Prior to the credit crunch in 2007, the average increase in house prices in the UK was an impressive 8% per annum, or thereabouts – and this includes taking into account the downturns in previous recessions. But with the current economic climate being as it is, many investors often wonder if we will continue to see a trend growth of this magnitude in the future.
Some would argue that given the ever increasing population and the increasing number of households, as well as the short supply of property (especially new property), at some point we should witness an annual growth rate far in excess of this. Of course, 8% is an average, and to quote the prolific investor Dolf de Roos, by definition half of all properties will do better than the average and the other half will do worse.
In property investing, there is the timeless principal that if you buy a reasonable property in a reasonable area and wait long enough, you will eventually benefit from capital gains – and with increased capital gains comes increased equity, or wealth.
There is also a school of thought that says areas which have experienced high rates of capital growth in the past will continue to experience high rates of capital growth in the future. With this in mind, concentrating on buying in these areas to benefit from continued high rates of capital growth might be a route to take.
Seasoned investors largely take the view that by carefully selecting a property that is better than the average, it’s possible to enjoy above average capital gains and consequently above average returns.
However, many fall into the trap of making a subjective assessment of what comprises an ‘above average’ property. As far as possible, an investor should objectively look at the facts and figures and this includes making an objective assessment of 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 likely to be hard to sell, and vice versa).
At the same time, some investors fail to estimate the extra returns that they could receive over the course of their investment projects by not putting in a little extra effort – they fail to see the power of compounding and overlook that the increase in return is totally disproportionate to the amount of effort involved.
Let me illustrate this to explain how it works.
There are three investors, Investor A, Investor B and Investor C. Investor A does not have the time to analyse and research the market and buys a slightly below average property in a slightly below average area where he can expect capital growth slightly below the average. Investor B takes a little time to research and buys an average property average that can expect an average rate of return. Investor C conducts a thorough study of the market and chooses a property that is likely to achieve a great rate on return – much higher than the average.
Ignoring costs etc. to keep the example simple, if all three properties cost £100,000 for cash and assuming all investors keep a hold of the property for 20 years, we can see what will happen to their returns two decades later. (NB: In this instance, as they have no loans on the property, the value and the equity will be the same.)
Investor A’s property enjoys capital growth slightly below the average UK rate of 8%, say at 5%; at the end of 20 year term the property is worth £265,000. Investor B’s property enjoys capital growth at the UK average rate of 8%; at the end of the 20 year term the property is worth £466,000. And Investor C’s Property enjoys capital growth at a rate slightly higher UK average, say 12% and at the end of 20 years the property is worth £964,000.
If you take a close look you’ll notice that twenty years later, Investor B is worth almost twice as much as Investor A, whereas Investor C who took the time to find the right property, in the right area for increased capital growth, now has a property that is about double the value of that of Investor B.
However, it doesn’t end there. Studying the power of compounding shows that exponential growth is produced over longer investment periods. In other words, most of the growth occurs in the last few years. To give an example, if the investors in our scenario were to hold their properties for 30 years instead of 20, the values would be £432,000, £1m and £3m respectively.
At this point 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.
But with an extra 10 years, the property belonging to Investor A would have increased in value by another 63%, the property belonging to Investor B would more than double in value, and the property belonging to Investor C would more than treble in value.
To put it simply, Investors B and C would experience more growth in value in the last 10 years than in the whole of the preceding 20 years, illustrating that property really is a truly excellent investment when held for the long-term.
Admittedly, it can be quite hard to envisage that property values can increase from £100,000 to £466,000 over a twenty-year period, or to even £1m over 30 years. But if we take a look back at what has happened historically, there’s no doubt that prices can certainly rise dramatically.
According to Nationwide, in 1952 in Q4, average UK houses prices stood at £1,891, and rose to £206,015 in Q3 of 2016. If you do the maths, the increase of £204,124 over the 64 years actually works out at around 7.6% per annum.
This does reiterate that if I’m going to buy property for the long-term, without a doubt it’s worth spending a little extra time to carefully select an investment which will provide the best prospects for capital growth. Wouldn’t you agree?
Peter Jones B.Sc FRICS
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