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What makes an “investment grade” property? - featured image
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What makes an “investment grade” property?

There are 10.8 million dwellings in Australia with a total value of close to $10 trillion and at any time there are hundreds of thousands of properties for sale.

The once-in-a-generation property boom we experienced in the last year or so is encouraging many investors to consider buying their first or their next property.

But don't just run out and buy any property.

Not all properties make good investments!

Residential Property

In fact, in my mind, less than 4% of the properties on the market currently are what I call “investment grade.”

You see...currently there are fewer properties on the market than there have been for a long time, and while there are still many properties on offer, there is now a real shortage of quality "investment grade" properties.

Of course, any property can become an investment property.

Just move the owner out, put in a tenant and it’s an investment, but that doesn't make it “investment grade”.

To help you understand what I consider an investment-grade property, let's first look at the characteristics of a great investment, and then let's see what type of properties fit these criteria.

What makes a good investment?

The things I look for in any investment (including property) are:

  • strong, stable rates of capital appreciation;
  • steady cash flow;
  • liquidity - the ability to take my money out by either selling or borrowing against my investment;

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  • easy management;
  • a hedge against inflation; and
  • good tax benefits.

So how do you make money from an investment?

Well…property investors make their money in four ways:

  1. Capital growth – as the property appreciates in value over time
  2. Rental returns – the cash flow you get from your tenant
  3. Accelerated or forced growth – this is capital growth you “manufacture” by adding value through renovations or development, and
  4. Tax benefits – things like negative gearing or depreciation allowances

But not all returns are created equal.

Capital growth is not taxed while rental returns are, and as your property increases in value, the rent increase also generates more cash flow.

Capital growth is a much more important driver of your wealth creation than cash flow.

Money Tree

Clearly, you need cash flow to allow you to hold your portfolio for long enough so that the power of compounding of capital growth kicks into gear, meaning you must have a financial buffer to see you through the lean times.

This means you need to be careful about your cash flow and your ability to service your debts.

Too many investors don’t recognise that property investment is a game of finance with some houses thrown in the middle and leaving themselves open to financial woes by not having rainy day money that they can draw on when needed, which often results in them selling at a bad time.

Cash flow keeps you in the game, but it's really capital growth that gets you out of the rat race.

You can't afford to do what most investors do

Let’s face it…statistics show that most property investors fail.

They never achieve the financial freedom they aspire to and this is, in part, due to the fact that they follow the wrong strategy – more often than not it's because they chase cash flow.

Just look at these stats (from the ATO)...

  • There are 2,207,905 property investors in Australia.
  • This means around 20% of Australian households hold an investment property and 80% don’t.
  • Here’s how many properties investors hold
    • 1 investment property – 71% (1.57million) – increased by 2.3% over the last year
    • 2 investment properties – 19% (418,000) – increased by 2.7% over the last year
    • 3 investment properties – 6% (129,784) – increased by 3 % over the last year
    • 4 investment properties – 2% (47,469) – increased by 2.2% over the last year
    • 5 investment properties – 1% (19,861) – increased by 1.8% over the last year
    • 6 or more investment properties – less than 1% (20,756) – increased by 2% in the last year

Property investment may be simple, but it’s not easy, as clearly most property investors failed to build a sufficiently large property portfolio to provide them with a substantial retirement income.

Property Retire

However, growing a property portfolio will supplement your superannuation and other investment assets to help secure your financial future.

Of course, the number of investment properties you own is not nearly as important as the quality of your assets and the amount of equity you have in them.

I’ve often said I’d prefer to own one Westfield shopping centre than 50 properties in regional Australia.

However, you can outperform these averages!

Examining these tax office statistics made me wonder how our clients at Metropole Property Strategists, who have been given strategic advice to guide their investing, have performed compared to the average property investor.

Currently, Metropole manages close to $2 billion worth of property assets on behalf of our clients and as you can see from the following chart, on the whole, clients of Metropole have significantly outperformed the averages:

  • Only around half of our clients own only one investment property – considerably below the Australian average, but that’s a good thing
  • 21% of our clients own two investment properties, and that’s more than the Australian average
  • Almost 10% of our clients own three investment properties, almost double the Australian average.
  • 6% of our clients own four investment properties, compared to 2% of typical property investors
  • 3% of our clients own five investment properties – three times the Australian average.
  • 7% of our clients own 6 or more investment properties – more than 7 times the number in the general property investment community.

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We’ve only counted the properties we have bought for clients or that we manage for them.

