The Power of Capital growth
As it seems that the property market is now in recovery, and property values are increasing, how do we make the most of a rising market?
In a sense there are a number of possible answers to this question, ranging from what we may describe as ‘unsophisticated’ through to ‘sophisticated’, and all would have merit.
So, at a basic ‘unsophisticated’ level, the answer could be ‘buy a property and wait’.
If an investor is happy to play the averages, and buy an average property in an average area, and wait for property prices to increase by the UK average, that might be good enough for them. That might particularly appeal to an ‘armchair’ investor with little time and little inclination to become knowledgeable about property and investing.
Don’t forget that the average increase in house prices in the UK prior to the credit crunch, including taking into account the downturns in previous recessions, was an impressive 8% per annum or thereabouts.
The big question now is “Will we continue to see trend growth of that magnitude in the future?”
Some would argue that given the ever increasing population and the increasing number of households, and given the shortage of supply, especially of new property, at some point in the future we will inevitably see annual growth far in excess of 8%.
Of course, 8% is an average and, to quote Dolf de Roos, by definition half of all properties will do better than the average and half will do worse than the average. That is, after all, how an average is calculated.
So our investor would be well advised to take care and trouble when choosing which property to buy, in case they buy from the wrong ‘half’ and buy one that performs worse than the average.
However, as I said earlier, this is a fairly unsophisticated answer but it does illustrate a timeless principle of property:
If you buy a reasonable property in a reasonable area and wait long enough, you will eventually benefit from capital gains.
And implicit with increased capital gains is increased equity (or wealth).
The more sophisticated view would be that by carefully selecting a property that is better than the average an investor will enjoy above average capital gains and consequently above average returns.
Many investors fall into the trap of making a subjective assessment of what comprises an ‘above average’ property but, as far as possible, an investor should objectively look at the facts and figures.
We’ll look at this in more detail in a moment but the main concerns of any investor should be cash flow, saleability, mortgageability and prospects of capital growth. To some extent mortgageablity and saleability are interchangeable because a property which is hard or impossible to finance is, all other things being equal, going to be hard to sell, and vice versa.
Many investors underestimate the extra returns they will receive over the course of their investing lives just by making a little more effort. In fact the increase in returns is totally disproportionate to the effort they put in.
The reason, of course, is the power of compounding.
Just think of this example.
There are three investors.
One doesn’t have much time to study and research and so buys a slightly below average property in a slightly below average area where he can expect capital growth slightly below the average.
One is a little more careful and does a little more research and buys a property which is average and where he can expect average rates of return.
The third investor knows that having the right knowledge can greatly increase his or her returns and takes the time to find a property which can reasonably be expected to enjoy greater than average rates of return.
For ease of illustration we’ll assume that all three properties cost £100,000 and we’ll ignore costs etc to keep the maths simple. We’ll also assume each investor keeps the property for 20 years. At this stage we’ll also assume that all 3 are cash buyers.
Let’s see what happens to their equity over a 20 year period – in this instance, as they have no loans on the property, the value and the equity will be the same.
Property No1 enjoys capital growth slightly below the average UK rate of 8%, say at 5%.
At the end of 20 years the property is worth £265,000.
Property No 2 enjoys capital growth at the long-term UK average rate of 8% and at the end of 20 years is worth £466,000.
Property No 3 enjoys capital growth at a rate slightly higher than the UK average, say 12% and at the end of 20 years is worth £964,000.
We can see that investor No 2 is worth almost, but not quite, twice as much as investor No 1.
We can see that investor No 3, who was prepared to put in just a little more time and effort to find a ‘better’ property, will be worth about twice the amount of investor No 2 and three times as much as investor No 1.
So we can see that if we are going to buy property for the long-term it’s worth spending a little extra time to carefully select a property which will provide the best prospects for capital growth.
This tells only part of the story.
Anyone who has studied the power of compounding will know that it produces exponential growth meaning that the longer the investment period, the more diverse the results.
Put another way, most of the growth occurs in the last few years. So, if our investors were to hold their properties for 30 years instead, the values would be £432,000, £1m and £3m respectively.
Now the spread of returns is 5% to 12% per annum, meaning that the higher rate is slightly more than double the lowest rate, but the difference in end value resulting from the lower and higher rates is much more than double.
In those extra 10 years we can see that the property belonging to investor No 1 increases in value by another 63%, the value of investor No 2’s property more than doubles in value in that extra 10 years, and the property belonging to investor No 3 more than trebles in value over that last 10 year period.
In other words, for investors No 2 and No 3 there is more growth in value in the last 10 years than in the whole of the preceding 20 years!
This illustrates another timeless principle:
Property is a truly excellent investment when held for the long-term.
I’m sure you’ll agree that these figures are, when you think about it, truly astounding although if you’ve been involved in property for any length of time you might have become a little blasé about what can happen or, depending upon when you became acquainted with property, perhaps even a little cynical in view of the falling and then stagnating market we had after 2007.
After all, it might be wise at this point to take a step back and to ask ourselves, “Is it really realistic to imagine that property values can increase from £100,000 to £466,000 over a twenty year period, or to £1m over 30 years?”
After all, I’d guess that for most of us it’s hard to imagine a property worth £100,000 today being worth £1m in the future.
If we look back at what has happened historically we can see that prices can rise this dramatically.
After all, these increases purely reflect the average annual increase, the growth rate we have adopted for investor No 2.
If you want to dig a little deeper into the detail, according to Nationwide average UK houses prices stood at £1,891 in Q4 1952, and at £174,444 at Q4 2013 (the latest data available at the time of writing). If you do the maths the increase of £172,553 over 61 years is the equivalent of just under 7.75% per annum.
I’d guess that it was as hard for our parents or grandparents to imagine their £1,891 house being worth £25,580 (the average UK house price in Q4 1982 i.e after 30 years) as it is for us to imagine our £100,000 property being worth £1m in 30 years.
It might seem an even bigger stretch to imagine our £100,000 house being worth £3m, but, as we identified before, an average is exactly that so half the properties will grow more in value than by 8% per annum and half will grow by less. So if you buy the ‘right’ £100,000 property, then, all other things being equal, a value of £3m after 30 years is not unbelievable.
Next time we’ll look at how our returns can be significantly improved just by borrowing some money.
Here’s to successful property investing
Peter Jones B.Sc FRICS
Chartered Surveyor, author and property investor
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