I am going to discuss an interesting way to look at real estate investing that may be a bit unconventional to most property investors.
A while ago, I watched a video by Charlie Munger, who is well-known as the business partner of Warren Buffet and his famous quote “Tell me where I’m gonna die and I’ll make sure I don’t go there.”
In this video, Charlie who was 83 at the time, shared his life time of wisdom to make him a billionaire with a group of university graduates who are about to start their career.
There is one particular statement that really interests me; he said “You are not entitled to an opinion unless you can state the arguments against your opinion better than your opponents can.”
I find this statement quite profound but very difficult to apply in real life, I thought I would put it through some of the opinions widely circulated within real estate investment and see how it goes.
Before I am entitled to an opinion of “how useful Charlie’s statement is”, the counter argument of “how useless it is” can be something like the following:
We are all entitled to our own opinion about anything, regardless of whether it is right or wrong, it doesn’t really matter what other people say.
Sometimes an opinion can be completely wrong, but still workable in life. “The earth is flat and still” is a good example of this, completely wrong, but workable! Wouldn’t it be more workable to think that you are walking on a still and flat surface than a rotating ball?
So for the rest of the article, allow me to focus on how useful I think Charlie’s statement can help us as real estate investors.
What I have done is, go back to look at some of the tenets of real estate investment that we have taken for granted without examining the opposite arguments, then see if we can learn something from it, and more importantly see if we can discover investment opportunities most people miss because they fail to see the other side of the story.
I found the most common opinion about real estate investing is: Land goes up in value because of its limited supply so buy properties where land is of limited supply!
If you look at the property performance in Australia since 1996, good quality established suburbs all share this land scarcity factor, they all perform very well according to this tenet. For example, while building cost is increasing 3-4% a year tracking CPI, the land value has increased as much as 12-14% a year, which averages out a 10% growth for a property over the last 15 years.
It is very easy to not question the opposite side of this opinion when the facts are overwhelmingly supporting this argument.
What if we follow Charlie’s suggestion, the counter argument can be something like: “Land goes down in value because of limited supply, don’t buy properties where land is of limited supply.”
I must say when I first wrote this down, I thought to myself this must be considered crazy by anyone with any common sense in the investment industry, it is just utterly against anything we have been told about investing in property.
The only reason I didn’t stop there was because of Charlie, he didn’t become a billionaire by being stupid, he must see tremendous value in this counter argument exercise to spot investment opportunities most people miss. So I ‘forced’ myself to see under what circumstances this counter argument could make sense.
Interestingly enough, it didn’t take too long for me to see that this counter argument not only has its value, but it could also help us discover investment opportunities most experienced property investors miss in today’s market.
Let me explain.
It is obvious that land appreciation was the main driving force behind the property price growth in the last 15 years. But property prices are ultimately capped by how much income people have for qualifying for a mortgage, this is more so in today’s lending market where releasing equity without income support has become increasingly difficult.
So you can almost say over the longer term, we should see something like:
Income Growth = Property Price Growth (which can be broken down to Land & Building price growth)
So if Income Growth is 3%, and Building Cost Growth is 3%, then Land Price Growth should also be 3% to make this formula work over the longer term. E.g.
Income Growth (3%) = Property Price Growth (3%) [Land Price Growth (3%) & Building Cost Growth (3%)]
However, in the last 15 years, our Income Growth is tracking along the Building Cost Growth, which is around CPI (3-4%), but the Land Price Growth has been 12-14% per year. So you have something like:
Income Growth (3%) < Property Price Growth (10%) [Land Price Growth (12%) & Building Cost Growth (3%)]
You can see the Land Price Growth has been much faster than Income Growth. When investors look at where to buy, they bought in areas where Land Price Growth has been 12%+ per annum, usually in established suburbs where land supply is very limited. And it has worked for them in the last 15 years (between 1996 till now).
The question is “how long can the gap between Income Growth and Land Price Growth last without the Land Price Growth being forced to slow down?”
Graphs of the Melbourne median house price between 1978 and 2009 show property prices have grown much faster than income for a long period of time till 1990 (reflected by the mortgage repayments of a median house taking up too larger a percentage of an average income), Property Price Growth then stopped for about 5 years to wait for the Income Growth to catch up.
These graphs show a similar phenomenon is looming if you move your attention towards 2009.
So I can see the counter argument “Land goes down in value because of limited supply, don’t buy properties where land is of limited supply” makes sense when the Land Scarcity factor has been over sold for too long to the point that land value was severely over priced. In other words, Land Scarcity can be the main reason why investors can make good money, but it can also become the main reason why investors may make less money or even lose money.
Before we all rush to abandon the traditional high growth areas, we all know that there is a shortage of supply of properties in comparison to demand, so property prices are likely to continue to go up for a while. The traditional strong growth areas didn’t become high growth areas for no reason.
