property is more valuable to you than $500k. At the same time, the only reason why the seller is willing to sell the property to you is that $500k is more valuable to them than the property is.
If there were any such thing as a “true” or objective value of a property, neither the buyer nor the seller would benefit from making a transaction at a price equal to that objective value, since what would be acquired would be of no greater value than what was given up. Why bother to make the transaction then?
On the other hand, if either the buyer or the seller was getting more than the objective value from the transaction, then the other one must be losing – in which case, why continue to be cheated? Continuing property transactions in the market between buyers and sellers make sense only if property values are subjective; each side is getting what is worth more subjectively.
So when we look at the value of an investment property, we need to understand that property values are very subjective to the transaction participants. It makes sense that property investors should measure the quality of an investment property subjectively, rather than just relying on the so-called objective measurements as growth and yield.
This is like if the minds of the two monks are not moving, they wouldn’t even notice the flag or the wind, let alone their movement.
Obviously you have to set yourself up in a way that your minds don’t have to move, and you can afford to ignore the flag and the wind, because it is silly to pretend nothing happens when the flag is flapping on your face!
Hence the reason why it is important that property investors should set themselves up to the position that external shocks from the market do not require them to get out of meditation!
Let me use your next investment property as an example to demonstrate how you can measure its quality subjectively while using some ‘objective’ data available for everyone to help your decisions.
You may ask some of the following subjective questions when you look at your next investment property. Let’s assume this list is all you care about at this stage and the order of importance at this very moment is how I list it here. (It is obvious that other investors will have a different list with a different order at different times).
You may say the quality of your next investment property is measured by how well it answers the questions on your list, acknowledging that you would give higher weighting to the ones that are more important to you and that some of the questions in the list are interrelated (more on this later).
Let’s look at the list and see why they could be important to you.
1. How long do you want to keep it?
The duration you will hold onto the property can determine what kind of properties you want to buy. Here are some examples:
- If you want to hold the property for more than 10-20 years until your retirement, you would probably buy a good conditioned property in a very established suburb. It may not have spectacular growth immediately, but its consistency will give you a handsome return in the long run.
- If you want to hold the property for only a few years, you would probably find a newly discovered suburb which has great potential, you will get in early before other people find out, and sell with a handsome profit when everyone is paying too much to get in a few years later.
- If you want to flip the property with minimum holding time, you would probably find a property with potential to add massive value with minimum cost in areas where there are lots of buyers currently.
2. What is the minimum growth you are happy with?
Any residential properties in Australia that can achieve consistent annual compound growth of 10% or more over the last 25 years are considered very good as most major cities median house price have grown about 8% annually on average.
There are properties that experience 20% to 40%+ growth in one year. But this growth usually does not last more than 3 years consecutively. Very often they can overshoot the market and come down from its peak later. Spectacular growth can be caused by real improvement in the area or pure speculation. Speculation is usually not sustainable unless the fundamentals are there.
In new suburbs it is possible to have a property growing 20% over the next 2 years and then remaining flat for the next 10 years. While it is also possible to have a property just doing 10% each year for the next 10 years in an established suburb.
Which one of these two properties has better quality to you? It really depends on how long you want to hold onto it: if you were to sell it after 2 years, you would be better off with the new suburb property, if you were to sell it after 10 years, the established suburb property is better.
Can you see the ‘objective’ data, growth in this case, can’t determine the quality of an investment property? Quality of an investment property is very subjective to the investor.
3. What is the minimum yield you are happy with?
Currently the rental yield for residential properties is between 3-5%. Occasionally you would see properties fall outside of this range. Typically they are either very expensive luxury properties or very inexpensive regional properties.
Luxury properties become very expensive because people are willing to pay for it, that willingness overshadows the importance of cash flow income from the property, hence lower rental yield.
Regional properties become very inexpensive because people are less willing to pay for it, hence rental is more reflective of the true cost of accommodation as a percentage of the property value.
Occasionally you will find some extraordinarily high yield (above 12%) residential properties. They are situated in areas which usually have a limited life span such as a mining town, etc. The yield is so high that it almost seems like the investors are expecting the property value to be reduced to zero in a few years time. They have factored the capital loss into the yield and try to recover their money plus profit before the property becomes useless to anyone.
Obviously not all extremely high yield properties are definitely given a short life span. However for those which are in this category, investors need to be aware that some of these properties can experience short term growth in value due to the fact that lots of uninformed property investors rush in for the scarce high yields and end up pushing the prices up temporarily. This price growth may not last and you also need to calculate the possible capital loss as well.
How much do you want to borrow?
If you compare the total return (growth + yield) of residential properties against all other types of investment such as equities (shares), bonds, commercial properties, etc. Over the last 25 years, shares and residential properties are very close and come out on top.
If you add how much risk you need to take in terms of volatility of their prices, residential properties would have outperformed shares by a long shot. (In fact, you can calculate the impact of price volatility by a measurement called ‘risk adjusted return’, instead of just total return).
Instead of going into the complicated formula of ‘risk adjusted return’, I can give you a simpler demonstration of why low price volatility of an asset such as properties is actually very important to your wealth creation.
When an asset has lower price volatility with steady growth, lenders are willing to lend you more money with less costs (lower interest rates). This is the reason why residential properties have been the best vehicle to leverage safely, compared to other more volatile investments such as shares.
When you can leverage safely, you can use more of other people’s money to create your wealth instead of waiting to save up all the money required to buy the asset.
