Understanding the basics of property investment

When it comes to buying an investment property, there are some basic guidelines that can allow you to make better decisions to achieve greater returns. Here are the fundamentals of property investment.

1. Land rises in value, buildings fall in value

When you purchase 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, investors should remember that over time the value of the land tends to rise, while the value of the building tends to fall.

Why land rises in value

The reason why land typically rises in value over time comes down to demand and supply.

Think of a house located in a suburb in a capital city’s inner or middle ring. In many instances, the land in these areas is already utilised by 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 – to build on the suburban fringes or to build more high-density dwellings in established suburbs, such as apartments.

This means that demand rises for land in the inner and middle rings of these growing cities, while supply of land in these areas typically remains limited, which can force up prices.

So why do buildings fall in value?

Buildings are a depreciating asset, meaning that they fall in value. This is because they generally have a limited lifespan as they age, become run down and outdated and end up being demolished for new housing.

Given this, when buying an investment property, investors need to be mindful of the proportion of the purchase price that comprises the value of the land and the value of the building as not all properties are created equal.

2. Consider demand and supply of the property market

How well your property performs, whether that’s capital growth or rental income, all depends on demand and supply.

Typically, if the demand from people is higher than the supply of housing stock, then property and rental prices will rise. So where is the best place to buy an investment property?

Common mistakes to avoid

A common mistake made by some investors 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, with new schools, parks and shopping centres, doesn’t necessarily mean property prices will rise in this area.

If there is nearby land that can be easily developed for new housing, then this will help supply meet the growing demand, and subsequently limit property price and rental rises.

It all comes down to supply and demand, so make sure you understand both sides of the equation when you’re buying an investment property.

The cyclical nature of property markets

The supply and demand dynamics also mean that property markets typically run in cycles, as these factors fluctuate through population rises and falls, which is subsequently driven by job growth, lifestyle offerings and other factors.

This means that property and rental prices won’t necessarily rise consistently but ebb and flow over time as supply and demand goes up and down.

This can be at a city-wide level, but there are also markets within markets, such as at a suburb level, or even pockets within suburbs.

3. Higher property prices don’t necessarily mean a positive return

Unlike some other investments, such as shares and bank deposits, the entry, exit and holding costs for investment properties can be significant.

For instance, when buying an investment property you’ll have to pay stamp duty, and when selling an investment property through a real estate agent you’ll have to pay the agent a fee also.

When holding an investment property it’s important to consider all the costs involved, not just the loan repayments. These costs can include property management fees, insurance, council rates, maintenance costs and strata fees, among others. To make a profit on property, it will have to rise in value more than these combined costs. Find out how much buying a property will cost you with our home loan fees calculator below.

4. The benefit of compound growth

The benefit of compound growth is that you can earn interest on interest. So if a property rises in value over subsequent years, you will earn interest on the previous price growth as the property continues to increase in value.

For example, if you buy an investment property for $400,000 and it increases in value by 6% every year, after 10 years the property will be worth $716,339.

Beneficially, the more time that passes the higher the compound growth will become.

So if you hold the same property for 20 years and it increases in value by 6% every year, it will be worth $1,282,854.

So in this scenario, the compound growth from years 1-10 is $316,339, but from years 11-20 the compound growth is $566,515.

Therefore, for investors who are seeking capital growth, it can be advantageous to take a long-term view.

Making the best decisions

Buying an investment property is a big decision and there are many factors to consider, however these fundamentals can provide some guidelines to making smarter decisions to achieve greater returns. Remember, it’s wise to contact an expert with regards to property investment advice, speak to a Bankwest Home Finance Manager today.

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Things you should know 

The information contained in this article is of a general nature and is not intended to be nor should it be considered as professional advice. You should not act on the basis of anything contained in this article without first obtaining specific professional advice. Also to the extent permitted by law, Bankwest, a division of Commonwealth Bank of Australia ABN 48 123 123 124 AFSL/Australian credit licence 234945, its related bodies corporate, employees and contractors accept no liability or responsibility to any persons for any loss which may be incurred or suffered as a result of acting on or refraining from acting as a result of anything contained in this article.