Following a recent presentation at Private Wealth Network’s Property Forum, Michael Drapac, a renowned property investment expert and founder of Drapac Group, stirred up discussion around the state of the current property market and made us think about the psychology behind buying.
Over the course of history, investments of all kinds have experienced massive booms and busts. It could be said that these cycles simply chart irrational investment behavior. This phenomenon (labelled the herd mentality) powerfully corrupts rational investment analyses and decisions.
Michael reminds us of the famous Warren Buffet quote ‘You can’t afford to follow the herd’ and believes that in today’s current booming property market, everyone (the herd) is looking in one direction – they fear that they will miss out, and the fundamentals of investment are totally discarded.
However, As Michael has seen time and time again, success is often achieved by those who look the other way. By defying or ignoring the psychological momentum of the herd, these buyer’s decisions are determined by pure fundamentals. Whilst preservation is arguably the most important of all, to that end it often requires an investor to defy the buying frenzy of the herd.
So, what is behind the current boom in the Australian property market? Steven Hynes, a Director specialising in Real Estate in Financial Advisory Services at Deloitte, believes this is due to the following factors:
- Total overseas migration has risen from 30,000 per annum in the early 1990’s to now circa 200,000 per annum.
- Household splitting has increased over time, creating greater demand for property.
- Limited supply (in some markets) has resulted in pricing pressures being applied.
- An increased availability of funding and reduced cost of such funding has enabled real estate ownership to be fuelled through higher leverage than in previous cycles.
However, affordability has become a negative contribution to the growth of the property market. The current un-affordability in certain markets has limited its growth and as such contributed to an increased prevalence of renting over buying, especially for the younger demographic.
Home ownership rate 1982-2011, in percentage terms
Source : ABS surveys of Income & Housing, Extract from Wood & Ong (2015) – The facts on Australian housing affordability
In terms of cycles, many of our readers may remember the stock market collapse of October 19, 1987 – Black Monday. Michael says that day gave rise to arguably the biggest property boom in Australian history. At the time the herd mentality was to preserve their money and not invest in property. Those who defied the irrational herd achieved massive returns.
Another significant example of defying the herd was in Australia in 2005, a period which will be remembered as one of the greatest economic booms in the country’s history.
At that time, high-rise development, both residential and commercial, was not viable or feasible in most of Australia and the herd were directing their investment dollars elsewhere. Subsequently, most of the land in Australian cities (which was suitable for high-rise development) dramatically dropped in value to approximately $1,000 to $2,000 per square metre. Many astute investors defied the herd and today the same land is valued between 10 – 20 times the price levels of 2005.
Significantly, most of this dramatic escalation in these land values occurred over the last two years, the same time that the value of the mining industry decreased.
It’s simple economics – supply and demand. Potential Riches are made from investing in the right property when the herd isn’t buying.
So what can an investor do to ensure the largest return?
Michael recommends the following steps:
- Gravitate to unloved markets (where no one else is looking).
- Ensure that these unloved markets have a solid history of being robust markets.
- Determine that the drivers and fundamentals that made these markets strong in the first place still exist.
Stephen believes that as well as selecting markets that have long term structural soundness but are experiencing short-term dislocation, alternative asset classes of retail, commercial and industrial properties provide a higher return (Residential property returns yields 3 – 4% of value, whereas Commercial and Industrial can yield as high as 7 – 9 %). However, the depth of the market is smaller than traditional residential, which does increase exit risks on such investments.
So, for an investor wanting to generate the biggest return, commercial investment in a dissipated but fundamentally strong market appears to be a great option. However, there are some factors to consider for investment in commercial markets:
- Retail – less demand for bricks and mortar due to increase in online sales.
- Office Space – Less demand due to increase in flexible working arrangements.
Additionally, buying commercial land and developing it can create larger returns. When property is leased, without raw development plans in place, the return investment is very small. Raw development increases value and overcomes the risk of the market dropping. Undeveloped land that is leased will risk a negative leverage effect on the asset if the markets drop. Raw development plans help overcome this.
Location, Location, Location
Michael believes the adage ‘location, location, location’ is a largely misunderstood concept. The most important thing is the underlying value of the land.
For example this is highlighted as follows:
If you purchased a newly constructed apartment in 1995 in a prime Melbourne location, its value has generally only doubled in the past 20 years.
Whereas in contrast, a 40 – 50 year old house purchased in an established suburb (which would have largely been land value only) generally has experienced a 5 to 6 fold increase in value in the same timeframe.
The only reason for this phenomenon is that land goes up in value and buildings decrease in value. In the apartment scenario, in 1995 the value of the land would have represented 10% of the total purchase, whereas in the house scenario, the underlying land would have represented close to 100% of the overall purchase price.
So why are we still buying apartments?
Part psychology, part convenience. Stephen agrees with the psychology of buying apartments in that there is high demand for apartment living. This is due to:
- Affordability constraints.
- Tradition of home ownership.
These points may be more important to the buyer than turning a large profit so they are valid. But for an investment property, Michael believes the ‘mum and dad’ investors that have made a lot of money are the ones that have brought property with high land components.
So, what can we take from this? The market always corrects itself and when it does it over corrects, then the cycle repeats itself, creating repeated booms and busts. However, most investors kid themselves that this time will be different and there will not be a bust. To that point, Michael strongly recommends reading Rogoff and Reinhardt’s ‘this time will be different’ which studies markets over a 800 year history that proves exactly that this time will not be different. In eight centuries, no market has been exempt from busting following a boom.
Michael’s final words to investors in the property market
This time will not be different, so remember the fundamentals: The market will normalise and over correct, which will be the time to get in. Consolidate debt and sell coastal properties and holiday homes now, if they are disposable.
- Don’t follow the herd.
- Buy when the market is low.
- Land is only thing that goes up in value
- Understand principle of leverage.
“I cannot remember a time when an investor should more prudent and conservative than now”.
Stephen’s final word to investors in the property market
Why recommend wealth creation through property investment?
- There are strong underlying demand fundamentals – migration, and natural population increases.
- Creates stable rental returns, especially in areas where population growth is sustainable.
- Property investment is a less volatile and longer term return profile, compared to other asset classes.
“I have never met a client who thought they got a bargain the day they bought property, but have met plenty of clients that 10 years later wish they had bought two’.
And finally: ‘Invest with less gearing”.
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Written by Melissa Watkins and Philip Kravaritis of Deloitte Private