Out with the old, in with the... more expensive
When I first became interested in property and investing I had trouble getting my head around compound growth of property prices. All the experts, including my father who was a successful investor himself, told me that property prices double every 7 to 10 years.
Blogger: Matthew Lewison, Open Corporation
I just found it hard to believe that they could keep doubling because eventually the “average” price would be in the $millions. Considering that the success of the typical buy/hold strategy relies on price escalation this was a pretty fundamental and important thing for me to get comfortable with.
It wasn’t until I was walking along the beach in Brighton with my wife (girlfriend at the time), looking back towards Melbourne CBD one Sunday afternoon, that it all started to fall into place.
You see, I’ve always been a visual person (pardon the pun) and I couldn’t visualise price growth. I could do an excel spreadsheet and produce a graph showing the median price over the last 60 years but I couldn’t rationalise the numbers against something real. It wasn’t until that day, walking along the beach and looking at the city skyline, that I was struck with a thought, “How cool would it be to come back here once a year and take a photo of the city?!? I reckon that over the next 60 or so years those 60 photo’s would tell a wonderful story about how cities develop.” Being honest, that wasn’t a ground breaking concept but my second thought was, “Hang on a tick, surely somebody else has thought of this and maybe they started 60 years ago!”
Over the following months I spent a lot of time researching old pictures of the city, mostly from the 70’s, 80’s and 90’s as there weren’t many images pre-dating that on the internet. The pictures told me a story about how the city develops with buildings going up, new jobs being created and drawing people to the city. I looked at planning maps that showed the extents of the city growing and related those maps to my parents, and their friends and families, own settlement patterns. I thought about the types of jobs that are created in the city CBD, and those on the city fringe and why people might choose to settle close to the city.
There are probably a dozen lessons that I learnt from this research and which I will endeavour to explain in coming weeks, but the one I want to share with you today is this:
Equity is created in the inner (older) suburbs by the first home buyers and investors that are buying in the outer suburbs. Sounds strange, I know because most people believe that “booms” start in the inner city and radiate out. In a bubble that is what happens but long term growth is generated by the market “pushing” prices up from the bottom, rather than “pulling” prices up from the top.
To demonstrate this you need to imagine a middle aged couple (we’ll call them the Middleton’s) living in a middle ring suburb in your city (middle ring is usually within 5km to 15km of the CBD). Now, let’s say that the Middleton’s purchased their property 10 years ago, when they were in their mid-20’s, for $400,000 and have paid off half of their loan, which started at $320,000. They now owe $160,000 and their property is worth $800,000 as competition from people wanting to move into this suburb over the last 10 years (normally from adjoining suburbs further from the CBD) has pushed up the price of property.
Just like many others that are trying to get into this middle ring suburb the Middleton’s are keen to get out. Mr Middleton has received numerous pay increases since he purchased 10 years ago, which is how he managed to pay down half his mortgage in just 10 years, and he wants to move one suburb closer to the city (where he works). The only problem is, the next suburb closer to the city has a median house price exceeding $1m. Nonetheless, the Middleton’s sell their house. After agent’s commissions they are left with $780,000 and after paying off their remaining mortgage they have $620,000. They secure a nice home in the next suburb for $1m, which means they have a new loan of $380,000 – representing a 38% LVR on their new property, which I’m sure you’ll agree is quite conservative and considering Mr Harrison paid off half of his previous $320,000 mortgage in just 10 years doesn’t seem too difficult for the Harrison’s to service.
But how does this give me confidence that price growth isn’t just a phenomenon of the past?
Each time an existing property is sold in an outer suburb it is freeing up the existing owners to “upgrade” to a slightly more expensive property. They benefit from any debt that they’ve repaid even if they achieve no capital growth when they sell their property. When these people upgrade, they are usually buying existing and the seller of their new property becomes an “upgrader” in their own right. They take on a little bit more debt but generally maintain low gearing. It is like a chain reaction and as it radiates closer to the CBD it allows each person to pay more for their property while still maintaining quite low gearing. As population grows, there are more people competing for the same number of inner and middle ring suburban homes – this is how prices go up.
So, my realisation was that the $ value of the median priced property isn’t the important factor in whether the market can continue to increase – it is the level of debt that is taken on (not on the outer suburbs but the middle ring and inner suburbs) that is important. Generally, it is the first home buyers and investors in the outer suburbs (and a few sprinkled through the middle ring suburbs) that take on high levels of debt but as they are generally quite young when they buy and their incomes are likely to grow through their 30’s and 40’s they are able to pay down their debt to acceptable levels and join the ever growing “upgrader” market.
Knowing how the city has developed gives me the confidence to pursue my strategy without fearing that the market is going to collapse. Knowing how to profit from it is another story altogether (and that’s a story for another day).
About Matthew Lewison
Matthew is an author, and managing director/CEO of Open Corporation. He believes that exceptional results are only achieved by pulling together a great team of professionals, all driven to a standard of excellence and focused on realising a shared vision. Understanding the competitive environment and investment risks, as well as the drivers of growth, is paramount in outperforming the competition – and Matthew has ensured a deep understanding of these factors in Open Corporation’s team.
Broad knowledge of the property market and investment fundamentals, saw Matthew promoted to General Manager (QLD) of a publically listed company at the tender age of just 26. In this role, he was responsible for a portfolio exceeding $1 billion. Having delivered such projects as the $185 million Knox City & Ozone Shopping Centre Redevelopment (Vic), the award winning Warner Lakes Estate (QLD) and the $200m Caboolture Riverbank master-planned community (QLD), Matthew has an established reputation in the Victorian, Queensland and Western Australian property industries and has also been involved in senior committees of the UDIA at a state level.