After a period of flat performance (such as 1990-1996), they will always bounce back and accelerate the growth, so I personally think they will always be good areas to hold your properties for the longer term.
The question is where you should be putting your money to work intelligently over the next 5-7 years to make the best return with the lowest risk?
Right now, if you buy an old house in a traditional strong growth area within 20km of CBD in most major cities, you are expected to pay $700k+ with a gross rent of 2.5-4%. Some of these properties were worth only $200k-$300k less than 10 years ago.
In contrast to these areas, you can still find property prices around $350k to $400k within 20km of CBD, whether they are houses in some transition areas (areas that are being re-zoned for residential housing) or lower price apartments in the more established areas, gross rent can still be around 4.5-6%, with the taxman helping the cash flow the first 5 years if the property is reasonably new.
Let’s look at an example.
Let’s say you have the capacity to buy up to $800k worth of investment properties, your wage is $100k pa, and you can borrow 100% plus stamp duty and costs at 7.5% interest rate, because you have equity from other properties.
Let’s compare the following two possible options using Melbourne data as an example:
If you buy 2 x $400k properties, two brand new houses, $200k building and $200k land, in a transition suburb 17km from Melbourne CBD.
Achievable gross rent currently is 4.6%, we may assume a potential growth for the next 5 year is at 9.4% per year (Melbourne’s average for the last few decades) due to its relatively lower price in comparison to Melbourne’s median house price of $550k and its distance from the CBD.
So 5 years later, each of these properties will be around $627k.
If you buy 1 x $800k property, an old house of 25 years, $200k building and $600k land, in an established & traditionally high growth suburb, also 17km from Melbourne CBD.
Achievable gross rent currently is 3.5%, we may assume a slightly lower growth at 6.5% for the next 8 year due to its relatively inflated land value after a 15 year great run.
So 5 years later, this property will be around $1.1m. (Please note that a $1.1m home in the same neighborhood at 7.5% interest rate, will attract a $83k mortgage repayment per annum, which is coming out of a family’s after tax net income.)
So let’s look at the following diagrams to compare the Cash Flow of the above two options.
Option 1 (2 x $400k):$75/week or $4k/year out-of-pocket the first year. A total $19k out-of-pocket for the first 5 years. (see below table)
Now – Property Value $400,000
Year 1 – Property Value $437,600, Cost per week to hold $75
Year 2 – Property Value $478,734, Cost per week to hold $97
Year 3 – Property Value $523,735, Cost per week to hold $82
Year 4 – Property Value $572,967, Cost per week to hold $65
Year 5 – Property Value $626,825, Cost per week to hold $45
Option 2 (1 x $800k):$489/week or $25k/year out-of-pocket the first year. A total $113k out-of-pocket for the first 5 years. (see below table)
Now – Property Value $800,000
Year 1 – Property Value $852,000, Cost per week to hold $489
Year 2 – Property Value $907,380, Cost per week to hold $465
Year 3 – Property Value $966,360, Cost per week to hold $436
Year 4 – Property Value $1.029m, Cost per week to hold $405
Year 5 – Property Value $1.096m, Cost per week to hold $375
Let’s compare the total money made over a 5 year period by simply using: capital gain + cash flow.
Option 1 (2 x $400k):Capital Gain ($627k x 2 -$400k x 2) + Cash Flow (-$19k x 2) = $416k.
Option 2 (1 x $800k): Capital Gain ($1.1m – $800k) + Cash Flow (-$113k) = $187k.
On top of that, the stamp duty difference was: $43k – $7k x 2 = $29k.
So Option 1 is better off than Option 2 by: $416k + $29k – $187k = $258k. This doesn’t include the following two major factors in favor of Option 1:
Easier finance:it is much easier to get 95% finance for a $400k property, and almost impossible or too expensive to do the same for a $800k property. In other words, option 1 needs less money from you!
Lower risk:the risk for a $400k property to lose $100k in value is a lot less than an $800k property in the current heated market condition. In other words, option 1 is lower risk for your money.
Before I rush to claim “Option 1 is better than Option 2”, I need to see under what circumstances Option 2 will be better than Option 1, if I were to follow Charlie’s teaching “You are not entitled an opinion unless you can state the arguments against your opinion better than your opponents can.”
So the argument for buying a higher price old house in an established suburb for investment purpose in the current market condition is that good suburbs will always be in high demand, and rich people get richer quicker. One can never underestimate the long-term potential of those high growth suburbs even when they may experience some temporary slow down coming off a long period of strong growth. These suburbs may ‘lose the battle’ over the next 5-7 years against the up and coming transition suburbs, but they still have what it takes to ‘win the war’ over a much longer time frame.