Why I buy in low socioeconomic areas

spludgey · 12th Jul, 2015

Preamble: I had a few messages back and forth between hotmail and myself talking about why I invest in high yielding areas (Elizabeth SA in this case) over blue chip areas. As we both took a bit of time writing our responses to each other, I thought it might be worth sharing on here.
Feel free to comment or critique.

Note: I've taken a few identifying details out.

hotmail said: ↑

Hi Spludgey,

I was looking at [Elizabeth property] and it seemed that the frontage was only 17m despite the land being a rectangular block. According to the council's development plan it seems that the frontage they are after for a duplex is 9m per lot (unless I am badly mistaken). Are you looking for a property to retain and develop later on down the track?
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spludgey said: ↑

Hey mate,

Not really, no. I think realistically speaking, developments won't make any sense in at least the next 5 years and probably not in the next 10. So I'm buying it only for cashflow purposes, with any capital gains being a bonus. I really don't know why developments are being spruiked so much in Elizabeth, the margins are way too tight to make gains worth the risks that you take.

I'm getting it for $1xxk, just in case you were wondering.

Cheers,
Spludgey
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hotmail said: ↑

Hi Spludgey,
Hmm interesting take on things, I never really thought of it that way. I was listening to D.T. and Corey saying that it may be good to buy and retain to develop in the long term. I may reconsider my approach

That's a good price! Well done !

Hotmail
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spludgey said: ↑

I guess no matter where you buy (within reason) might be a potential development site in years to come. Who thought that Parramatta would get the highest building in Australia (or was it NSW) 10 years ago, for example?
But if you buy something for that reason alone, then you're not investing, you're speculating.
As it stands today, you won't make much money from developing, but you will make money from positive cashflow. So I like to focus on properties paying their own way first and then look at potential for growth. So I buy houses with high yield, if possible.

Don't change your strategies just off my back though. Read lots and then make your decision.

You're doing alright though, the main thing you're lacking is the confidence to know what you're doing is right.
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hotmail said: ↑

Hi Spludgey,

I was just reading Playford Councils DCP and also the various Elizabeth threads which seemed to indicate that lots of 600sqm+/18m+ blocks would be able to be subdivided, but that it would not be profitable to do so at present stage due to the low prices. I just thought it might provide something of a kicker in 10-15 years time. Unfortunately it's been quite difficult to find those types of properties which also have a 7%+ yield, are priced correctly, have reasonable vendors and real estate agents managing them and don't require any renovation.

I definitely like the idea of cash flow neutral or positive in the sense of keeping high levels of servicing and making it easier for yourself if (touch wood) we ever lost our jobs or income. It's interesting regarding what you said about speculating. I want to ask you though, just to be a devil's advocate, let's say you invest 60k purchase costs into securing a 250k property @ 80% and 7.5% yield, wouldn't it also be speculating on the increase in value of the property? Because you've just invested a sum of money (in this case 60k) which in the immediate term, without capital gain, is returning 0% per annum? I feel that this is not much different to a cash flow negative (albeit slightly e.g. 20 dollars per week) property which without capital gain is returning -0.5% per annum. But the thing is, -0.5% per annum and 0% per annum, both are as bad as each other and the cash flow neutral one would not be a good investment either. So would the capital growth be king then? I feel that this also washes away the "I could pay for it if I lost my job" type of argument because no reasonable person would be forced to bail on a property because it was costing them 20 dollars per week.

What are your thoughts on this?

Sometimes I just get scared because I forecast in my mind a future world where the gap between rich and poor will simply continue to grow and widen. I'm thinking that because of this, all of the low end high cash flow suburbs will suffer poorer capital growth based on a percentage comparison compared to higher end properties (650k+) in more expensive cities, particularly Sydney to become like HK, London, Singapore, and New York where they are essentially international cities governed by global demand which is far greater and creates immunity against the traditional forces which govern the house prices in our other cities.

