November 14, 2018 – Article by Paul Sonntag (Reading time: 7 mins)
The Power of Compound Growth
The absolute highlight of investing in real estate is seeing your property go up in value. You buy a property for $500,000, and without doing anything to it, in a few years time it is worth $700,000. Amazing. That is $200,000 that you didn’t have when you bought the property, and thanks to your particular property market rising you have experienced capital growth in your investment. On the other-hand there is nothing more deflating to watch an investment property stagnate, and not go up at all. Or even worse, to watch the value drop over time to levels well below what you paid for it.
Why does this happen? And where does this happen?
Let’s start with a basic scenario. We are going back 10 years to 2008, and we have two property investors Bill and Peter who each buy a $600,000 investment property in Sydney. Both invested for the very long-term as they should be and still own these properties. The guys both took buying advice from their friends and parents, so for the most part left it up to luck on what and where they bought. Bill likes new things so buys a brand new in Sydney’s CBD. It has two bedrooms, one car space and is in the heart of the city. Bill thinks that if he ever moves into it he can walk to work. Peter instead buys a three bedroom terraced house in Redfern. It is 100 years old and he needs to fix a few things before renting it out, and is hoping he hasn’t purchased a “money pit”.
Fast forward 10 years and the results are enormously different. Both investments have been rented out consistently over the decade, bringing in decent yields on their original purchase price. But with more and more apartments being built in and around Bill’s investment, capital growth has stalled and his unit is currently worth $1.05M. Sure he has seen $450,000 in growth, but could he have done better? Well, yes. Redfern along with a lot of suburbs close to Sydney’s CBD is almost all heritage listed. Therefore it cannot be redeveloped, which greatly limits the supply of new properties. As the population swells and more people want to live in these areas, and invariably prices rise. Peter’s investment is now worth $1.4million. He has seen meteoric growth of $800,000 on his original $600,000 purchase (this is not normal ladies and gentlemen. Many call Sydney’s latest growth period a “once in a lifetime boom”).
The decision on where you invest in the property market has very long-term implications. Get it right and it sets you up nicely for your next purchase. Get it wrong and it may be the only investment you make.
The Power of Compounding
Capital growth is the increase in value seen in an investment. The rate that your investment grows (or declines) varies, which is the capital growth rate. Property markets work in cycles so you will have good years where the growth rate is high and you see a lot of growth. Other years the growth rate may be minimal, or even negative, depending on the performance of the market.
Real estate is a long-term play, and you should only be interested in how your investment will perform over a number of years. When we calculate the historical growth rate of a suburb, this is calculating the average growth rate over a 20-year period. This allows for peaks and troughs of the market over time, giving you a much more accurate picture of the performance of that market.
“Compounded interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” – Albert Einstein
Compounded growth in property works by generating more value within the property due to the growth remaining within the property. What that means is that as the value grows, the percentage of growth is calculated on that whole amount. This leads to exponential growth, and for it to work it needs two things: the funds to remain within the asset and time. The earlier you start investing and having property working for you, the better off you will be.
1% Makes a Huge Difference
If we were to buy a $500,000 property today and over the next 20 years the property to could average a capital growth rate of 4%, 5% or 6%.
Our $500,000 investment over 20 years:
• At a 4% growth rate will have a value of $1.095M (Capital growth = $595,000)
• At a 5% growth rate will have a value of $1.326M (Capital growth = $826,000)
• At a 6% growth rate will have a value of $1.603M (Capital growth = $1.103M)
When your property appreciates at 1% more each year the effects are enormous. Because your assets value goes up from year to year, you also start making money on the interest (or growth) that you have had also. This is the compounding effect.
So for this $500,000 purchase, the difference over 20 years between one growth rate and the next is $100,000s. It is so very important to buy quality real estate that will see capital growth over the long term, so you can tap into these type of growth rates (or higher ones hopefully).
Where Do You Find These Growth Rates?
There are a lot of factors that play into strong growth rates, but let’s keep it super simple. Firstly, go where the people go and concentrate on areas that do not have high supply levels of new properties. Major capital cities are where the jobs are concentrated and the infrastructure investment, which means that more and more people want to live close to these centres. Sydney, Melbourne, Brisbane and Perth are our four largest cities, with further planning and demographic studies suggesting this will continue to be the case for decades.
Monitoring supply of new properties is the biggest factor with this. If you are investing in apartments, stay well away from areas that have a lot of large-scale developments. Areas with towers of apartments already have a high number of dwellings per square kilometre, usually with the ability for more to be built in the future. This will hamper your capital growth, and your rental return will also suffer over time. Buy in areas that have a limited supply of apartments. Suburbs that are almost fully developed, and when you look out over the suburb the largest apartment buildings you see are 6 to 7 storeys high (and not 15 to 20 storeys).
Houses are much easier to manage this as land is finite. But people do fall into the trap of buying into house and land estates where new land is almost endless. Stick to established suburbs that were created decades ago. When you look over them with Google Earth, all you will see if houses. This is great. There is no more land to be developed with new houses which is what you want. Limit the supply on new properties and maximise the demand from the population.
Property is Playing the Long Game
As an investor, realise that real estate is a long-term play. The game is to buy great real estate at great prices, and hold onto these properties for the long-term. There is a great saying in property “the longer you own it, the luckier you become”. This only holds true on good quality property. The apartment that you purchased amongst thousands of others will definitely suffer in the short-term, and will not have the long-term growth when compared to other tightly-held areas.
“The longer you own it, the luckier you become”
When you are investing in property, do it for the long-term. Don’t check the monthly or quarterly performance of your property, unless you are planning on selling. Otherwise the game is to buy well and hold. And if you work with the factors above and have higher growth rates working for you, then you will be much better off. The power of compounding growth doesn’t happen in the first few years. The power is unleashed in years to come, as the growth of your property increases exponentially. Hopefully by that stage you have a few properties going up at strong growth rates, all pointing you towards an extremely comfortable retirement, and very secure nest-egg for your next generation.
Paul Sonntag is a Director and Chief Strategist at AQUUS, a boutique investment buyers agency based in Sydney. It costs nothing to book an initial call with him to discuss your ideal investment strategy. Contact him through our website or email him at firstname.lastname@example.org