Should you buy a block of flats?

PORTFOLIO POINT: A whole block of apartments can be tempting for investors, but requires careful due diligence.

For investors with $2–5 million, the chance to purchase an established block of flats, a row of terrace houses or a townhouse development can prove a worthy opportunity. But this type of investment requires patience and a strict strategy to ensure the full benefit is returned, even when the right asset is selected.

The most compelling factor in favour of low-rise unit blocks or clusters is their scarcity. Very few established blocks hit the market as a set and fewer apartment blocks, townhouse clusters and terrace house rows are being built, as we can see from the approval figures for all non-detached housing in the 15 years to 2006-07.

Bureau of Statistics figures show that low-rise buildings – up to three storeys – saw their proportion of approvals halve to about 15%, while the figure for terraces and townhouse complexes fell from 68.5% to 46.1%. During the same period, apartment buildings above four storeys (mostly high rises), rose from only 2.9% of non-detached housing approvals to about 40% today.

Source: ABS

This trend for fewer low-rise units is being driven by local councils, responding to resident pressure by putting restrictive planning schemes in place. In many suburbs, the construction of new apartment blocks has been effectively banned since the mid 1970s. At the same time, the rising cost of land has left developers focusing on commercial projects or high density in-fill sites. This underwrites the scarcity of established apartment blocks.

Like any other type of residential property, the greater the scarcity value, the better the long-term capital growth prospects. But this is not the only advantage in owning all the units in one building. Dealing with a single property manager instead of several is a practical advantage that often translates into lower costs. Owners also have a greater ability to match rental income with financing or cash flow needs.

But the greatest advantage of all is control. For many owners, the flexibility to sell one or more units is a key advantage giving the owner the ability to raise a substantial amount of cash should another opportunity arise, or to guard against an unanticipated setback. The owner can also upgrade and add value to an entire complex, whereas the owner of one unit will be restricted by owners’ corporation rules.

When apartment blocks or unit complexes appear on the market in high land value areas, their inherent scarcity commands top dollars at sale. Investors need to have deep pockets and may experience sub-market growth in the first two or three years given the price premium that may be required, although it is usually well worth it in the long run. But there are disadvantages to owning an entire apartment block or townhouse complex.

For a start, owning a complex as an investor’s only asset is not ideal. A single apartment block will generally secure a lower gross yield than could be achieved with a diversified portfolio of apartments or houses strategically located throughout the market. Lack of diversification can also impact capital growth because there are times when even blue ribbon residential areas underperform the market.

Finance for investors purchasing more than four properties (such as a whole apartment block), is generally suppled by banks at commercial lending terms as opposed to those generally offered to investors in residential property. ANZ Business Banking confirmed that it would only offer a maximum loan to valuation ratio of 65% and require the customer to demonstrate an interest payment cover of at least 1.5 times the projected income. Banks will obtain an independent valuation and also need to satisfy themselves that the contract of sale and lease agreements are in order before approving finance. And a revaluation would be conducted every two years to ensure the maximum loan to value ratio was not breached.

Even though the advantages are considerable, the downsides, if they materialise, can be very unforgiving. Extensive due diligence on an ongoing basis is vital as is comfortable financing and a long-term view.

Many high net worth families own apartment blocks, recognising that the increasing scarcity value combines with property’s conservative profile, strong capital growth and steady income stream. Apartment blocks are ideally suited to entities with multiple stakeholders or different generations with different needs to consider (to read about commercial property syndicates see Robert Gottliebsen’s feature, Commercial property’s new force: barbecue shoppers). Similarly, not-for-profit institutions such as hospitals, charitable faith-based trusts and caused-based societies often invest in low-rise unit complexes for their capital stability, income and the control it affords them over the investment.

Interestingly, it’s the nature of these owner types that often brings complexes on to the market for sale. After two or three generations, the number of beneficiaries to a family trust or business can grow from a handful to 15 or more, all of whom have different financial needs. In these situations, a sale and financial distribution is the most equitable way to resolve competing interests. A looming maintenance or construction bill is the other factor producing sales of an entire complex.

Assuming investors are already well diversified and adequately financed, the rules for investing in this sector are the same as for other residential property but the rewards for proper selection and the penalties for a poor choice are typically magnified over time.

Positioning in the right street and in the right suburb is key, as is proximity to shops, transport and recreation. The structural integrity and maintenance requirements of the building should be considered with the help of expert opinion. Adjoining use is a key consideration but owners of apartment blocks are usually less exposed than the owners of, say, 12 units scattered across a metropolitan area, all of which may be adversely affected by an adjoining use detracting from each property’s appeal.

As with any residential property investment, care, consideration and thorough due diligence tend to produce the best possible result.

It was interesting to hear Reserve Bank governor Glenn Stevens echoing my concerns yesterday, saying the real challenge from the recent increase in housing loans is to ensure it finances “more dwellings, not just higher prices”. Of course, an RBA governor is (rightly) restrained in his comments, but perhaps he hinted at his inner thoughts when he said the current situation could "pose elevated risks of problems of over-leverage and asset price deflation down the track".

Fortunately I don’t have to be as restrained when I say that irresponsible stimuli have a habit of inflating markets irrationally. While I don’t see any serious bubbles down the track, I do see evidence of over-leveraged buyers in our increasingly yo-yo like property market. It’s in this environment that investors need to take even greater care when investing in property. Bargain hunting (read buying substandard assets!) and over-gearing for residential investment property is becoming increasingly perilous.

