The nature of growth

Greetings from bright but rather brisk England where I've been hanging out for the past week. Busy as ever, I've been taking in a bit of culture, being the history buff that I am. 

In the last week, I've visited the ruins of the 6th century fort of Bolingbroke Castle, which was once one of the most important sites in Britain, being the birthplace of Henry IV. Today, it's essentially a mound of earth and a pile of stones in the countryside, but tremendously interesting nonetheless!

This morning I also visited the magnificent Kings College in Cambridge which was founded by Henry VI in 1441, and the restoration of which - a bit like the unending painting of the Sydney Harbour Bridge - seems to be an ongoing, 365-day-a-year job.

And, just in case all that wasn't tiring enough, I've also been spending some time with my three nieces.

Not having children of my own, I forget just how darned noisy and energetic kids can be, and I'm also amazed at how they seemingly eat round the clock: breakfast at 7am, sausage sandwiches by 9am, morning snacks by 10.30..."Well, they're growing kids, y'know..." - and it's true enough, they definitely are growing!

Physical growth and price appreciation

So, what have I missed in the world of Aussie real estate this week? Prices are on the move in some cities, it seems, with data provider indices showing some "growth".

A couple of commentators have again highlighted the risks inherent in mining towns, noting the possibility of land being released. I wholeheartedly agree with this assessment, although I note that this risk extends to many regional towns in general: land being available for release introduces a risk of very weak real long-term price appreciation.

Over here in the chilly south-east of England, it's very noticeable how so many former greenfield sites have been developed on the fringes of provincial towns and the smaller satellite cities in recent years. New property developments are sprouting up all over the place in fringe suburbs, with the UK Government and Bank of England pushing things along with its 'Help to Buy' scheme and ZIRP respectively.

While UK median prices have shown a very moderate uptick (this can happen when new builds come online), in many areas outside London the prices of existing properties remain way below where they were in 2007.

Remember that the physical growth of a town or city does not necessarily equate to price growth in existing properties, and this is especially the case where new land is being released.

In London, the dynamic is markedly different. Not only is there a massive, growing population and almost no prime land available for release, investors from Britain and overseas who were spooked by share market crashes during and after the financial crisis are simply throwing money at the property market, pushing prices up to unheard of levels, way ahead of their previous peaks.

"Room to grow"?

Some commentators say that investors should buy in the cheapest quartile of the market where properties have "more room to grow". 

But properties do not "grow", unless of course you are investing in building them to make them bigger. No. Instead, properties, just, well...kind of sit there.

Plants grow. Trees grow (though, as the saying goes, trees don't grow to the sky). My nieces grow. 

But properties do not grow.

And besides, why on earth should each successive generation pay more for property than its immediate predecessor? Particularly now that the deregulation of lending standards and products is well in the past and interest rates have fallen to as close to the 'zero bound' as they hopefully ever will be in Australia. 

If you want investments to grow - like my nieces - they need to be fed. You need to re-invest in them.

If you want a term deposit to grow, re-invest the interest.

How do companies grow? Because companies tend to only pay out a small portion of their net earnings as dividends and they retain sufficient capital to re-invest in the business. 

This is why value investors and Buffett-types seek businesses with strong and growing owner earnings (reported earnings with depreciation and amortisation added back, less capital expenditure for plant and equipment) - they want companies which can be self-perpetuating and are able to re-invest in their own futures.

If you want to grow your own share portfolio, re-invest your dividends via a dividend re-investment plan (DRP).

But, I'm afraid to say, properties do not "grow", especially if you take the approach recommended by some pundits of not maintaining properties to a reasonable standard.

In fact, if you don't re-invest in a property regularly through paying for repairs and maintenance (as the chaps do at Kings College in Cambridge nigh on continually) then eventually the property will fall down and you will be left with a pile of rubble and some earth (such as exists at Bolingbroke Castle in rural Lincolnshire).

Price growth

It's common to talk of "market value" or "intrinsic value" in the world of real estate. 

But what is market value? It's really only what another individual or entity will pay for the title at a given point in time.

Imputed rents don't make for a great measure of 'fair value' in residential property for they take little account of the emotional factors impacting homebuyers. In property, price is perhaps a far more appropriate word to use than value.

All things being equal, the price of a property should only move in line with inflation: as the currency becomes gradually worth less over time, the price of property should slowly tick up accordingly, but no faster than inflation.

A property in strong demand might potentially move rather in tandem with the growth in household incomes over time, with the effective speed limit for price growth being the ability of the populace to service mortgage repayments.

So how does an investor source price growth which outperforms inflation over the long term? Ultimately, unless you are a skilled renovator (and, let's face it, most property investors definitely aren't) there's only one way that it is possible to do this, by finding a property which:

(1) is in an area with a strongly increasing population, with real wages appreciation and booming demand;

(2) is in an area where there is little or no land available for development or release and thus supply does not keep pace; and

(3) where investors are pushing up prices through seeking returns on their capital.

This discounts most regional markets and fringe suburbs where land is available for release, demand is very low and price-to-income ratios remain subdued.

The markets which are fitting the criteria for price growth at present are Perth, Sydney and Darwin and prices are increasing accordingly.

Investors tend to prefer capital cities and the combination of land-locked suburbs and growing populations tend to be a happy one for investors and an unhappy one for homebuyers, pushing the price of the prime-location land ever higher.