Don’t fall for shiny new buildings in property investment

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CONTRIBUTED ARTICLE Most property investors start out with a specific idea in their mind – to purchase a flat or house somewhere (often in an area they like themselves) and rent it out.  And then perhaps they’ll repeat the process as often as they can.

While some people can find investment success this way, it usually needs a good dose of those intangible, and unpredictable, elements – good luck and good timing.

Some investors might become more sophisticated and add a smart office building to their portfolio or self-managed superannuation fund, either directly or via a real estate investment trust (REIT).

But there is a trick being missed. The focus is still on the building, not on the true generator of real estate return and growth – the land. It may be a cliché, but that doesn’t mean it’s not true: when it comes to property investing, whether directly or indirectly through REITs, it’s all about location, location, location – or to put it another way, land.

The problem for many property investors is that, by itself, land is hard to finance and therefore difficult to hold for a period of time. It’s necessary to have improvements on the land in order to earn income – that is, some kind of development, which allows the land to be financed and held for a long period of time.

At the same time, however, these improvements are a cost of ownership via economic depreciation.

The secret, therefore, to long-term success in property investment is to look for high quality land (i.e. in a good location that will become even more desirable over time) with a low-cost building (or at least one that is low cost to maintain), that can generate suitable income.

With this in mind, it’s obvious that properties which demand a lot of up-keep and ongoing investment to keep up to scratch don’t fit this criteria. That’s not to say they aren’t good investments – rather that, for long-term investors, there are better options.

One way to find these investments is to identify real estate where the maintenance spend, or capital expenditure, is low. This is also known as “stay in business CAPEX”.

Over time, it can be demonstrated that real estate sectors with a high ongoing CAPEX have historically generated lower total returns compared to those with low CAPEX. The accompanying chart illustrates this using US REITs.

As this chart shows, sectors such as storage and healthcare may not seem as glamorous as residential or retail, but their low ongoing CAPEX means more free cash for dividends and re-investment.

And after all, when it comes to property investment, it’s all about the return.

* Chris Bedingfield is portfolio manager at Quay Global Investors, a Bennelong boutique.

First published in Your Property Investment