Property Q&A

This week:

• New or renovated in the city?
• Investing in Darwin.
• Property advisers.
• Too good to be true?

Shock of the new

I am interested in buying an investment property in Melbourne’s CBD. What difference in capital gain can I expect from a new apartment building when compared with renovated classic?

I am not keen on high-rise apartments or units in refurbished complexes in the CBD. The reason is fairly simple: very few of these buildings have genuine scarcity value. While many CBD developments are marketed as “unique”, the accommodation style and features are usually quite similar. The other challenge facing investors in these developments is that the stock of CBD apartments and dwellings on the fringe are regularly supplemented by new developments, so the prospect of demand outstripping supply is not great.

Mention was made earlier of the restrictions curbing the building of new low-rise apartment buildings in suburbs near the centre of the Melbourne and other cities. It’s these restrictions that underpin the capital growth of established apartments in these suburbs, compared with the virtually unlimited potential supply in and around the CBD.

There are some apartments in sought-after locations of the CBD where similar restrictions prevent new developments. This confers some scarcity value on these apartments, which can make them worthy investments, but they’re few and far between and entry level prices in these buildings are usually $700,000 or more. At that level, it raises the question of whether a small period-style house would be a better option.

North poll

How do you feel about Darwin as a potential area for property investment? I was thinking that its proximity to Asia and the new gas project may be positive signs.

As the centre of administration in the Northern Territory, Darwin has delivered impressive median house price growth of 10.7% in the year to February 2009. The population of more than 120,000 is mostly employed in the resources, agriculture and tourism sectors. Growth comes from a fast-growing population driven by the expanding presence of the Australian Defence Force and the recent burst of gas developments, as you mention. Native Title claims and a lack of new land releases means residential property in Darwin and Palmerston is benefiting from rising demand and tight supply.

Proximity to Asia is probably of less benefit than you might think, because of Darwin’s relatively small population and the concentration of industry. When times are good, fortune favours investors in the property market, and when conditions are less robust the market tends to stagnate. So be careful in your selection – this may not be an ideal profile for an investor who may need to sell just when the local business climate pulls back. Darwin’s investors should ensure their asset selection is spot-on and targets permanent local residents in key industries.

Hired guns

I wish to invest in property over the long term. As a novice is it best to employ the services of a buyer’s agent to assist me in identifying, acquiring and managing the investment properties?

I think many investors can get value from a qualified, experienced and independent property adviser. For first-time investors, independent advice is very important, as finding investment-grade property requires skill and experience in weighing up all the factors which underpin above market performance. Unfortunately, I have seen many investors make decisions that don’t take all these factors into account, costing them serious capital growth. Indeed, I have seen quite a few examples where even seasoned investors who shrewdly understand some of the issues driving the market, have overlooked others, limiting their property’s performance and costing themselves tens of thousands of dollars.

There are several things to look for in a property adviser. First, they need to be completely independent, unaffiliated with any other third party such as a developer or real estate agency with unrestricted access to the market. You should also look for an adviser who specialises in residential investment property and is experienced in working primarily with investors. Buyers advocates, for instance, while typically skilled at buying a home to live in may not be as skilled at finding the right investment property.

Finally, you should look for an adviser who charges a fee for their service as their only source of remuneration during the advisory and purchasing process. This is important because it means they are rewarded for buying a property on your behalf and saving you money, not paid a commission by someone else for selling their property to you.

Read the fine print

I have been trying to sell our investment property. Recently I received an approach from a company that promotes itself as helping renters get into their first home. It proposed an arrangement whereby I give an option to buy my property within the next 12 months for an agreed amount (5% above my current list price), no sales commission, and it would arrange above-market rentals. There is a nominal premium for the option.

No commissions, rented out at an above-market rate and an option to buy in 12 months, supposedly at a better price than what you can obtain currently. As they say: if it sounds too good to be true, it probably is!

Your first clue is that this property company is dedicated to helping renters become first-home buyers; you are not the primary stakeholder. Its option to buy in 12 months’ time probably does not contract it to buy, but your solicitor’s review of the contract may reveal it does oblige you to sell. And if your property’s value rises by more than 5% in that time, the company is taking money straight out of your pocket '¦ and that’s assuming you can all agree on the correct current value for the property. This is the hidden cost behind all the other sweet-sounding inducements such as the above-market rents and the apparent lack of sales commissions. Steer clear at all cost!

If you’re having difficulty selling in the current climate, it may be that your property is not ideally suited for investment. Investment-grade properties I am seeing on the market are attracting strong buyer interest and sales prices generally at or above their technical price range. My advice is to undertake a thorough evaluation of the current agents selling your property, your expected price and the advertising campaign, and make the changes required to ensure you meet the market in respect of the true value of your property.

Monique Wakelin is co-founder of Wakelin Property Advisory, a Melbourne-based independent property acquisition and advisory company, and co-author of Streets Ahead: How to Make Money from Residential Property.

Note: We make every attempt to provide answers to readers’ questions, however, answers are of a general nature only. Subscribers should seek independent professional advice for more in-depth information that is specific to their situation.

Do you have a question for Monique Wakelin? Send an email to monique@eurekareport.com.au.