Thanks
Hotmail
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spludgey said: ↑

A kicker in 15 years time would be nice, and if possible it would be good if you could ensure that you plan for it. So if there had been an identical property with a wider (and bigger) block for the same price, I would have definitely gone for that instead. However, obviously that wasn't the case, so I prioritised a decent place with good yield over something that may or may not have development potential in a decade or so.
I think that buying properties is always about prioritising, you're never going to get a property with everything that you want for a price that you're happy to pay.

For your slightly negative cash flow properties: I'll have 9 IPs when this one settles. Let's assume each one is $20/week cash flow negative, that adds up to over $9000, which isn't insignificant to me now, much less if I lost my job. Plus if you lose your job, all those negative gearing advantages that you might currently enjoy vanish instantly.

But I have to agree that everything in investing (or even in life) is a bit of a gamble. As I see it, there are three real risks with my strategy:

Rental income decreases (vacancies, dropping rents)

Costs rising more than rents (in particular interest rates)

Deflation

I've had properties where I've had to reduce the rent slightly, but all in all my rents have been going up slightly and I think it's a much more safe assumption that rents will increase roughly inline with CPI than banking on capital gains. While rental increases aren't totally predictable, I feel that they're much more reliable than capital gains. Over a five year period you can pretty much assume that rents are going to go up, but prices might not (see Sydney 2003 to 2008).
Rents are often around the 30% mark of incomes, so if incomes are going to go up (which they generally do), rents are likely to follow, as people will be able to afford an increase in living costs.

Personally, I don't see interest rates rising significantly over the next five years, by which time rents would have increased sufficiently to absorb any increased costs (see point above).
If the RBA allowed interest rates to increase more than a couple of percent, they would risk a large percentage of Australians to default on their loans and we'd be in a situation similar to the USA after the subprime mortgage crisis. Again, I don't think this is a likely scenario.

Finally deflation, which in a way is similar to the point above but obviously happens on a very different scale. If deflation on a significant scale was to hit Australia, we'd all be stuffed anyway. So really, we'd be no worse off by investing in cash flow positive property. Plus interest rates would drop to near zero or possibly even go negative. So as long as you'd be able to weather the storm, you might be okay afterwards.
The risk of deflation occurring is probably the most unpredictable of the three scenarios, but I would hope that the government would do whatever it possibly could to avoid this. Currently this isn't a risk in Australia with our CPI still being positive, even if it has been dropping slightly.

I see the gap between rich and poor growing as well, however, I have a different stance on it. While I don't think that it's good/right/fair to be happening, I think that I probably can't stop this global change from occurring, so really I have one choice to make: Do I want to be on the rich side or on the poor side?
Karl Marx (who got married in my home town), might turn in his grave if he heard this, but I'd prefer to be on the rich side. This doesn't mean that you look down on poor people or that you take joy in their plight, it simply means that you'd prefer to be able to help yourself and those that you care about rather than being impotent.

So yes, more and more people will be renters for life while fewer people control more property. The growth of investment loans is certainly a good indicator of this. So the driver for capital gains in poor areas is a bit different to that in rich areas. In rich areas it's straight forward: If people can afford to pay more and are willing to do so, prices go up. In poor areas it's more that if people can afford to pay more rent, landlords will increase rents which increases yields and investors will start buying at whatever yield, pushing the prices up.
So if wage growth is faster in rich areas, you can probably assume capital gains to be faster as well, however once you take the cashflow into account, I would still pick a lower socioeconomic area every time.

By the way, do you mind if I post this in a thread on the forums? I'll take all identifying information out of it, such as your name and username. That way others can either learn from this or shoot down my arguments completely.

Cheers,
Spludgey
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hotmail said: ↑

Yeah, you seem quite decisive about your decision, good on you! I'm probably the opposite...

I'm really interested that you say that buying property is about prioritising, this is the first time I've ever heard this on propertychat/somersoft to be honest. I seem to get the impression that for almost everyone on the forum that perfection should be the standard. My most vivid memories are reading about Nixba's BMV Brisbane purchases which also were yielding 7.5% at a time when I was strugglinig to find properties at 6.5% and also about Michael Xia's portfolio whereby basically every purchase is 7.5% AND has development potential. Here I am tearing my hair out wondering how these guys do it...

