Looking to buy an investment property? Here are some basic guidelines to help you navigate the cyclical nature of the property market.
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Understand the property market before you invest
Land rises in value, buildings fall in value
When buying an investment property, there are two components that make up the price you pay – the value of the land and the value of the building. As a general rule of thumb, over time the value of the land tends to rise, while the value of the building tends to fall.
Why land rises in value
This typically comes down to supply and demand.
Think of a house located in a capital city’s inner or middle ring. The land is most likely already taken up with parks, schools, shopping centres and other houses.
As the city’s population increases over time, there are commonly two options to accommodate the growing number of people – build on the suburban fringes, or build more high density dwellings (like apartments) in established suburbs.
This means that demand rises for the land, while supply of land in these areas typically remains limited – which can force up prices.
Why buildings fall in value
Buildings are a depreciating asset because they generally have a limited lifespan as they age. They become run down and outdated, and end up being demolished for new housing.
That’s why you need to be mindful of the proportion of the purchase price that comprises the value of the land and the proportion that comprises the value of the building, as not all properties are created equal.
Tip: Have a think about which investment property type is right for you.
It’s all about supply and demand
How well your property performs - whether that’s through capital growth or rental income – all depends on supply and demand.
Typically, if the demand from people is higher than the supply of housing stock, then property and rental prices will rise.
However, a common mistake is to only focus on the demand-side drivers and not consider the supply-side drivers.
For example, just because a suburb has the fastest growing population in a city and boasts new schools, parks and shopping centres, it doesn’t necessarily mean property prices will rise there. If there’s nearby land that can be easily developed for new housing, this will help supply meet the growing demand – and subsequently limit property price and rental rises.
Property markets are cyclical in nature
The supply and demand dynamics also mean that property markets typically run in cycles as supply and demand fluctuate. This means property and rental prices won’t necessarily rise consistently, but ebb and flow over time. This can happen at a city-wide level, but there are also markets within markets – such as at a suburb level, or even pockets within suburbs.
Get familiar with the property cycle
They come under different names, but the phases of the property cycle are typically boom, downturn, stabilisation and upturn. Here’s a breakdown of each:
- Boom – New investors and home owners increase the demand for property and drive up real estate prices. New houses and apartments have to be built quickly to meet this rising demand.
- Downturn – The supply of properties catches up with the demand, leading to an oversupply. Vacancy rates rise, and property and rental prices fall.
- Stabilisation – As the market adjusts to the oversupply, construction slows or stops and interest rates fall. Property prices flatten and may start moving up again.
- Upturn – Vacancy rates start to fall, property and rental prices start rising more steadily, and construction picks up again. As property value continues to increase, we return to the Boom phase and the cycle starts up again.
Timing the market vs time in the market
Some people may try to time the market by buying an investment property at the bottom of a cycle and selling it at the top of a cycle. However, it’s extremely difficult to accurately predict peaks and troughs in the market, and some phases – like downturn and stabilisation – can be hard to differentiate when you’re living them. The buying and selling costs also mean that the property has to rise very significantly in value in that time for there to be a true return on investment.
Instead of trying to time the market, some people choose to take a long-term view and focus on properties that are best placed to grow in value over a longer period of time, while keeping in mind there can be peaks and troughs along the way.
It’s important to keep an objective view of the market and avoid buying an investment property on emotion. Some investors get caught out by buying property during an upswing for fear of missing out on the price growth. But the market can turn quickly. If you buy at the peak of an up-cycle, just before the market starts to cool, you may have to wait several years for the next upswing, and could end up with negative equity (when the value of the property falls below the size of the loan).
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