Why it’s important to understand the difference between Physical Growth & Capital Growth

Do you understand the difference between physical growth and capital growth?

Don't worry if you don’t, because I’ll explain.

You see… physical growth will often be masked as capital growth.

On the surface, there is no way of telling the difference.

However, by digging deeper and having a greater level of awareness and perspective, you will quickly understand the difference.

So why is it important to know the difference?

Well, it could cost you hundreds of thousands of dollars over a decade or more, not to mention the opportunity costs that are foregone.

Let me explain –

A starting point

To start with you will need to find the right data to analyse.

As a property investor, your primary focus should be capital growth.

So, this would be my starting point.

Unfortunately, most investors will only analyse the last 3 – 5 years of data, as this is all that is provided by most free property research websites.

I feel that this time short frame has a much higher risk as it barely captures one full property cycle.

Ideally, as a professional investor, I would be analysing 20 to 30 years’ worth of data, which encompasses multiple property cycles, downturns, and X–factor–type events.

Note: This longer-term data will greatly reduce your level of risk.

After analysing the data you will be left with a list of suburbs that have had the best capital growth over that specific time frame.

Now you must separate the contenders from the pretenders.

Physical growth

You will need to dig a little deeper to separate the suburbs that have had true capital growth from those that have only had “physical” growth.

The easiest way to define suburbs that have had physical growth are ones that are new and were only established over the last few years.

The reason they did not show up on our longer-term 20-year data set is that there were likely sheep, cows, and koalas living there before.

The land has been cleared and subdivided for new housing estates.

There are brand new houses being built on smaller blocks of land, then there are shopping centres and schools popping up.

The odd McDonald's or KFC shows up and maybe even a new bus stop or training.

It is really just “physical” growth, as the suburb begins to transform and expand.

But not “capital” growth where the value of a particular property increases.

What happens is demand slowly increases as these areas are new, exciting, and affordable, but that is only one side of the equation.

The other side supplies and this is where, in my opinion, the excitement ends.

Quite often there is still 7 – 10 years’ worth of land left to be built out, Stage 1 quickly becomes Stage 3 or 5, and so on.

Then demand for the existing, established properties drops like a stone.

After all, who would want to buy a 2-3-year-old home, when they can pay $10,000 more and build their own home with their personalised touches?

Likewise, for investors chasing depreciation, this can only be captured with newly built properties.

While it is not uncommon to receive a small burst of equity in the early stages, you will be stuck holding a bad investment as the physical growth vanishes.

Capital growth

While physical growth may initially mimic capital growth, it is very different from capital growth in the true sense.

The suburbs that show up on the longer-term growth charts are what you should be looking for, as they have been established for many decades.

In addition, these established suburbs tend to have the opposite ratio of Demand and Supply to the newer suburbs.

Firstly, there is consistent, higher demand in these locations as they are close to our major employment hubs, public transport and lifestyle precincts.

And there are no new parcels of land available for more housing.

Sure, you may be able to knock over or subdivide existing lots, but you can not just pop in another 1,000 new homes or release new stages.

So, with a level of high demand and very low supply, the ingredients are right for long-term, sustainable, capital growth.

You can see the results here from my recent article about the best-performing suburbs in Brisbane over the last 20 years.

You will also be able to understand the common traits each of them had to attain the higher levels of capital growth, consistently over two decades.

It pays to know the difference

You may ask, why is it so important to know the difference?

Properties with superior, true capital growth will always outperform suburbs with physical growth over the longer term.

As an investor, you need to find assets with above-average, consistent, wealth-producing levels of return that you can hold in your portfolio.

While a physical growth suburb may appear to have superior growth over a 2-3 year period, it will consistently underperform over the longer term.

Even just a few percentage points difference in capital growth each year, annualised and compounded over a decade or two, could equate to hundreds of thousands of dollars.

Not to mention the opportunities to further expand your portfolio and wealth, given superior return and additional equity.

In summary

For the majority of investors, Capital Growth should be a primary focus when building an asset base.

So, it makes sense to analyse the appropriate data and, in my opinion, the longer the timeframe the better.

With a long list of suburbs, you must then distinguish the areas that have proven capital growth as opposed to superficial physical growth.

You will find the suburbs with Capital Growth, consistently demonstrate above-average demand and very low supply.

While Physical Growth suburbs generally have huge amounts of land supply and demand barely keep up with the average.

There may be a small initial “sugar hit” with physical growth suburbs, which is why they make a lot of short-term capital growth lists, but longer-term they are non-existent.

To build wealth you need to maintain above-average, consistent levels of capital growth for decades, not just a short-term hotspot.

Therefore, it pays to know the difference – it could cost you hundreds of thousands of dollars over the long run.

About Brett Warren Brett Warren is National Director of Metropole Properties and uses his two decades of property investment experience to advise clients how to grow, protect and pass on their wealth through strategic property advice.