Why did apartments miss out on the recent property boom?

It’s been well documented that property prices rose significantly over the course of 2020 and 2021.

According to the Real Estate Institute of Australia, median house prices in eastern capital cities rose between 30% to 40% over those 2 years.

However, unfortunately, apartments underperformed compared to houses in a big way.

I wanted to discuss why this occurred and consider what growth prospects apartments might provide in the future.

Apartment relative to houses (median prices)

The chart below compares the median price of apartments to the median price of houses from March 1980 to March 2022 (source: REIA).

On average, the median house price has ranged between 1.2 and 1.4 times higher than the median apartment price in Melbourne and Sydney.

However, since house prices increased strongly during 2020 and 2021, the median house price is now almost 1.6 times the median apartment price in Sydney and Brisbane, and over 1.9 times in Melbourne.

This is because the price of houses rose strongly over this time whereas the price of apartments barely changed.

Covid negatively impacted apartment values

Apartments are typically owned by people on lower incomes or investors.

It has been well documented that lower-income earners suffered the most during Covid lockdowns, as typically their occupations do not lend themselves well to working from home and/or their industries were closed e.g., hospitality and retail.

Investors that owned apartments during Covid were asked to provide rental discounts/waivers and were restricted from vacating tenants and/or increasing rent.

Consequently, throughout 2020 and 2021, apartment vacancy rates rose, rental incomes fell and of course, investors avoided this segment of the market.

Conversely, Covid had a positive effect on house prices

Homeowners tend to earn higher incomes than apartment owners, especially in blue-chip suburbs.

These higher-income earners were able to work from home during lockdowns and as such, they didn’t suffer any reduction in income.

In fact, because they were in lockdown, they found they saved a lot more money which strengthened their financial position.

Falling interest rates also helped higher income earners as it increased their borrowing capacity and ability to service debt.

Together with an increased focus on lifestyles such as having a home office and/or relocating to a tree or seaside location, prompted more higher-income earners to upgrade their houses.

As such, houses enjoyed very strong buyer demand.

What drives the gap between apartments and houses?

Of course, it makes sense that houses cost more than apartments.

Houses provide a larger amount of accommodation and provide the benefit of a direct land holding.

The supply of houses in a blue-chip suburb is fixed because subdividing a block and constructing multiple dwellings tends to be uneconomic for developers (due to the high cost of the land) or restricted by governing municipalities.

However, the price gap between houses and apartments cannot continue to grow perpetually.

Eventually, fewer people will be able to afford to buy a house in a particular location/suburb.

These people either must move to a more affordable location or buy an apartment instead of a house.

As such, demand will increase for apartments and that will translate to price growth (due to the law of supply and demand).

The cost of new apartments will rise

Apartment buyers have the choice to buy a new apartment or an existing one.

Often, buyers are attracted to a shiny and new building (however, I strongly recommend you steer clear of these for the reasons stated here).

A lot of cheaply constructed apartments were built between 2010 and 2018 and sold to investors and overseas buyers.

However, since then, the Australian government cracked down on selling to overseas buyers, which means developers must build apartments for domestic buyers.

Domestic buyers demand higher levels of finish and quality.

As such, the cost to construct and market new-build apartments is expected to rise significantly, which will be reflected in higher sales prices.

This will make existing apartments more attractive (cheaper) by comparison.

In addition to rising costs and prices, there are lower levels of new construction as charted by Pete Wargent here:

This will also contribute to upward price pressure.

Return of overseas immigration

Students account for approximately 40% of temporary migration (temporary visa holders).

Of course, almost no temporary visa holders entered the country in 2020 and 2021.

However, as international borders reopen, the return of overseas students will create strong rental demand for apartments.

That increase in demand should push rents higher, which will attract more investors and eventually translate to price growth.

Reversion to the mean

Nobel Prize laureate and economist, Harry Markowitz was fond of saying that the market only gives you two free lunches:

1. diversification and
2. long-horizon mean reversion.

Considering relative value (i.e., the chart above) and recent returns (see below), Melbourne looks like the most likely market to benefit from long-horizon mean reversion.

> Growth in median Melbourne apartment price between 1980 and 2010: 9.2%

> Growth in median Melbourne apartment price between 2010 and 2022: 3.2%

About Stuart Wemyss Stuart was a Chartered Accountant before establishing mortgage broking firm ProSolution Private Clients. He has authored two books and shares his experience with readers of Property Update. Visit www.prosolution.com.au