Mastering supply and demand: part 1

Over the past few years we have seen many supposed hotspots turn out to be not-spots. Without question, it is becoming harder for the average investor to determine how to create wealth.

Yet what is indisputable is that the average property in Sydney has almost doubled in value over a few short years. If the secret to investment success is simply buying in Sydney, our biggest and most commercial city, what clue did everyone miss?

The value chain is a simple concept and a handy tool for investors. The best way to understand the value chain is to divide it into two groups: the supply chain and the demand chain.

The supply chain
Supply comes with planning and development. The market experiences new land releases, for example in master-plan communities. We also see medium-density housing and new unit complexes come on the market closer to the CBD, often as part of infill developments or renewal projects.

Supply can be a double-edged sword for investors. If there is an oversupply of housing when demand is low, prices may reverse. Conversely, when demand is high, new supply can help investors improve their equity position by pushing prices higher.

How do you monitor supply? One great way is to follow developers and what they are paying for development sites. Let’s use an easy example. A developer buys a property in an area during a period of low demand. They obtain an approval to build 10 units on the property. “Unit site” is a term to describe the price one pays per unit on the site.

Let’s say this developer buys early in the value chain and pays $30,000 a unit site.

$30,000 x 10 units = $300,000 (meaning the developer has paid $300,000 for the land).

The units are now constructed and sold off to early investors who see value long before owner-occupier buyers.

Later on, the value chain gets exciting for early investors and developers. The value of development sites goes up as land becomes harder to buy because demand for the end product has increased.

In boom periods, developers will often pay three times the value they would early in the chain to keep up with demand levels. Now, the same developer is paying $90,000 per unit site in a less-impressive area or street than before to build their 10 units.

$90,000 x 10 units = $900,000 (meaning now the developer has paid $900,000 for the land!)

In order to maintain buoyancy and be profitable, the developer goes to market asking $60,000 more for each unit than previously.

As demand picks up, tradespeople and builders tend to be in shorter supply and prices for works and materials go up. At the peak level of the value chain, build costs are often 5 to 8 per cent higher than at the beginning of the value chain. In other words, the developer now needs to increase their prices by $80,000, rather than $60,000, to develop the product feasibly.

Savvy investors would have bought early when the market was slow. These investors get to reap the benefits as new values are created within that area, as well as snagging the best location.

If you are caught at the end of the supply chain, a period of downturn usually follows, where demand falls and prices correct. You may have paid too much for that unit or house.

The supply chain of new, available land follows a similar trend. Land can be tightly controlled at times and it is very much linked to demand levels. As demand levels increase, publicly listed companies that control the master-planned estates feed the supply of land to the market. The rate they feed land is a good way to gauge value.

Early on within the supply chain, land lot sizes tend to be bigger. For example, a master plan may start out by offering 600 square metre blocks at $250,000 a block. As demand increases, they cut block sizes to 400 square metres but still sell that land for $250,000. Within this example, we would effectively see a 33 per cent increase in land price.

Early on in the value chain there is little to no demand. Generally, owner-occupiers are choosing to hunker down and tenants are not leaving the rental pool, preferring the safety and the limited commitment of renting. During this period, savvy investors are generally buying real estate in great locations and developers are stockpiling and land-banking.

What investors at this point are really buying is market position. In a strong market, the positional suburbs grow in value and rapidly become unaffordable. As the market firms up, you are pushed further out of the better suburbs to secondary locations.

Case study of supply chain
If you try to buy in better suburbs in a bull market, you pay a lot for the privilege. For example, in 2008 I bought a town house-style strata property in Dulwich Hill for $400,000. The total usable area was 118 square metres.

In 2008, Sydney was at the bottom of the price cycle. I bought for the position, just six kilometres to the CBD. In subsequent years the property’s value climbed to about $625,000. I didn’t get instant growth in 2008 or for a few more years after, but I did get a prime location.

Today, Sydney is a bull market. Many people are getting good growth even at this late stage in the value chain as the demand is unprecedented. But today $400,000 would get you a dwelling of similar size in Kingsford near Penrith, about 66 kilometres from the Sydney CBD rather than six.

Due to the cost to develop in Dulwich Hill, new supply is also being sold at a higher rate. Effectively, two-bedroom, off-the-plan units are as high as $775,000. Again, this is great for early investors as the new supply brings higher prices.

The great benefit to the Australian property market is that there are so many places to buy! You can always find a new start to the value chain.

Where is today’s best value chain? Let me explain via a real property. In six weeks I am settling on a breathtaking piece of real estate just 14 metres from the Modern Art Gallery of Brisbane. To use golfing terms, the property is a short par 5 to Queen Street Mall, the main retail hub of Brisbane and a short wedge to Queensland Performing Arts Centre.

I purchased the property for $670,000 and it will rent for around $670 a week. It is a large, two-bedroom apartment with two bathrooms and parking. To put some context around this, similar properties in Sydney and Melbourne sell for $1.6 million-plus. Can I see this property doubling in value in 10 years or less? Sure. With more than 200,000 office workers at this property’s doorstep and a downsizing population with money and a hunger for property, I absolutely can.

There is evidence this supply is already getting more expensive. In the same area right now, it is impossible to build an inferior property in a less-impressive street for the same money. The next supply in this suburb will be about $50,000 to $70,000 more expensive – the supply chain is on the move.

Don't miss part 2, where I detail how the demand chain works and how this all comes together for savvy investors looking for the next hotspot.