Going back to your personal situation, if you are comfortable taking on more debt and want to go to a higher leverage to build a larger portfolio quicker, then the type of properties you need to buy need to fit into the lender’s preference: low volatility + steady growth.
There are many residential properties that don’t fit into this:
- Some regional properties with very small population. They might have high rental yield, but no steady growth of value, price can also be volatile due to the lack of demand from a small population.
- Some rural properties with large acreage. These properties may have very good growth in value, but very volatile in prices due to the difficulty for a quick sale when the lender needs their money back.
- Many other specialized properties such as serviced apartments, holiday resorts, etc. Many of these properties have a commercial arrangement that needs to be sold together with the property, which in turn reduces the appeal to general public and increases volatility on their sale price.
The properties that fit into the lender’s preference are usually the ones that can be put on the market with no strings attached, and within a very short period of time can be sold at or above the price of the lender’s original valuation.
So it is very important to understand that your desired leverage level can overwrite other conditions such as growth and yield.
2. What is the minimum return on investment?
It is very common that property investors measure how much cash they put into an investment property against how much cash they get out eventually, we call it cash on cash return. We all like higher cash on cash return all things being equal.
The problem is that things are not always equal. Objectively, you can say that you can’t ask for higher return without considering accepting higher risk. But this statement is not much use in practice because risk itself is very subjective to the individual.
What is considered risky to me may not be risky to Warren Buffet, what I consider too much to lose can be so small that he wouldn’t even notice that he has lost it. On top of that, someone like Buffet could probably alter the property prices in a suburb with his personal influence to reduce the risk of his investment property. That option is not available to everyone!
So again, the minimum return on investment is determined by your risk appetite and personal capacity, including skills, money and time you can bring to the game, this will dramatically alter the way you go about doing properties.
As a very rough guideline for return on investment in the current market, it can range around 8% to 30%. While the low end is representing almost risk free type investments such as bank saving deposits and highly secured debts, and the high end is representing unsecured capital investment into higher risk business activities.
3. How much of your own money are you happy to put in?
Many property investors started investing in properties with very little money, they were forced to be creative and leverage other people’s money. What they usually do is to trade other people’s money with their own time and effort.
After a while, you may have accumulated a certain level of wealth and experience, and start to find yourself having less time and more money sitting around not being deployed to make more money for you. So you would probably start thinking about paying other people to do the work or putting a bit more of your own money in the deal to save some of your time and efforts.
There are also investors who are still doing a lot of the work themselves and trade their own time and effort with other people’s money after they have accumulated a lot of wealth. There could be many reasons for this: some do it because that is what they love to do, others do it because they are happy to share profits with others as long as they can protect their capital.
If little of your own money down is very important to you, you may find yourself targeting property transactions that require a lot more creativity and effort, and your people skills will become more important.
4. Are you prepared to work at it?
One of the main attractions of residential properties is that you can do something about it to increase its value such as renovation, subdivision and other forms of value added activities. You can also work hard to get a bargain by good research and negotiation because you are always dealing with a subjective seller.
There are lots of ways to speed up wealth with properties, it all depends on whether you are prepared or able to work at it.
A large percentage of property investors can’t afford the time or haven’t got the know how to work their properties, they make their money elsewhere, property is simply a vehicle to store and grow the money they have made from other activities.
A very small percentage of property investors work very hard at their properties, some even go so far to quit their other jobs and businesses to concentrate on this.
Depending on who you are in this category, you will look at your properties quite differently according to your needs, and there is no need to stop doing what you’re good at and follow others. The best person to emulate is always yourself.
5. When, where, how and what to buy?
These are the 4 standard questions most property investors would ask, but most of them ask as if the answers can be obtained objectively, and that is far from reality.
When to buy
People often try to get in at the bottom and sell at the top, but most of us can never get this timing right. I think the best time to buy is whenever you are ready financially, it is more important that you are ready than other people are ready for you.
Where to buy
Many research institutions can list the top performing suburbs and streets for you, but eventually it all comes down to whether they fit your other requirements, or whether you are able to physically inspect lots of properties in those areas if you don’t live close by and unwilling to buy the site unseen.
How to buy
There are so many ways to buy a property, anything between do it yourself to completely hands free using professional help, again this is very much dependent on your experience and the time you have available for your investing.
What to buy
There are different types of properties and different price ranges, choosing what to buy is very subjective to the investor. For example, the most expensive properties have outperformed the low end properties due to the fact that the rich become richer quicker. Depending on the investor’s financial capacity, these properties may or may not be a viable option.
6. What about tax benefit?
The amount of tax benefits you could get based on your personal situation can alter dramatically the type of properties you would buy. For example, a very high income earner would get better depreciation and negative gearing benefit from a more recently built property, whereas a self employed business owner may not put as much weight on the negative gearing benefit from their properties.
This can further complicate the situation if there are other family members involved in the property when you consider the future capital gain tax distribution.
We can’t really gauge the true value of an investment property objectively. The quality of an investment property can be measured by how well it meets the needs of the investor at a point in time; hence property performance is a subjective measurement to the investor, and it has very little meaning to other people.
If we go one step further, we can almost say that wealth creation itself is a self arriving journey, it has very little to do with external market conditions.
Bill Zheng is founder of Investors Direct Financial Group, a leading property finance company providing financial solutions for property investors and developers. Bill is a keynote speaker at many property and finance conferences throughout Australia. www.investorsdirect.com.au
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