To be honest with you when I saw your reply, I immediately started to formulate an argument about how capital growth is king but I think you do have a point with the cash flow increases which I've never remembered after the initial consideration a few years ago. What you're saying is basically if the rent of the neutral cash flow property doubles in 10 years, even if you pay down no debt, you will get to keep the roughly 35-40% of the rental increase after accounting for the fact that all holding costs (besides interest rates - which may have only moved 2% up from their current historic lows) will have doubled. Therefore a property currently renting for 250pw will generate about 90 dollars or so in your pocket after 10 years. But keep in mind 90 dollars in the year 2025 may only be equal to about 60 dollars per week in today's money. So basically you'd need to buy and hold 10 of these properties for as long as it takes for the rent to double for a gross income of 60k per year. Is this your strategy Rueben?

The more I type this out, the more I think it is quite a good strategy and offering a good alternative to blue chip people who are waiting for the fact that blue chip properties will increase higher percentage rate than cash flow properties. But then again think about it further, isn't it just a matter of WHAT these two types of strategies is speculating on?

For example the cashflow investor invests in (using stereotypical examples) low growth capital growth stock but higher cash flow stock, let's say their rental return is 7% and their capital growth is 3% that's still a total 'return' of 10%. On the other hand, the blue chip investor invests in high capital growth stock with lower cash flow and that may look like 6% per annum capital growth and only 4% yield which is still a 'total return' of 10%. In the end both arrive at the same destination because the cashflow investor makes most of their money from the rents from each property (possibly supplementing by drawing down a little equity) whilst the blue chip person simply uses the "living off equity" strategy to put food on the table with some minor income from rent. In the end, everyone buys different property and has a different strategy but the end goal for each person is the same, to live off property, it simply depends on what you will be eating once you reach your destination, will you be mainly eating your rent, or will you be eating mainly from your equity.

This means a mumbo jumbo portofolio containing all types of property will still feed you in retirement(!), but you just have to know how to pull the money from them, so for example if you had 5 cashflow properties and 5 capital growth properties, you would eat the rent of the 5 cashflows, whilst drawing down equity from the 5 capital growth ones in the living off equity manner.

I think this is an epiphany....

So to summarise, I think you're right the cash flow strategy is probably safer (because it's harder to lose your property from not being able to service), you still get capital growth because when you're buying when yields are high, capital growth always follows high yields (high referring to the idea of being relatively high compared to the particular area's historical yields), and finally that you're able to use higher leverage earler in the portfolio to accelerate accumulation (although this is essentially trading yield for opportunity cost to buy more).

That being said then, the implication is just to 'buy well', because as long as you buy well no matter the strategy, you will be able to get money from property.

Well done, you've just made me convince myself that cashflow is king...after one hour thinking about this, I've now got a headache lol...

Finally to respond to the point of poor areas still growing well, your argument was something I had thought about at once stage but never considered it seriously. You are basically saying that poor people will always need somewhere to live and they will have to live in the cheapest ones (cash flow ones) so with hard times it will create a whole generation of life renters and buy increasing the rent you are further trapping them in this cycle of having to rent for life.

This has been a very productive and helpful discussion, you're certainly welcome to post it on the forums, dw about the identifiers, my shame has already been exposed to the world, can't get any worse lol

Hotmail
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planPerth · 12th Jul, 2015

Thanks for this Spludgey, it is very useful. What is your experience with tenants in these areas? Do you think they are more likely to default on the rent or damage the property?

Fielding · 12th Jul, 2015

Great thread guys, glad you both shared.

