Episode Details

The price you pay for an investment property will only matter if you purchase the wrong asset. An investment grade asset will, in the long run, mask any purchase price errors that you may have made. That is why focusing on the quality of the asset is easily the most important thing you must do when investing in property. Simple math proves timing the market or buying below fair value is relatively meaningless.

Purchasing above or below intrinsic value

Let’s face it. We all want to get the best deal we can, and no one wants to pay any more for a property than they have to. It is my guess that the desire to buy well is driven mainly by two things; ego and misinformation.

Most people feel stupid if they subsequently realise that they overpaid for an asset - and none of us like feeling stupid.

The misinformation problem is that most people think the price they pay for an asset will have an impact on its performance. But that is not true for investment grade assets.

Show me the numbers

Anyone that has followed my blogs for any length of time knows that I love to dive into the numbers. This topic is no different. My findings are summarised in the table below.

I compared the after-tax compounding returns resulting from investing in a $750,000 property, holding it for 20 years and then selling. I assumed that you borrowed the full cost of this acquisition (including stamp duty). The only cash you had to contribute to the investment is the holding costs i.e. the difference between the loan repayments and net rental income. I then calculated the internal rate of return - which essentially is your annual compounding investment return after tax.

I then varied two assumptions:

§ Whether the price you paid for the asset was above or below intrinsic value; and

§ The average capital growth rate over the 20-year holding period.

The reason the investment returns ranges (far right column) might seem high, particularly for higher growth scenarios, is because of the impact of gearing i.e. you achieve relatively large returns for minimal cash contributed towards the investment.

What did I find?

If you purchase a property that has very low growth prospects e.g. 3% p.a. over 20 years, the price you pay for that asset will have a big impact on your investment return. For example, if you purchase the asset for a price 10% below its intrinsic value (i.e. buy well), you improve your return by 75%. Whereas if you overpay by 10%, you reduce your return by 77%. But the important point is that the return range is relatively low i.e. between 1% and 7.5% p.a.

However, if you buy a high-quality asset that will deliver say 9% p.a. of capital growth on average over the next 20 years, it doesn’t really matter if you overpay. For example, if you pay 10% too much, your return reduces by 8% - but you still achieve a compound annual return of over 21% p.a., which isn’t anything to sneeze at.

This data shows that the best way to mitigate risk is to level up on quality.

Great property for a fair price

Adapting a quote attributed to Warren Buffett, I assert that “I would much prefer to buy a great property for a fair price than a fair property for a great price”. That’s because a high growth asset will mask any purchase price mistakes.

Buying well (or not) will only impact your investment returns for one year (it’s a one-off event). However, the quality of your asset will impact investment returns each and every year. As such, you will remember (or be reminded of) an asset's quality long after you have f