Misinterpreting certain aspects of the real estate market is an easy thing for under-experienced investors to do – but it can be avoided.
Blogger: Cate Bakos, director, Cate Bakos Property
Often I meet investors who might require some gentle reprogramming or perhaps they have missed an obvious risk and need it pointed out. I’ve decided to share some of my most recent and concerning investor misconceptions in an effort to better equip you for the world of property investing (which often features twists and turns).
The first misconception is that land is king. This ideal dates back to the 1960s, when many Australian couples held tight to the ‘quarter acre block with new home’ dream and pursued their slice of paradise in places like Greensborough, Chelsea, and . Back then, these neighbourhoods were at the end of the train lines. They were fringe locations where house and land sales were rife. My Dad’s family cashed in their double-storey terrace on Burnely Street, and had to fund additional cash to ‘upgrade’ to their new house in Greensborough. At the time they were so pleased to be moving out of the stigmatised inner suburbs. Little did they know that the next three generations would have a complete change of mindset around how they felt about inner-ring suburbs. The following three decades witnessed a transition which not only gained momentum but changed property in Melbourne as we know it.
People are now prepared to trade money for time. With greater congestion on our roads, an ever-increasing urban fringe, and longer hours due to more commanding jobs and less job security, workers now cherish their time and are motivated to spend less time travelling to (and from) work.
Gone are the days where land is king. Location is now king. I have witnessed capital growth trajectories over the last 20 years which prove that a well located, inner-ring suburb unit or townhouse will outperform a 700 square-metre parcel of land of the same value. And younger generations are voting with their feet.
Most professional twenty-somethings would rather live in a cramped inner-urban apartment than a four-bedroom house at the end of the train line.
Being able to ditch this misconception is an important step for any investor – and as always; growth drivers need to be recognised, understood and measured when comparing assets of differing qualities.
The second misconception is that of financing a challenging property. Many investors bring a property to my attention which has a difficult flaw. The flaws which bother me the most are the flaws which the lenders don’t like. Such examples include company share titles, commercial zoning, water or fire damaged properties, or those which are in high-risk areas (such as flood zones, bushfire zones, areas where major employers are backing away from... the list goes on). A mortgage insurer often has the final say, and for any properties which are being financed above 80 per cent loan-to-value ratio, these ‘difficult’ properties can become ‘securities’ which are rejected by the lenders; or in plain language, the loan can be rejected for no fault of the buyer. I’ll always spell out the concerns I have based on the property not ideally meeting banking policy and often the buyer will nonchalantly tell me that they don’t need that level of finance – or worse still, don’t need finance at all. The concerns I have aren’t only about their ability to finance the purchase. The real issue becomes the effect on the asset’s future performance based on the lending restrictions placed upon it. These restrictions will adversely impact their ability to sell the property easily, and even for those who don’t wish to sell (ever), the impact on other similar and comparable properties in the block or the area. If other similarly zoned or impacted properties are subjected to the same tough lender scrutiny, the number of eligible buyers will be significantly reduced, and with a reduced buyer pool comes reduced buyer competition. When buying a bargain, one has to accept that not only will they sell as a bargain, but other properties which compare will also perform as bargains.
Banks place restrictions on certain types of property for good reasons. Actuaries, risk consultants and insurers each know all too well why particular investments carry higher risks than others. Being guided by LMI-restricted properties is one easy, but valuable lesson to learn in the world of property investing.
The last and most common one is 'old versus new'. Clients sometimes come to me with a brief commanding a brand new purchase; often reinforced by a well-meaning accountant or a financial planner who has introduced them to the idea of maximising tax deductability and depreciation benefits. In their quest for saving some tax (and often tens of thousands of dollars are discussed), they neglect to consider the impact on the capital gain they could enjoy over the long term. The easiest explanation I can offer is that of 'land-to-asset ratio'. If the land component appreciates and the dwelling component depreciates, then the investor needs to be confident that the majority of the value of the price they’ve paid is represented by the portion which grows. If they have targeted a sparkling, brand new dwelling, they can be reasonably certain that more than half of the price they’ve paid is represented by the dwelling component, and less so by the land. In most cases, the value growth is negative for around three to four years until the rate of depreciation of the dwelling slows enough to allow the land to start to catch up. A healthy rule of thumb is to ensure that the land component is worth at least 50 per cent of the price tag. An optimum land-to-asset value is closer to 70 per cent, where the quality of the dwelling (internally in particular) is still decent enough to attract a quality tenant at a good rental level, yet still dated enough to not be losing value at a faster pace than the land can grow at.
With this simple rule of thumb, an investor can avoid a negative growth asset that will likely disappoint in the early years when immediate equity growth is actually highly prized for a new portfolio.
About the Blogger
Cate Bakos is an independent buyers advocate, a qualified property investment advisor, and owner and manager of Cate Bakos Property.