This excludes properties clients purchased prior to coming to us and naturally skews our figures to the conservative side.

It’s easy to buy the first property, but each additional property added is progressively more difficult.

We’d like to think our strategic approach to investing has contributed to our client’s outperformance, so I'll explain that in more detail in a moment.

But first I'd like to explain that...

Capital growth is the most important factor of all

Although I accept that not everyone agrees with me.

Now don’t misunderstand me, cash flow is the ultimate end goal.

But you only turn to cash flow only once you’ve built a sufficiently large asset base of “investment grade” properties, meaning your investment journey will comprise 5 stages:

  1. The education stage – learning what property investment is all about.
  2. In the savings stage – they spend less than they earn and trap this extra cash flow in a saving account, to up a deposit to invest.
  3. In the asset accumulation stage – it will take 2 or 3 property cycles to build a sufficiently large asset base of income-producing properties to move to the next stage…
  4. Lowering their Loan to Value Ratios – asset accumulation requires borrowing and gearing but eventually, your LVR must slowly come down so you can…
  5. Live off the Cash Flow from your property portfolio

The safest way through this journey, which will obviously take a number of property cycles, is to ensure you only buy properties that will outperform the market averages with regard to capital growth.

Of course, we have just come through a significant property boom meaning capital growth will be minimal or stagnant for a while, but it's important to recognise...

Here's what's has happened to property values in the long term?

Research by Metropole, based on data by the REA Group and the Australian Bureau of Statistics (ABS) shows that Australia’s national median house value has risen by an enormous 540.1% over the past 42 years.

This is an average annual growth rate of 7.62%.

The numbers did, however, vary by state.

02

Over the past 42 years, Melbourne had the highest average annual price growth for houses at 8.26%.

Sydney was the second-fastest-growing with a 7.98% average annual house price growth, only just ahead of Canberra which enjoyed a 7.9% increase.

The average annual house price grew 7.51% in Brisbane while Adelaide and Perth saw 6.94% and 6.26% increases respectively over the 42-year period.

There were no 40-year figures for Hobart and Darwin but the 30-year average annual house price growth was 7.29% and 5.84% respectively.

Of course, these are just overall averages and within each state here are some locations that have enjoyed significantly more capital growth than these averages, and other locations which have underperformed.

I guess that's how averages work.

And while we may be moving into the Winter of our property cycle at the moment, for over 2000 years Spring has followed Winter and I'm betting my money that the same will occur in the winter of this property cycle.

That's why at Metropole we spend a lot of time researching locations that deliver wealth-producing rates of capital growth.

And once we find these locations, this is how we chose the right properties in those locations:

Our 6 Stranded Strategic Approach to my investing  

We would only buy a property:

  • That would appeal to owner-occupiers.
    Not that we plan to sell the property, but because owner-occupiers will buy similar properties pushing up local real estate values.
    This will be particularly important in the future as the percentage of investors in the market is likely to diminish
  • Below intrinsic value – that’s why we avoid new and off-the-plan properties which come at a premium price.
  • With a high land-to-asset ratio – doesn’t necessarily mean a large block of land, but one where the land component makes up a significant part of the asset value.

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  • In an area that has a long history of strong capital growth and that will continue to outperform the averages because of the demographics in the area including gentrifying areas.
  • With a twist – something unique, or special, different or scarce about the property, and finally;
  • Where they can manufacture capital growth through refurbishment, renovations or redevelopment rather than waiting for the market to do the heavy lifting as we’re heading into a period of lower capital growth.

Not all properties are “investment grade”

O.K. back to my original comment that less than only 4% of properties on the market are investment grade.

Of course, there is plenty of investment stock out there, but don’t confuse the two.

These properties are built specifically built for the investor market – think of the many high-rise new developments that are littering our cities - yet most of these are not “investment grade.”

They are what the property marketers and developers sell in bulk to naïve investors - usually off the plan, but they are not “investment grade” because they have little owner-occupier appeal, they lack scarcity, they are usually bought at a premium and there is no opportunity to add value.

Off-the-plan apartments make terrible investments!

Analysis by BIS Oxford Economics a couple of years ago (when the markets were booming last time around) reported that of the apartments sold off the plan during the previous eight years:

  • Two out of three Melbourne apartments have made no price gains, or have lost money upon resale. And this is despite record immigration and a significant property boom.
  • In Brisbane, about half of these apartments bought off the plan are selling at a loss, or at no profit.
  • In Sydney, it is about one in four apartments bought since 2015 are selling at a loss, or at no profit.

