6 Things property investors need to know about capital appreciation

Any property investor who has been in the game for some time will tell you that the big money in property investment comes from capital appreciation. The rental income or yield is peanuts in comparison. 

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The typical buyer will usually look at a basket of factors that can increase a property’s potential for appreciation. This would include:

• Price/affordability
• Location
• Infrastructure
• Facilities and amenities
• Build quality

These factors do play an important role in capital appreciation but to really appreciate and look at them meaningfully, you need to understand price appreciation on a macro level. Understanding them will give you the confidence to make better choices when investing in property.

#1 Inflation could be your best friend

The vast majority of economies in the world are inflationary by nature. Governments target a certain degree of inflation; for example, the Federal Reserve System’s yearly inflation target is 2% and it is more or less the same for the rest of the world. This isn’t exact science, so some governments fall short of or exceed their inflation target.

Inflation is good because it encourages spending and it makes long-term debt attractive. As a property investor, your RM1,000,000 mortgage for a 30-year period is the equivalent of borrowing only RM350,000 when adjusted for a 3.56% inflation rate. That is a huge discount when you factor in inflation!

Malaysia has averaged an inflation rate of 3.56% from 1973 to 2019. If your property price has increased in tandem with inflation, a house bought in 1973 for RM100,000 would be worth nearly RM500,000 today. In effect, your wealth has not been eroded by inflation.

Inflation drives property prices up and very importantly, it makes long-term mortgage attractive.

#2 Price has to be proportionate to wages

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One reason why property appreciation will never shoot through the sky forever is because it is anchored to wages in the economy. If wages do not increase, property prices would have a difficult time going up because there would be no buyers.

Yes, housing is an essential good in the economy. Everyone needs a house and businesses need commercial property to conduct business in. However, there is only so much of a person’s income that can be spent on housing. One’s money is competing for other essential goods too, like food and clothing. An individual cannot spend 80% or 90% of his or her wages on housing and likewise, a business cannot afford the same on its premises.

Price is an efficient balance between demand and supply. While property prices will always increase in the long run, it cannot outpace wages. Malaysia’s income must grow or people will simply not be able to afford a property.

Let us put this into context. Say you are looking to purchase a property in either Location A or Location B.

Location A has good road infrastructure, is 15 minutes from the city, and attracts high-income earners. There are plenty of big MNCs nearby, international schools in the neighbourhood and the amenities cater suitably for local high-income earners and expatriates. The average price of an apartment here is RM1,000,000.

Location B also has good road infrastructure, there is an LRT station nearby but it is a good 1-hour drive from the city. There are no MNCs nearby and most of the jobs around the area pay under RM3,000 per month. There are good amenities within the neighbourhood but there are no malls and such nearby. The average apartment here is going for RM350,000.

Now, it would seem that Location B is affordable and therefore has good potential for capital appreciation right? Not necessarily. If the average household in Location A has an income of RM20,000 and the average household in Location B has an income of RM4,000 – Location A has a more equitable market which means properties are more affordable there and better appreciation can be expected.

#3 Economic growth is the engine that drives wages up

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It is clear that wages have to go up for property prices to increase. In general, wages do go up due to inflation but economic growth can fuel fantastic increases in the overall wealth of the nation.

Long-term economic growth is tied to productivity. In Malaysia for example, we are rich with natural resources. Combined with a stable government and growing population, it has helped the country enjoy very good economic growth. However, natural resources can only do so much. Enjoying the benefits of natural resources is in fact, economic rent.

Eventually, the productivity of the nation has to go up as well. People need to become more efficient at what they are doing. Innovation needs to be spurred. Without proportionate increases in productivity and innovation, the nation’s GDP per capita growth can stall over the long term.

Productivity and innovation are strongly tied to education and government policy. The education of an economy’s real resources – its people, is pivotal for continued economic growth. Government policy must encourage an educational system that values critical thinking. Its policies should help spark innovation. When productivity and innovation increase, per capita output increases and the economic pistons fire-up to drive the economy at a healthy pace forward. Higher wages become bearable and the property prices move up.

