How to build the perfect property portfolio

Timing is everything; now is the time to review your property interests.

Diversity is about being selective and discerning within the context of spreading risk. Prudent diversification occurs over time, and aims to fill gaps in a portfolio with each subsequent purchase according to a set of ideal outcomes and selection criteria. These cover optimising growth and income potential in the choice of location, architecture, property type and cash flow over the life of the investment cycle.

Each time you have the opportunity to invest, ask yourself; what is the balance of localities, houses versus apartments and architectural styles in my portfolio? Where are the gaps, and which of these gaps does my present financial capacity allow me to fill without overcommitting?

Every investor is different and people may wish to buy commercial properties or farms or whatever. Personally, I like to recommend that your first stage of diversification might be to have a house and an apartment or vice versa. They should both be in inner-city locations although not necessarily in the same city. After that? Read on.

Location

Diversify within the most sought-after, high-land-value locations.

You don’t always have to invest in your home city or region, especially if you live in a smaller capital. Plenty of investors choose to have one property in their home locality and then diversify into Melbourne, Brisbane or Sydney as their equity builds to achieve higher and more consistent returns.

Ideally, an investment property should be located two to 12 kilometres from the CBD of a major capital city such as Melbourne or Sydney. These are the ideal choice because both have big populations, well diversified economies, intense infrastructure, a diverse demographic profile, world-class educational facilities and appealing cultural aspects. Brisbane is also an option within closer proximity to its CBD.

These parameters offer the highest underlying demand, land values and, therefore, the highest growth. The outlay for a single asset should be ideally between $350,000 and $1 million. It’s that demand, scarcity and the finite supply of land in these areas that drive the growth.

Perth has undergone stellar capital growth, but within the ideal context it’s too geographically isolated, and its economy is overly dependent on mining. Similarly, mining towns, retirement and holiday resort regions have similar limitations. It’s not only important that physical characteristics and infrastructure are plentiful; demographic composition is key. Prices and demand only rise consistently when the bulk of the population is permanent and actively contributing to economic output.

Remember Far North Queensland in the late1980s? All it took was the pilot strike to kill tourism – the predominant industry – and inevitably the economy, which hurt the property market. Now it’s mining towns, where fibro shacks are selling for $400,000, but what would happen to mining if the economy was hit by stagflation or China’s growth slowed significantly?

Even within the top cities and areas, selectivity is still critical. There has been a trend for investors to speculate on potential growth of a suburb while there are many who buy close to where they live because they “know and love the area”. This is emotionally driven reasoning and bears no resemblance to an optimally diversified investment model.

Architectural style

Victorian, Federation, Edwardian and Art Deco styles are timeless, in limited supply and have demonstrated consistent capital growth over many property cycles. Houses built between the 1880s and the 1940s and apartments built between the 1930s through the mid-1970s will offer the best growth. It’s perfectly appropriate to diversify within these parameters.

Houses built later than the 1960s and most established mid-priced apartments built after the mid-1970s are unlikely to have the scarcity value or timeless appeal of their older counterparts and are therefore less likely to deliver the requisite growth and ongoing demand, at least for the foreseeable future

Tax savings and depreciation benefits should only be viewed as the icing on the cake, never as the primary investment driver. As a point of diversification, and only if all the other fundamentals are right, combining these with depreciation benefits is fine.

Property types

When diversifying a portfolio, investors can choose between houses, apartments, town houses and villa units. The best choices are established apartments and houses because these types attract the vast majority of the population the vast majority of the time. Apartments with one bedroom (occasionally up to three) and two or three-bedroom houses work best. Never buy an apartment without off-street parking entitlements.

Townhouses may be the new trend for owner-occupiers, but as investments they may not perform as consistently because they tend to appeal to a limited pool of buyers and tenants. Similarly, the villa unit had its day in the 1950s and 1960s but they too usually have limited appeal. They seem to attract a narrower demographic from both a rental and re-sale point of view because of the “community” style of these developments.

It will be no surprise that I also steer investors away from run-of-the-mill apartments in high-rise towers, again because they lack scarcity value in spite of perceived tax or rent-related incentives. Certainly, some more exclusive towers aimed squarely at owner-occupiers have experienced strong growth but in the main, had investors who bought these gone for established dwellings in coveted locations instead, their assets would have appreciated far more.

The gearing/cash flow myth

Gearing is often touted as the “bee’s knees” of successful property investment. In fact, the only justification for high levels of gearing – that is more than 75% – is strong capital growth. This is why the highly geared, “positive cash flow” (PCF) investment property is nothing more than a red herring when it comes to creating an optimal diversification platform.

PCFs provide an immediate positive cash flow in spite of high gearing. Values and growth patterns lag seriously behind much of the market, making the percentage return high. It’s only the percentage that looks good in relation to the asset value.

The dollar value of the rent is actually quite low compared to an equivalent property in a prime area, where growth drives both the asset and rental value. The problem is that the low value creates the illusion that they are great investments because they can be bought at bargain prices and as a proportion of the low value, the rent appears fabulous!

Many investors reason that it’s a good diversification strategy to include one or two PCFs in their portfolio to balance the outlay required by the negatively geared ones. In fact, the cost of low or absent capital growth over time is far greater than the short-term perceived benefit of the balancing effect. I know of one investor who bought high yielding, low-growth properties and dropped about $300,000 in capital growth over a period of six years. This severely hampered their ability to build a solid diversification platform.

There is really only one legitimate way to get a positive cash flow from an investment property; to have more equity than borrowings.

Rising interest rates are another reason to avoid this category of investment because over the long term, you will end up paying far more for the privilege of borrowing than will ever be justified by the low rate of appreciation.

Finally… It’s far sounder to understand the correct meaning and application of diversification. Acquire fewer top-notch properties rather than numerous lemons, and pay down some debt on a regular basis. No matter what the text books say, ideally the more equity you control, the more financially independent and economically insulated you become.

This article first appeared in Eureka Report