An Average 12-Month-Old Can Do All Of The Following Except An Unconventional Way to View the Property Market

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An Unconventional Way to View the Property Market

I’m going to discuss an interesting way of looking at real estate investing that might be a bit unusual for most real estate investors.

Watched a video of Charlie Munger a while ago, Munger is famous for being Warren Buffett’s business partner and his famous quote “Tell me where I’m going to die and I’ll make sure I don’t go there.”

In this video, Charlie, then 83, shares his life wisdom on becoming a billionaire with a group of college graduates who are about to enter the workforce.

One statement in particular interested me; he said, “You have no right to an opinion unless you can present the arguments against it better than your opponent can.”

I think this sentence is very profound, but it is difficult to apply it in real life. I would like to express it through some widely circulated views in real estate investment and see how it works.

Before I have the right to comment on “how useful Charlie’s statement is”, a counter-argument to “how useless it is” might look like this:

  • We all have the right to our opinion on anything, whether it is right or wrong, it doesn’t matter what other people say.
  • Sometimes an opinion can be completely wrong but still work in life. “Earth is flat and stationary” is a good example, totally wrong, but doable! Think you’re more feasible to walk on a stationary flat surface than a spinning ball?

So, for the rest of this article, allow me to focus on how useful I think Charlie’s statement is for us as real estate investors.

What I did was, go back and look at some of the principles of real estate investing that we take for granted, without examining arguments to the contrary, and see if we can learn something from them, and more importantly, see if we can discover Investing is an opportunity that most people miss because they don’t see the other side of things.

The most common beliefs I’ve found about investing in real estate are: Land appreciates in value due to limited supply, so buy a property with limited land supply!

If you look at the performance of real estate in Australia since 1996, good quality mature suburbs all have this land scarcity factor and by this principle they have all performed very well. For example, while construction costs increase by 3-4% per year to track the CPI, land values ​​increase by 12-14% per year, which is an average increase of 10% over the past 15 years.

When the facts overwhelmingly support the thesis, it is easy not to question the opposite of the idea.

If we follow Charlie’s advice, the counterargument might look like this: “Land will depreciate in value due to limited supply, don’t buy properties with limited land supply.”

I must say that when I first wrote this article, I thought to myself that anyone with common sense in the investment industry would think this must be crazy, and it totally goes against anything we’ve been told about investing in real estate.

The only reason I didn’t stop was because Charlie, he didn’t become a billionaire by being stupid, he had to see tremendous value in this rebuttal exercise to uncover investment opportunities that most people miss. So I “forced” myself to see under what circumstances this counter-argument would make sense.

Interestingly, it didn’t take long for me to discover that this counter-argument not only has its value, but can also help us uncover investment opportunities that most experienced real estate investors miss in today’s market.

let me explain.

Clearly, land appreciation has been the main driver of property price increases over the past 15 years. But real estate prices are ultimately limited by how much income people have to qualify for a mortgage, and even more so in today’s lending market, it’s becoming increasingly difficult to unlock equity without income support.

So you could almost say we should see something like this in the long run:

Income growth = property price growth (can be broken down into land and building price growth)

So if revenue growth is 3% and construction costs are 3%, then land price growth should also be 3% for the formula to work in the long run.For example

Income Growth (3%) = House Price Growth (3%) [Land Price Growth (3%) & Building Cost Growth (3%)]

However, over the past 15 years, our revenue has grown in line with construction cost growth, roughly CPI (3-4%), but land prices have increased 12-14% per annum. So you have something like:

Income Growth (3%) < House Price Growth (10%) [Land Price Growth (12%) & Building Cost Growth (3%)]

You can see that land prices are growing much faster than income. When investors considered where to buy, they bought areas where land values ​​were growing at more than 12 per cent a year, often in established suburbs where land supply was very limited. It has been working for them for the past 15 years (from 1996 until now).

The question is “how long can the gap between income growth and land price growth last without land price growth being forced to slow?”

A graph of Melbourne’s median house price from 1978 to 2009 shows that for a long period before 1990, house prices grew much faster than income (reflected in the median house’s mortgage repayments as a percentage of average income too large), property price growth then stalled for about 5 years, waiting for income growth to catch up.

These charts show that if you turn your attention to 2009, a similar phenomenon is looming.

So I can see the opposite argument “Land depreciates due to limited supply, don’t buy properties with limited land supply” This makes sense when the land scarcity factor has been oversold for so long that land values ​​are grossly overvalued. In other words, the scarcity of land may be the main reason why investors make a lot of money, but it may also be the main reason why investors may not make money or even lose money.

Before everyone rushes to abandon the traditional high-growth areas, we all know that there is an oversupply in the housing market, so property prices may continue to rise for a while. Traditional strong growth areas have not become high growth areas for no reason.

After a period of flatness (like 1990-1996), they always bounce back and accelerate growth, so I personally think they are always a good area for you to hold properties for the long term.

