It could take you 5 years or more to get out of a dud property investment. But how do you know if your property is a dud?
Last week a journalist asked me “what percentage of investors I thought owned dud investment properties?” It is an interesting question. My answer was that after over a decade of reviewing hundreds of investor portfolios I would estimate that approximately 60 % to 70% of people have a least one dud (under-performing) property. This fact is costing many investors literally hundreds of thousands of dollars in lost wealth.
I do not think you can ever over-obsess about the quality of your investments assets. Quality is fundamental. My favourite saying is the quality of the assets you invest in will determine 80% of your financial outcomes. It is something we spend a lot of time helping clients to understand. If you invest in the highest quality assets you can find you are almost guaranteed to make a lot of money. So if you are a property investor (or plan to become one), this is an important point so please read on.
How much does a dud property cost you?
Firstly, let me clarify what I mean when I talk about a dud investment. Primarily, I am referring to the property’s long term capital growth rate. Investment-grade property should double in value every 7 to 10 years and I have seen hundreds of examples of properties doing this. A dud property won’t achieve these returns.
You have to hold a property for the long term to see the real benefit of compounding capital growth. For example, at a growth rate of 8% p.a. a $500,000 property will be worth $2.15 million in 20 years’ time. In the first 5 years of ownership the property increases by only $180,000 (or 11% of the total projected gain over 20 years). In years 6 to 10 the property will increase by $320,000 or 19% of the total gain. In years 11 to 15 the growth will be $470,000 or 28% and years 16 to 20 will be $690,000 or 42% (note: it’s unlikely that growth will be uniform each and every year but the average growth over the long term should be close to what I have projected). As you can see, a substantial amount of the total gain occurs in the last 5 years (of a 20 year holding period). But here’s the warning. You certainly don’t want to wait 15 years to find out that your property is a dud and you won’t enjoy these returns.
[Watch this 33-minute on-demand presentation called “Investing in property – no mistakes” by Stuart Wemyss: – click here. If you are short of time, skip to slide 5 and listen for about 20 minutes through to slide 15]
The second important point is that the cash flow cost of an excellent property versus a dud property is materially the same. You have to borrow the same amount of money to buy it. You pay the same stamp duty and same interest rate. It is likely that you will receive a similar amount of rental income.
There are two costs as a result of holding a dud property:
- Lost opportunity costs money: This is the amount of lost wealth/equity as a result of holding a lower than investment-grade property. For example, the difference between a 5% and 8% p.a. growth rate on a $500,000 property in 20 years is over $890,000 in equity. We all have a limited borrowing capacity. This is your scarce resource and you need to allocate it wisely and sparingly. Even if a property is not costing your money each moth (i.e. the rental income pays for all expenses and interest), it is still using up some of your borrowing capacity and that could be allocated to a better quality asset with better returns. If you have the maximum capacity to hold two investment properties, make sure they are the best two quality properties you can lay your hands on. It will make a massive difference in the longer term.
- Lost time costs money: There is one thing you can never replace and that is lost time. The more time you have, the lower the investment risk you have to take to achieve your goals. For example, someone 30 years from retirement has to take very few risks to build sufficient wealth to fund retirement. Conversely, if you only have 10 years until retirement, you have no room for mistakes and you need to get started… yesterday. Wasting time is the most costly error that compromises many people from achieving their financial goals.
As you can see from the above two points, holding a dud property is very costly (in terms of lost time and lost opportunity) and I do not think many people realise how significant that can be.
How do you know if you have a dud?
The answer to the above question is obvious. You have a dud if the value of the property is not growing in line with expectations for an investment grade property. A better question is “how long do you wait until you know if you have a dud?” There is no hard and fast rule to this as it depends on the circumstances. We spend a lot of time with clients helping them assess their holdings and clients often comment that it is one of the most useful and valuable things we can do. When undertaking a review we will consider (note that this is not an exhaustive list):
- The actual capital growth rate since purchase date compared to the median/market rate
- The historic growth rate of the property (before the client owned it)
- The land value as a percentage of total value of the property (even if it is an apartment)
- The age of the building
- The location of the property, orientation, architectural style, floor plan, etc.
- Discussions with local real estate professionals and/or buyers’ agents.
Sometimes it is obvious when a client owns a dud property – even if they have not owned the asset for a long period. Other times it is less obvious. We would only recommend selling a property when we are virtually certain that the property’s capital growth rate will not achieve 7% to 10% p.a. over the long term. If we are uncertain we will recommend “watching” the property and reviewing it annually. It can sometimes take 5 or more years before you can work out of it’s a dud or not.
Ultimately, the question we ask ourselves is “how certain are we that the property will double in value over the next 10 years?” If we are not certain then we are probably accepting too much investment risk and the client’s investment approach starts to move away from investment towards speculation. We do not speculate with our clients’ money.
How to avoid buying a dud?
Given the quantum of entry and exist costs associated with buying and selling property it is far more efficient to get it right the first time (and not have to sell a dud asset). I am bemused by how many people buy property without any professional advice. I am in the industry and even I always get advice before I buy property. Sure, like many people, I do not have time to scour the market and attend many auctions and opens. But more importantly, I do not have the property selection experience that a professional buyers’ agent does and I do not want to take the risk of buying a dud property (because I know how costly it can be). Therefore, I engage a buyers’ agent and view the fee as insurance against picking a poor quality property. It is not a risk-free exercise. Of course, there is always some risk. But I am convinced that this is the lowest risk approach.
We do try and provide clients with some assistance such as access to RP Data property reports at no cost. These Reports allow you to assess the past capital growth rate of a property amongst other things. We can also share our opinion if we feel comfortable doing so. Whilst these things are often helpful, they are no substitute for trustworthy, independent advice from reputable buyers’ agent. After all, you are spending hundreds of thousands of dollars today and risking probably millions of dollars of future wealth so it is worth paying someone a fee to reduce your risk.
We help clients through this process
Whilst most new prospective clients approach us to discuss acquiring a property, one of the first things I always do is review their existing property assets. I think that there is little point in adding to a property portfolio until we are sure that the existing assets are right. If existing assets are all high quality it will make building the portfolio in the future a lot easier (because growth is stronger). There is never a bad time to buy a quality investment asset. Also, there is never a bad time to sell a bad quality investment asset. Therefore, if you are uncertain about the quality of your assets and would like a review, please get in touch with us. Finding out sooner rather than later could save you a lot in lost equity and time.
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