A few weeks ago Stephen met up with a friend for a quick catch up. While they were chatting, Stephen’s friend brought up an investment he was looking to purchase in Cockle Bay. An off the plan apartment selling for $1.2 million. Sound like a good deal to you? It didn’t to Stephen.
This story starts off with Stephen’s friend. Being a successful solicitor, he is no fool and he is certainly not strapped for cash. Wanting to expand his investment portfolio, he thought he’d run the Cockle Bay investment by Stephen. As he went over the details, Stephen became more and more concerned, and even more skeptical of how good a deal this really was.
So Stephen put the question to him, ‘What makes you think this is a good investment to have?’
Location, location, location.
It might seem logical to you, after all, location is almost always given as the best way to determine if a house or apartment is a good investment, and Cockle Bay is a nice area if you can afford it. But is this the only factor to consider? Smart investors don’t just look at what makes a good investment, they also look at when the best time to invest is. Warren Buffett says, ‘When everyone else is brave, be fearful’, and we agree. Even if Stephen’s friend knew nothing about the property market, he did know that there were only 300 apartments in the complex, but 2100 people registered as interested to buy.
As a developer, if you have 300 units and 2100 people interested in buying, wouldn’t you push up the price? Now does that sound like the top of the market, or the bottom?
Stephen’s friend believed that the location alone was enough to make the investment worth it. But thinking completely economically, surely this couldn’t be the best use of $1.2 million. By buying in a boom, the price for the apartment is already at its peak, there really isn’t a lot more room to grow, other than inflation that is. It would make much more sense to purchase two $600,000 properties during a slump, but instead of doing this he committed himself to purchasing at the top of the market.
There is a little known phrase, ‘market hysteria’ that relates to how people react to news on investment markets going up and down. When the market goes up and up, every fool with a website and a keyboard goes crazy announcing that now is the time to buy! But realistically at that point the best time has passed. Reactions from this are almost always emotional, misinformation becomes widespread and suddenly everybody wants to buy a property when they are at their most expensive!
Let’s now just assume that Stephen’s friend buys the apartment. He locks himself in off the plan at $1.2 million. Now fast forward a year or so and the apartments are all up and ready for tenants. Stephen’s friend receives a valuation of his new apartment – $800,000.
The market was at its peak, so the apartment was only worth $800,000 but he paid $1.2 million, having been caught up in the hysteria. Now he needs to get a loan to cover the cost of the $1.2 million he locked himself in at, but the bank will only provide 80% of the valuation price. So he might be able to get a loan of $640,000, but what about the other $560,000 he owes to the developer? Suddenly he needs to find that extra cash, and quickly.
What happens if he can’t?
He sells the apartment to recover the cost of course! This is known as a distress sale, where money is needed quickly to cover the cost of something. In this case, the cost of the apartment is too high, so it must be sold to recoup on the $400,000 loss he has from buying off the plan. A smarter investor would pounce in at this point and buy the property from him at a much lower price.
Ultimately, the location of the property mattered very little in comparison to the peak market conditions and their impact on the amount paid for the property compared to its true value.
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