What makes an “investment grade” property?

There are around 9.6 million dwellings in Australia and at any time there are about 250,000 properties for sale.

But not all properties make good investments! In fact, in my mind less than 2% of the properties on the market currently are what I call “investment grade.”

Of course, any property can become an investment property. Just move the owner out, put in a tenant and it’s an investment, but that doesn't make it “investment grade”.

Also read: Overheated Sydney market is at risk of a housing bubble

To help you understand what I consider an investment grade property, let's first look at the characteristics of a great investment, and then let's see what type of properties fit these criteria.

What makes a good investment?

The things I look for in any investment (including property) are:

• strong, stable rates of capital appreciation;

• steady cash flow;

• liquidity - the ability to take my money out by either selling or borrowing against my investment;

• easy management;

• a hedge against inflation; and

• good tax benefits.
  

So how do you make money from an investment?

Well…property investors make their money in four ways:

1. Capital growth – as the property appreciates in value over time

2. Rental returns – the cash flow you get from your tenant

3. Accelerated or forced growth – this is capital growth you “manufacture” by adding value through renovations or development, and

4. Tax benefits – things like negative gearing or depreciation allowances.

In my mind capital growth is the most important factor of all, although not everyone agrees with me.

But, let’s face it…statistics show that most property investors fail. They never achieve the financial freedom they aspire to and this is, in part, due to the fact that they follow the wrong strategy – many chase cash flow. Now don’t misunderstand me, cash flow is the ultimate aim goal – but only once you’ve built a sufficiently large asset base of “investment grade” properties, meaning your investment journey will comprise three stages:

1. The Accumulation Stage – when build your asset base (net worth) through capital growth of well-located properties. You can speed up your wealth accumulation through leverage, compounding, time and “manufacturing” capital growth through renovations or development. You then move on to the…

2. Transition Stage – once you have a sufficiently large asset base you slowly lower your loan to value ratios so you can progress to the…

3. Cash Flow Stage – when you can live off your property portfolio.
   

Also read: Surging house prices are locking Sydney families out the market

The safest way through this journey, which will obviously take a number of property cycles, is to ensure you only buy properties that will outperform the market averages with regards to capital growth. To facilitate this, I use a 5 Stranded Strategic Approach.

1. I would only buy a property that appeals to owner occupiers. Not that I plan to sell my property, but because owner occupiers will buy similar properties pushing up local real estate values. This will be particularly important in the current stage of the property cycle as the percentage of investors in the market is likely to diminish.

2. I would buy this property below its intrinsic value – that’s why I avoid new and off the plan properties which come at a premium price.

3. In a location that has a long history of strong capital growth and that will continue to outperform the averages because of the demographics in the area. This will be an area where more owner occupiers will want to live because of lifestyle choices and one where the locals will be prepared to, and can afford to, pay a premium price to live because they have higher disposable incomes. In general, these are the more affluent inner and middle ring suburbs of our big capital cities

4. I would look for a property with a twist – something unique, special, different or scarce about the property, and finally…

5. I would buy a property where I can manufacture capital growth through refurbishment, renovations or redevelopment rather than waiting for the market to deliver me capital growth.
   

Not all properties are “investment grade.”

O.K. back to my comment that less than 2% of properties on the market are investment grade.

While there are a lot of properties built specifically built for the investor market – think the many high rise new developments that are littering our cities - most of these are not “investment grade.”

Some would call these properties “investment stock” – they are what the property marketers and developers sell in bulk to naïve investors, but they are not “investment grade” because they have little owner occupier appeal, they lack scarcity, they are usually bought at a premium and there is no opportunity to add value.

Also read: Things real estate agents must tell you when buying a property

On the other hand, investment grade properties:

• Have to a wide range of affluent owner occupiers

• Are in the right location. By this I don't just mean the right suburb –one with multiple drivers of capital growth - but they’re a short walking distance to lifestyle amenities such as cafes, shops, restaurants and parks. And they’re close to public transport – a factor that will become more important in the future as our population grows, our roads become more congested and people will want to reduce commuting time.

• Have street appeal as well as a favourable aspect or good views.

• Offer security - by being located in the right suburbs as well as having security features such as gates, intercoms and alarms.

• Offer secure off street car parking.

• Have the potential to add value through renovations.

• Have a high land to asset ratio - this is different to a large amount of land. I'd rather own a sixth of a block of land under my apartment building in a good inner suburb, than a large block of land in regional Australia.
  

The bottom line is buying the right ‘investment grade’ property is all about following a proven blueprint that successful investors follow. This increases your chance of better financial returns and reduce your risks of getting caught out as our property markets move into the next, less buoyant stage of the property cycle.

Michael Yardney is a director of

Metropole Property Strategists, which creates wealth for its clients through independent, unbiased property advice and advocacy. He is a best-selling author, one of Australia’s leading experts in wealth creation through property and writes the Property Update blog.