The fundamentals of property investing
By Sarah Mills
Property is one of four asset classes in which you can invest, the other three being shares, bonds and cash.
The fundamentals of investing are very similar across the asset classes and there are a few cardinal rules would-be investors should follow.
- Maximise your yield — ensure a reliable competitive return on funds
- Maximise your capital gain — buy low, sell high
- Manage risk — minimise risk while maximising returns
Maximise your yield
The yield on property is similar to the interest return on a fixed deposit or an annual dividend on a share. It is the annual return on
the money you have invested in the property expressed as a percentage. So, if you were to buy a property for $400,000 for which you
received annual rental of $20,000, you would calculate the yield by dividing $20,000 by $400,000 and multiplying the answer by 100. In
this instance, it would give a yield of five percent. Based on this calculation, if the bank were offering 10 percent to borrow your
money, you might be tempted to put your money in the bank instead.
In some instances, the yield can be a sign for an opportunity to make a capital gain. A very high yield would suggest that either the price of the house is very low or the rental return is very high or both. It is generally advisable for property investors to buy high-yield properties. It not only represents a greater return on funds, but provides a higher income against which you can borrow to buy more properties.
Yield is a driving factor behind asset-classes valuations and cycles. For example, once the yield on property falls too low, investors will switch to another asset class offering higher returns. This in turn will cause a huge drain of funds from that sector, creating a slump in demand and value. This takes us to another of the fundamentals of property investing - the subject of capital gains.
Maximise your capital gain
The key to successful investing is to "buy low and sell high" — in other words to make a profit or a capital gain. Your capital is the
money you have invested. If you sell at a higher price than you invested, you have made a capital gain. If you sell for less than you
invested, you have made a loss.
The property cycle
There is an old saying that any fool can make a profit in a rising market. That is why it is crucial to know where you are in the
property cycle. The property cycle, like the share, cash and bond cycle, tends to move in six to 10 year intervals, with seven years
being the commonly cited benchmark.
During this period, property values "boom" then "bust". Property prices usually rise for a few years, before peaking. Once prices have peaked and yields have bottomed, investors move on to another asset class offering better returns and opportunity, leaving the market to languish for another few years. Then, when property values and yields start to look attractive again, the market rises and a new cycle begins.
The key to making a strong capital gain is to buy in the first year or two of the property cycle. It is extremely unwise to buy property as an investment near the top of the cycle as it can be very difficult to sell in a poor market and you may not gain a return for several years. Given a lot of money is tied up in a property, this can also be a substantial loss in terms of opportunity cost — money that could have been earning thousands if it were free to be invested in another investment class.
Interest rates
The property cycle also is driven in part by interest rates. High interest rates usually equate to a subdued property market as they
affect the affordability of housing. So keeping an eye to the interest rate outlook can be helpful in determining the direction of
property prices.
Affordability
In addition to interest rates and yields, the property market is driven by affordability. If property prices rise much faster than
incomes, or interest rates rise sharply, then it is not long before the average person can no longer afford to invest in housing. This
causes the market to peak. For this reason, it is important to look at affordability indexes and the economy. A weak economy suggests
lower incomes and lower property prices. A strong economy with low interest rates usually enhances affordability. A strong economy with
high interest rates tends to dampen affordability.
Supply and demand — location and demographics
Property does not necessarily peak in every part of a country or state at the same time. This is because, unlike government bonds for
example, each property is not fungible (identical), and is not traded on a central exchange.
Property prices are driven by a combination of personal, business and economic imperatives. For example, properties located in states with different economic drivers will perform differently. The Western Australian market for example, is driven heavily by the resources sector. Queensland's property prices have tended to be driven by strong immigration and resources. These factors can change over time, so it is always important to keep an eye on the economic fundamentals of an area.
The property market is also heavily driven by demographics such as the age of residents, employment opportunities and population growth. So, for example, when baby boomers reach nesting age, the price of houses is likely to rise. But when their children hit the property market, units may be more popular. Similarly, in areas with an ageing population, retirement villas may be in demand.
Finding a bargain
Outside of playing the cycle and following supply and demand fundamentals, the only other way to make a good capital gain is to find a
bargain. In a hot market, this can be hard, but there are always opportunities. Some people are forced to sell houses quickly for any
number of reasons — such as liquidations, partnership disputes, divorces and deceased estates. If, for whatever reason, a flood of
bargains hit the market, it can be a sign that the property market cycle is coming full circle.
Making a call
If you understand the fundamentals (which includes demographics) of the property market in each part of the country, and combine that
with an up-to-date knowledge of interest rate cycle and asset class cycles, you should be able to ascertain to some degree where you are
in the property cycle in a particular area. The better you are at making an accurate call, the more successful you will be as an
investor.
The next cardinal rule to investing is managing risk.