Real Estate investment is not about location

This time, I would like to challenge the ‘Golden Rule’ of real estate namely – “location, location, location”. I believe that for property investors, the so-called ‘best’ location can actually deliver the worst return for property investors. Let me explain.

To say that you will always make the most money by investing in the best location, is to say that you will always make the most money by buying shares in the best company. But what if, when you buy the shares in the company, you pay 10 times more than the fair value of the shares in this “best company”? If you do, you know you are unlikely to see a good return on your money for a very long time.

It is the same for real estate. While there are great locations (by real estate definition), such as close to employment and amenities, or irreplaceable features such as an ocean view or golf course, property investors usually lose the most money when buying these unique real estate opportunities, because they ending up paying over-value due to the hype generated by the marketing efforts of the vendors.

In general, real estate prices for any area are always going to rise only to the level where local residents can still afford it and no more. So to work out what would be considered fair value for property prices in any area, would be the first step in investing in properties. There is not much point buying into an area where the prices have already gone way above the ability of local residents to afford to live there, regardless of how appealing the location might be. (Unless, of course, all you want to do is to bet your money on the way up and you can pull your money out quick enough before prices stop growing or even start falling.)

I have seen many examples over the years where some of the ‘best locations’ in real estate deliver the worst return for property investors. And I have also seen some of the ‘less quality locations’ by real estate definition deliver far superior returns. See the following two diagrams for some comparison:

InvestmentComparison

I am not saying that one suburb is definitely better than others or that one suburb will always deliver a better return than another, for those who know Melbourne, you would at least know from the above examples there is no correlation between investment performance and distance to CBD. There may well be many explanations for why the above examples occurred, but one thing is obvious, the two outer suburbs that have seen tremendous growth in the above examples still have much higher affordability in relation to their prices at the time of purchase, whereas the inner city ones have become less affordable for local residents. This trend has become more obvious in recent years with the migrating population younger aged people with higher disposable income moving into the outer suburbs of the major cities due to Australia’s need to replace our retiring baby boomers with a younger workforce.

Australia’s residential property market hasn’t done too well over the past few years. We’ve seen many more established suburbs with older populations and higher property prices experience significant decline in prices partly because they have become less affordable. Whereas some upcoming suburbs with younger populations and lower property prices have at least resisted the same decline. These areas have also become the focus areas of major banks when it comes to lending. As we know as property investors, areas that receive the strongest support from our largest financial institutions in terms of lending tend to perform better, as banks by nature are very conservative. If they sense any area has become unaffordable, they will be the first one to reduce their lending to both the end purchasers and the property developers.

In case you didn’t know, currently the major banks have reduced lending to developers for projects that are closer to the CBD but have a more favourable lending attitude to development projects in areas that are a bit away from the CBD. Again, this is not to say that all inner areas are not good for investing and all outer areas are better, as we still need to look at each area individually and examine the banks’ lending attitude towards those areas and the specific types of properties in those areas. If the major banks are not willing to lend 95% against your property (for an Australian resident who can afford it), then you should think twice about investing in it. If this is an area or type of property that the banks believe will not hold its value and are reducing their lending to protect themselves, why would you take the risk yourself?

So to summarise, it would be a lot wiser to find properties in areas where the local residents can afford to pay up to a 50% higher mortgage repayment at least, as property prices always end up growing to a level where the local residents can just afford it. You can bet over the medium and longer term, the lenders (banks) and the borrowers (property buyers) will work together to ensure that their local property prices will go up to the point that they can’t afford any more rises. In that I mean the banks can’t afford to lose money and the purchasers can’t afford to pay any more interest ☺.

Until next month, happy investing.

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