As a property investor, you should be monitoring economic growth along with your properties.

#4 Leverage magnifies appreciation

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I once had a client from India who was based in Singapore. He was cash rich and bought his properties in cash. He did not like mortgages or debt. Despite the possibility of sounding like the devil, I asked him if he would be willing to take some debt to finance his next property purchase.

“Why in the world would you advice that?” he asked me. I showed him a side-by-side comparison on his gains and he was amused. He did not buy a property through me, but his perspective on mortgages changed.

Let us assume you buy an apartment for RM500,000 and take a 90% loan on it. Jimmy, your friend, also buys an identical apartment with the same price but he buys it on cash. After 5 years, both properties appreciate to RM750,000. Do you both make the same return on investment (ROI)?

The answer is no. Your capital outlay was RM50,000 and after 5 years you make RM232,000 (I have factored in legal fees, SPA stamp duty, rent of RM2,000 per month, maintenance and taxes). Your ROI is therefore 464%.

Jimmy’s capital outlay was RM500,000. After 5 years Jimmy makes RM325,589 (I have factored in the same legal fees, SPA stamp duty, rent of RM2,000 per month, maintenance and taxes). Jimmy’s ROI is 65%.

In fact, if you did have RM500,000 like Jimmy, you could have put the excess RM450,000 in a REIT or Mutual Fund giving you a return of 5% per year and you would have made an additional RM100,000.

While leverage magnifies appreciation, it also does the same for losses. The repayments on a mortgage can suck cashflow, leaving you vulnerable if your income source disappears. That is why leverage carries risk and must be evaluated carefully.

#5 You cannot afford to ignore opportunity cost

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Using the same example above, let’s say you bought an apartment 5 years ago for RM500,000 with 90% margin of financing. It is now worth RM750,000. You can sell and make a capital gain of RM232,000. It is good money, so you find a buyer and sell it off.

You now have RM282,000 (including your down payment of RM50,000). What do you do with it? If you do nothing with this money, this money is now no longer growing with inflation, it, in fact, devalues every year. This is your opportunity cost.

If you use this money to buy a new property, the new property’s appreciation potential should exceed 8.44% per year (which is the performance of the property you sold). The rental yield should also be better. If this is not the case, you are actually worse off.

Even if the new property continues with the same 8.44% appreciation per year, you are still on the losing end because you have incurred additional transaction costs in the form of legal fees, stamp duty, and renovations to earn the same appreciation.

It is therefore better to hold on to your property if you do not have a better investment alternative. Selling just because your property has appreciated to your expectation is not always a good strategy.

#6 Land appreciates, not buildings

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Most of us forget this when we look at a property’s appreciation. Technically the house or building that sits on your land depreciates over time. It ages and is subject to wear and tear. A 30-year old house may require a lot of repairs.

Furthermore, the cost to build a 2-storey bungalow in Rawang is exactly as much if you were to build it in KLCC. There is no difference in the labour and capital inputs. However, 2 identical bungalows in Rawang and KLCC would be vastly different in price, mainly due to the disparity in land costs.

MORE: Supercharge your portfolio with land investment

It is land prices that appreciate, and with land prices appreciating at different levels across various locations within an economy, it results in economic rent. It is not exactly the same but think of economic rent as “unearned income”. Economic rent does not create wealth. It only transfers wealth from one party to another.

This contributes to property cycles. Booms and busts happen in the property market because of economic rent. In fact, there are some proponents of a tax system that are based on taxing land value instead of income and profits. The argument is that wealth is created by the increase in land value and that is what governments should tax. Such a system would keep land in a stable appreciation trajectory instead of being cyclical.

How does this affect you? The fact that land values create economic rent makes the market cyclical and there will be booms and busts. As an investor, these cycles need to be understood and should be a part of your outlook.

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