The question is where should you invest your money in the next 5-7 years to get the best return with the lowest risk?

Currently, if you buy an older property in traditionally strong growth areas within 20km of the CBD in most major cities, you can expect to pay upwards of $700,000 with a gross rent of 2.5-4%. Some of those properties are worth just $200,000 to $300,000 compared to 10 years ago.

Compared to those areas, you can still find prices around $350,000 to $400,000 within 20km of the CBD, either in some transitional areas (which are being rezoned to residential) or for cheaper apartments . Gross rents can still be around 4.5-6% in mature areas, and if the property is fairly new, the tax man will help with cash flow for the first 5 years.

Let’s look at an example.

Let’s say you can afford to buy an investment property worth up to $800,000, your salary is $100,000 per annum, and you can borrow 100% at 7.5% plus stamp duty and costs because you own equity in other properties.

Let’s use the Melbourne data as an example and compare the following two possible options:

Option 1:

  • If you buy 2 x $400,000 property, two brand new houses, $200,000 building and $200,000 land in a transitional suburb 17km from Melbourne CBD.
  • With a current gross achievable rent of 4.6%, we can assume a potential growth rate of 9.4% per annum over the next 5 years (Melbourne’s average over the past few decades) as prices Relatively low and its distance from the CBD.
  • So in 5 years each of these properties would be worth around $627,000.

Option 2:

  • If you buy 1 x $800,000 property, a 25 year old house, $200,000 building and $600,000 land in a mature and traditionally high growth suburb also 17km from Melbourne CBD .
  • With a current achievable gross rent of 3.5%, we might assume a slightly lower growth rate of 6.5% over the next 8 years as its land values ​​are relatively inflated after a good 15 years of operation.
  • So in 5 years, the property will be worth around $1.1 million. (Note that buying a $1.1 million home in the same neighborhood at a 7.5% rate would attract $83,000 in annual mortgage payments from a family’s net after-tax income.)

So let’s look at the graph below to compare the cash flow of the two options above.

Option 1 (2 x $400,000):Out-of-pocket costs of $75 per week or $4,000 per year for the first year. Total out-of-pocket expenses for the first 5 years are $19,000. (see table below)

Now – property value $400,000

Year 1 – Property value $437,600 with weekly holding costs of $75

Year 2 – Property value $478,734 with weekly holding costs of $97

Year 3 – Property value $523,735 with weekly holding costs of $82

Year 4 – Property value $572,967 with weekly holding costs of $65

Year 5 – Property value $626,825 with weekly holding costs of $45

Option 2 (1 x $800,000):First year out-of-pocket costs $489 per week or $25,000 per year. Total out-of-pocket expenses for the first 5 years are $113,000. (see table below)

Now – property value $800,000

Year 1 – Property value $852,000, weekly holding costs $489

Year 2 – property value $907,380, weekly holding costs $465

Year 3 – property value $966,360, weekly holding costs $436

Year 4 – $1,029,000 property value, $405 weekly holding costs

Year 5 – $1,096,000 property value, $375 weekly holding costs

Let’s compare total income over a 5 year period by simply using: Capital Gains + Cash Flow.

  • Option 1 (2 x $400,000):Capital Gain ($627kx 2 -$400kx 2) + Cash Flow ($19kx 2) = $416k.
  • Option 2 (1 x $800,000): Capital gains ($1.1 million – $0.8 million) + cash flow ($113,000) = $187,000.

On top of that, the stamp duty difference is: $43k – $7kx 2 = $29k.

So option 1 is better than option 2: $416k + $29k – $187k = $258k. This excludes the following two main factors in favor of option 1:

  • Easier Finances:It is much easier to get 95% financing for a $400k property, while doing the same for an $800k property is next to impossible or too expensive. In other words, Option 1 costs you less!
  • reduce risk:In today’s intense market conditions, the risk of losing $100,000 in value on a $400,000 property is much lower than on an $800,000 property. In other words, option 1 is less risky for your capital.

Before I rush to declare “option 1 is better than option 2”, I need to see under what circumstances option 2 is better than option 1 if I follow Charlie’s teachings “You have no right to an opinion unless you can present the arguments against it better than your opponent can.”

So the rationale for buying a pricier older home in a given suburb for investment purposes in current market conditions is that good suburbs are always in short supply and the rich get rich faster. One should never underestimate the long-term potential of those high-growth suburbs, even if they may experience some temporary slowdowns after a long period of strong growth. These suburbs may “lose” the battle to the impending transformation suburbs over the next 5 to 7 years, but they still have what it takes to “win the war” on a longer time horizon.

Can you see the power of one of the principles of applying Charlie’s teachings to real estate investing? When we apply this to other areas of our lives such as relationships, work, values, moral standards and spiritual beliefs, the benefits are huge, it can teach us to avoid extreme ideologies and be more accepting of people who are different from us .

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