D.T. · 12th Jul, 2015

Spludgey, All very good reasons. Good write up. I also like that @Corey Batt and @D.T. got a mention in there

planPerth, not in my experience. I have inherited 1 that was a non payer, but chucked them on Centrepay and haven't heard a peep from them since. All the others have been completely fine. Maintain an acceptable condition property and there's plenty of tenants about.

spludgey · 13th Jul, 2015

planPerth said: ↑

Thanks for this Spludgey, it is very useful. What is your experience with tenants in these areas? Do you think they are more likely to default on the rent or damage the property?
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I've only had investment properties in Elizabeth for just under a year, so I've got limited experience with tenants there, but I've had investment properties in comparable areas in NSW and QLD for over five years now, so I'll comment from that perspective.
Out of ten sets of tenants over tenfive years, I've had to take two to tribunal.
Personally, I don't feel that's a huge number for roughly 25 years of rental years, but it's obviously not zero either.

Property Twins · 12th Jul, 2015

Great post @spludgey and @hotmail

eng · 12th Jul, 2015

Thanks for sharing

Kael · 13th Jul, 2015

Great post and discussion, thanks for sharing!

Chilliblue · 13th Jul, 2015

Great read and thank you for sharing

trinity168 · 13th Jul, 2015

spludgey said: ↑

Out of ten sets of tenants over ten years, I've had to take two to tribunal.
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How was your experience with the tribunal?
Cost?
Time?

Thanks.

spludgey · 13th Jul, 2015

trinity168 said: ↑

How was your experience with the tribunal?
Cost?
Time?

Thanks.
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I'd say I lost somewhere between $1000 and $2000 each time. So certainly annoying, but in no way a deal breaker for investing.

2FAST4U · 13th Jul, 2015

I'm following a similar strategy mainly due to serviceability.
With APRA cracking down on lending many people are saying that serviceability is going to be crucial in the future. I think you’ve got a pretty good strategy going for yield since it’s enabled you to acquire 9 properties. If you focused more on capital growth your serviceability may have run out at 3-4 properties depending on income etc. so the opportunity cost is another factor to consider.

ross100 · 13th Jul, 2015

Good read thanks for sharing

jins13 · 19th Jul, 2015

spludgey said: ↑

I've only had investment properties in Elizabeth for just under a year, so I've got limited experience with tenants there, but I've had investment properties in comparable areas in NSW and QLD for over five years now, so I'll comment from that perspective.
Out of ten sets of tenants over tenfive years, I've had to take two to tribunal.
Personally, I don't feel that's a huge number for roughly 25 years of rental years, but it's obviously not zero either.
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Thats pretty good track record. For myself I am so time poor that I cant really take time off work to go to tribunals so often, so didnt really consider low socio areas too much.

D.T. · 19th Jul, 2015

jins13 said: ↑

Thats pretty good track record. For myself I am so time poor that I cant really take time off work to go to tribunals so often, so didnt really consider low socio areas too much.
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Use a property manager then?

HUGH72 · 19th Jul, 2015

jins13 said: ↑

Thats pretty good track record. For myself I am so time poor that I cant really take time off work to go to tribunals so often, so didnt really consider low socio areas too much.
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You can find yourself in that situation with any tenants. Unfortunately higher weekly rent is no guarantee. I have never attended, only the pm.

trinity168 · 19th Jul, 2015

HUGH72 said: ↑

You can find yourself in that situation with any tenants. Unfortunately higher weekly rent is no guarantee. I have never attended, only the pm.
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Is my understanding correct that the PM charges extra for each appearance?

Thanks!

HUGH72 · 19th Jul, 2015

trinity168 said: ↑

Is my understanding correct that the PM charges extra for each appearance?

Thanks!
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Yes, normally an hourly rate in your management agreement, not that an appearance generally takes very long.

C-mac · 19th Jul, 2015

Great read mate! Anyone had any experience holding property in the low socio-economic suburbs of Hobart, by any chance?

Kael · 19th Jul, 2015

HUGH72 said: ↑

Yes, normally an hourly rate in your management agreement, not that an appearance generally takes very long.
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Had an issue with my tenant being behind in rent by about 6 weeks in my VIC IP, my PM charged me a flat rate to attend tribunal. Was a fair amount, imo though.

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