In other words... more investors in the planned high-rise apartments have lost money than have made money.

And of course, there are all those investors sitting on the apartments which are continuing to fall in value, but they haven’t crystallised their loss yet.

Buying Off The Plan2

According to the BIS research, resales of apartments within three to five kilometres of central Sydney, Melbourne and Brisbane have realised consistently lower prices than established apartment resales.
 
And this is likely to get worse now considering people are very wary of buying new or off the plan apartment in the high-rise towers that are likely to become the slums of the future.
 
They recognise that many of these in the past have had structural issues and moving forward people are going to be concerned about living in cramped high-rise towers.

On the other hand, investment-grade properties:

  • Appeal to a wide range of affluent owner-occupiers
  • Are in the right location. By this, I don't just mean the right suburb –one with multiple drivers of capital growth - but they’re a short walking distance to lifestyle amenities such as cafes,  shops, restaurants and parks. And they’re close to public transport – a factor that will become more important in the future as our population grows, our roads become more congested and people will want to reduce commuting time.
  • Have street appeal as well as a favourable aspect or good views.

Location

  • Offer security - by being located in the right suburbs as well as having security features such as gates, intercoms and alarms.
  • Offers secure off-street car parking.
  • Have the potential to add value through renovations.
  • Have a high land-to-asset ratio - this is different to a large amount of land. I'd rather own a sixth of a block of land under my apartment building in a good inner suburb, than a large block of land in regional Australia.

The bottom line is buying the right ‘investment grade’ property is all about following a proven blueprint that successful investors follow.

This increases your chance of better financial returns and reduces your risks of getting caught out as our property markets move into the next, less buoyant stage of the property cycle.

It’s not just the property – it’s also about location.

By now you would know that location will do about eighty per cent of the heavy lifting of your property’s capital growth.

Top Down Approach

Not all locations are created equal

It seems that in our new “Covid Normal” world, people love the thought that most of the things needed for a good life are within a 20-minute public transport trip, bike ride or walk from home.

Things such as shopping, business services, education, community facilities, recreational and sporting resources, and some jobs.

But this is nothing new…the rise of the 20-minute neighbourhood started long before Covid19.

Neighbourhood2

However now, the ability to work, live and play all within 20 minutes’ reach is the new gold standard desirable lifestyle.

Some suburbs will always be more popular than others, some areas will have more scarcity than others and over time some land will increase in value more than others.

That’s why it’s important to buy your investment property in a suburb that is dominated by more homeowners, rather than a suburb where tenants predominate.

And you’ll find suburbs where more affluent owners live will outperform the cheaper outer suburbs where wage growth is likely to stagnate moving forward.

But it’s the same all over the world.

Go to any major city – London, Paris, Vienna, Los Angeles – and you’ll find that wealthy people tend to live within a 10 – 15 minutes drive from the CBD or near the water.

Why is this so? The cynics would say because they can afford to.

And in part that’s true.

In general the more established suburbs with better infrastructure, shopping and amenities tend to be close to the CBD and the water and that’s where the wealthy want to and can afford to live, and they’re prepared to pay a premium to live there.

The rich do not like to commute.

Overall, by focussing your research on what those often overlooked owner-occupiers are doing, you may just find an investment that outperforms the market and delivers strong value and growth over the long term.

Two-thirds of the market are homeowners

So it’s interesting that while owner-occupiers are one of the most significant influences on property, they are commonly overlooked.

Think about it…with almost 70% of all homes in Australia owned by owner-occupiers, this underpins the steady long-term growth of property values.

On the other hand, investors, who comprise just 30% of the market, create our property booms (often driven by Fear OF Missing Out or greed) and our property downturns (when they exit the market by sitting on the sidelines or selling up) creating volatility.

Here’s a relatively current snapshot of the national property market according to the Australian Bureau of Statistics (ABS) and CoreLogic:

  • There are 10.4 million residential dwellings Australia-wide with a total value of $7.2 Trillion;
  • Spread across around 15,000 suburbs;
  • An additional 130,000 to 160,000 new dwellings are added every year;

First Home Owners

  • The total debt against these dwellings is $1.83Trillion (giving an overall Loan to Value Ratio for residential property of considerably less than 30%);
  • Residential real estate makes up 52.4% of Australian household wealth;
  • Investors own around 27% of Australian dwellings by number, and 24% by value;
  • There are more than 2 million individual property investors in Australia;
  • Each property investor in Australia owns an average of 1.28 properties;

Now, from these figures it’s fairly clear that owner-occupiers comprise the largest portion of the market – in fact, they outnumber investors two to one.

