There’s no saying for certain whether real estate will forever rise in value at such impressive growth rates. There’s no saying for certain which locations will perform well and which locations will be left behind. There’s also no saying for certain which dwelling types will be most lucrative, and which will be most burdensome. The last is probably a little easier to forecast than the rest, but even then we can only make educated guesses. And today we’re making educated guesses. Let me therefore qualify this article by noting that this is very opinion-based and that we’re strictly speaking investment here, not owner-occupied. The value you attribute to your owner-occupied dream home is sentimental and not up for discussion.
How is property valued?
Valuing property is actually a bit of a peculiar task. When you value a company you generally do so using what are called valuation multiples. You have to make certain assumptions and predictions about how the company is expected to grow in the short-to-medium term. A very simplified model of valuing a company is to take its price and divide it by its sales. A price to revenue ratio of say 10x, implies the company is trading at 10 times its annual sales, meaning it’s expected to earn its valuation in sales over the course of 10 years. You cannot do this with property.
If you tried you would have to use rent as the revenue figure and doing so leads to some awful investment analysis conclusions. The median house price in Sydney is around $1.4m and the median house rent is around $550 per week (or $28.6k per year). $1.4m/$28.6k gets you an absurdly high price/rent ratio of ~49x. If this was a company (and not a tech company for reasons we’ve previously discussed), it would probably be a pretty clear indicator that the company is overvalued. But property is special – and not just because of politics and favourable tax concessions. What makes property special is its scarcity. Most (but admittedly not all) companies can simply scale up their operations to meet a boost in demand. What we can’t do is create more land. There’s a limited supply of it and the factor which tends to drive house prices up the most is that available finite pool of land getting ever-so-smaller as populations grow.
Therefore we need to look to relative analysis – which effectively means that a property is valued based on whatever comparable property in the same suburb very recently sold for. Of course I could’ve just said that right off the bat but I wanted to introduce this scarcity point to make the following arguments.
Appreciation and depreciation
In very general terms, the value of the structural improvements of a property (ie the building itself) depreciates over time. The materials become older and less reliable. The bricks, the tiling, the skirting boards, the benchtops, the cabinets etc are all subject to wear & tear and become less desirable as newer designs are introduced into the market. As we hypothesised above, what’s likely driving up the price of the property therefore is the value of the land (again, scarcity). It seems the government agrees with us given the valuer-general tends to move land valuations upwards over time rather than downwards. You can probably see where I’m going with this but let’s keep going anyway.
When you purchase an apartment, what you’re purchasing is airspace in a building. Of course, that building is situated on a block of land. Remember that the value of the building will depreciate over time and the value of the land on which the building is situated tends to rise over time, but your right to enjoy the benefits of that appreciation must be shared with all the other apartment owners. This is one reason why apartment values tend to underperform against other property types. Another reason is strata. Strata fees suck. They suck because they drag on your investment yield but they also suck because they tend to rise over time. Strata fees for the typical Sydney apartment will set you back around $800-1,200 per quarter today and it’s not uncommon for the rate of strata fee growth to outpace the rate of rental yield growth (and that’s without having even explored the topic of “special levies”). Being bound by strata by-laws also restricts your renovation goals and it’s quite difficult to sway a vote against the status quo. Finally, thanks to relaxed building regulations, many new-build properties are commonly falling victim to structural defects. A structural defect in an apartment block affects all apartments and may be costly enough to bankrupt investors.
Plenty of apartment owners will correctly argue that their investment growth has outpaced house price growth when compared to other suburbs. For example, an apartment in a highly desirable coastal suburb may outperform a house that’s situated more inland. However if we’re comparing property types, this is a false equivalence. If we really want to measure apartment growth against that of townhouses or houses, it’s better to compare within the same suburb. You’ll then see that a house in Bondi Beach will likely be growing at a much quicker pace than an apartment on the same street.
Townhouses are a sort of middle-ground between apartments and houses. Situated on plots of land starting from around 150sqm in size, a townhouse owner has a much better claim to the appreciation of land than that of an apartment owner but not as much as the owner of a house. Strata fees are also a problem for townhouse owners but they tend to be much more affordable than those of an apartment owner and therefore, less of a drag on rental yield. Townhouses are not shielded from structural defects. However if a structural defect is identified in one townhouse, that doesn’t necessarily impact another townhouse owner with a defect-free property (assuming the properties are detached). This stands in clear contrast with an apartment owner where a structural defect threatens the stability of the entire building and therefore, all investors.
No rewards for guessing that my personal favourite type of investment dwelling are houses, in particular houses on larger blocks of land. The child of every migrant parent in Australia has heard those famous words all their lives – “touch the soil, my child”. The owner of a house has the greatest claim to the capital appreciation in the value of land in a suburb, is unburdened by high and consistently-rising strata fees, has more control and visibility over any structural defects on their property, and also has the greatest potential for development opportunity. Developing an apartment means applying a lick of paint to the walls or maybe installing a walk-in closet to store all your clothes and shoes (preferably with a strict no-birks policy). Changing anything will probably need to be done within the limitations of your building’s strata rules. Townhouses face similar issues, with slightly relaxed restrictions on average. The potential for houses however is limitless.
With the right council planning permissions, you could knock a house down altogether and rebuild one from scratch. If your zoning rules allow, you may even be able to subdivide and turn one dwelling into two or more dwellings – increasing your rental yield or adding more equity to the property than your cost of construction (this often happens in a bull market but not so much in a flat or bear market). Adding a granny flat tends to almost double your rental yield. Perhaps a little more ambitiously, subdividing and knocking down an older dwelling and building two modern duplexes has the potential to double your property’s valuation.
Standalone, detached housing therefore tends to outperform other dwelling types within the same or similar suburbs. Having said all of that, affordability is another matter. We’ve just demonstrated that apartments tend to underperform townhouses and townhouses tend to underperform houses, but affordability tends to moves in the other direction. But can you see why that may be?
Tune in next time for a discussion on yield vs capital growth.