This is why I always give the following advice to investors who are searching for a strong property performer: buy the type of property that will appeal to owner-occupiers.

As I've already explained…in my mind, an investment-grade property must have owner-occupier appeal.

What's your investment strategy?

Most investors start with the property and that's actually the wrong way round.

It's important to start with the endgame in mind and understand what you need and what you want to achieve.

And then you have to build a plan, a strategy to get there.

The property you eventually buy will be the physical manifestation of a whole lot of decisions that you will make, and they must be made in the right order.

That's because property investment is a process, not an event.

Investment Strategy

The problem is, that most people become property investors without putting much thought into it.

Some upgrade their home and turn their old house into an investment.

However, that doesn’t mean it will make a good investment because they probably bought it for emotional, rather than objective, reasons.

Others buy an off-the-plan property based on promises made by marketers, while others buy a property in their comfort zone – close to where they live.

Now don’t make the mistake many investors make and buy in your own backyard because you’re familiar with the location.

That’s really not a good reason to buy there.

In fact, a recent university study showed those investors who bought a property close to where they lived tended to buy underperforming properties and didn’t even get price advantage on purchase.

You’ve heard it before – failing to plan is really planning to fail.

On the other hand, strategic investors devise a strategy – they bring their future into the present and devise a plan to achieve the results they want.

So your "end game", might look something like this...

  1. You will have your own home with no debt against it and...
  2. A substantial asset base of investment-grade residential real estate with a level of gearing against it, plus
  3. Some commercial properties which bring in cash flow, as well as
  4. Some income-producing assets such as shares or managed funds may be in your Superfund.

By having a mixture of growth and income assets and a conservative level of debt, you'll be able to live off the "cash machine" of your investments.

Financial Advice

How big an asset base you're going to need, how long it will take to accumulate, and how much cash it will spin out will depend on a myriad of factors and that's why we always recommend the starting point - even before you start looking at a property is building a customised Strategic Property Plan.

And that's what we always recommend for our clients at Metropole - whether they have beginning investors or are in the middle of their wealth creation journey.

That's because attaining wealth doesn’t just happen, it really is the result of a well-executed plan.

Planning is bringing the future into the present so you can do something about it now!

When you have a Strategic Property Plan you’re more likely to achieve the financial freedom you desire because we’ll help you:

  • Define your financial goals;
  • See whether your goals are realistic, especially for your timeline;
  • Measure your progress towards your goals – whether your property portfolio is working for you, or if you’re working for it;
  • Find ways to maximise your wealth creation through property;
  • Identify risks you hadn’t thought of.

And the real benefit is you’ll be able to grow your wealth through your property portfolio faster and more safely than the average investor.

What's worse than having no strategy?

Almost as bad as having no strategy is following the wrong one.

As I said, residential real estate is a long-term, high growth low yield investment.

Your strategy should be to use the capital growth of your property portfolio to grow a large asset base that will give you more choices in the future.

Planing Strategy Future

Yet many beginners chase cash flow or the next hot spot or try and make a quick profit by flipping.

All recipes for investment disaster!

Others chase tax benefits because they think negatively gearing new properties will “keep their tax down.”

So they buy a new house in an outer suburb or put a deposit on an off-the-plan unit due for completion in two years’ time, because of the higher depreciation deductions on offer.

The problem is that these properties just don’t offer the capital growth you require to grow your wealth.

And then almost as bad as - changing strategy.

Unfortunately, some investors get spooked when markets soften and rather than sticking to a proven strategy to secure their wealth creation through capital growth, they opt for something cheap and supposedly cheerful instead.

Rather than looking at what has “always worked” over the long term, they look for “what will work now.”

It’s no surprise then that their smiles turn into frowns when that inferior property underperforms down the line.

About Michael is a director of Metropole Property Strategists who help their clients grow, protect and pass on their wealth through independent, unbiased property advice and advocacy. He's once again been voted Australia's leading property investment adviser and one of Australia's 50 most influential Thought Leaders. His opinions are regularly featured in the media. Visit Metropole.com.au
32 comments

NO - because this would not be your PR in the long term

0 replies

Got it. As a PR - will your recommendation change?

1 reply

Patricia - As a foreigner you are restricted to buying a new or off the plan proeprty - $500,000 is not enough to buy a townhouse in an investment grade location

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