How many properties to buy

Long-term growth is the secret to making the best buying decisions

Over the years, many people have asked me about buying property. “Should I buy one expensive property or two or more less expensive properties?” It’s a difficult question that requires quite a lot of analysis to make the right decision. But I can help provide the steps of analysis an investor should take when considering what to do.

I spent almost seven years as a stock analyst, early in my career, at the Chicago-based research firm Morningstar, working out of its Sydney office and covering a range of stockmarket-listed companies. It was a humbling experience and one that, in hindsight, was the best training ground for building an investment framework, which I have used in my career ever since.

A stock analyst studies different companies

throughout the day and writes up their research to help people decide where to invest. These are typically large companies listed on the stockmarket. This means we have the ability to look through their public accounts and periodic filings to find patterns and trends.

This is a great place for any investor to start. If you’re not into stocks, pick a couple of companies you engage with as a customer – for example, if you buy groceries from Woolworths, it’s a good habit every now and then to gloss over its financials and see what’s happening in its business.

After studying hundreds of companies, reading thousands of investment reports and speaking to some of Australia’s most well-regarded chief executives, I learnt two very important lessons over those seven years:

1. How to think about investment returns; and

2. Patience is the most important investment virtue of them all.

Returns in context

There’s a big difference between people who give advice and those who invest money into the market for a living. The sideline critic will tell you a whole bunch of things they’ve learned or heard. But the person investing in the market, taking hits and making wins, will always give you a different picture from the experience of doing the real thing.

Battle scars are important. Skin in the game counts. This is the difference between learning about investing at university from a lecturer or learning in the markets, alongside traders with grey hair. One of the biggest eye-openers for me was in the way money managers, particularly those investing in stocks, think about income generation and long-term returns.

Money managers are in the business of managing other people’s money. It comes with a big obligation. If you underperform, it’s hard to stay in the market. Watching money managers is a good way to quickly validate what works and what doesn’t.

So let’s drill into the numbers and the psychology of investing. Most ordinary investors think a 5% yield is better than a 4% yield, thus they are lured into the 5% investment over the 4% investment. But this is only one dimension and often a trap.

Don’t be a sucker. There are other dimensions to consider. The income you generate from an investment expressed in percentage per year needs to be tested against two other variables: its quality and its ability to grow.

The highest-quality investments are often those with the lowest returns relative to peers.

Lending money to the Australian government will give you a lower return than lending money to a stranger at the casino looking for a quick loan. Buying a house in Vaucluse or Toorak will give you a lower rental return than a house in a regional city with a tiny population. The reason is risk and quality. The higher the quality, the lower the return and vice versa.

Banks generally pay less interest on term deposits than peer-to-peer lending sites or other types of innovators because there is more demand for deposits at the bank. They don’t need to compete like the innovator does.

Commonwealth Bank doesn’t need to convince you of its creditworthiness. The new kid on the block does.

So, keep in mind that a higher return is usually a trap when you compromise quality. Diamonds are always more expensive than crystals, gold is more expensive than silver and Bitcoin is worth more than Dogecoin because of inherent demand and supply principles.

Check the numbers

The second variable is income growth. Often a 4% yield is better than a 5% yield if it can grow faster and cheaper over the long term.

Income growth is more important than today’s income return. It’s the future that matters. This is what many investors don’t understand and a lesson I learnt from a colleague who spent 20 years investing in small companies, often in their infancy, before they became big household names.

Let’s use a simple example of two investments making 4%pa and 5%pa on an initial $100,000. One gives you $4000 and the other $5000. Sounds pretty straightforward. But assume we’re talking about real estate. Also assume that the one giving you $4000pa has the ability to grow its earnings by 20%pa because it is in a desirable location, near the ocean and handy to transport, schools, amenities and recreation facilities.

The one that gives you $5000 will only grow its earnings by 10% because it is in a new area where there will be more supply for many more years.

In 10 years, the $4000pa investment return would have grown to $24,766pa while the $5000pa investment would have grown to $12,968pa. They’ve both done exceptionally well; but the return of the lower-starting investment is now double the return of the higher-starting amount.

The lesson here is this: it’s not what yield you get today, but what you earn over the future of the investment

Income growth is more important than today’s income return. It’s the future that matters.

and how this grows. Income from investments is about quality, reliability and growth over a long-term horizon.

Don’t be fooled

Tesla has a market value of around $US600 billion/$777 billion (as at the time of writing) and it makes around 500,000 cars a year. Ford, the oldest car maker in the world, is worth around $US50 billion and makes 1.2 million cars a year.

Why is Tesla 12 times more expensive than Ford when it makes half the number of cars? Because the market thinks Tesla’s earnings have a higher rate of growth than Ford and is pricing that growth over the long term.

I actually think Ford is good value, but I’m blind to the fact that Ford is mature while Tesla is the future. I don’t assume people buying Tesla are stupid or naive.

And even if this is perception and reality, it’s what the market trades on. Even in property, there is not always an easy and definitive answer to why a certain area outperforms another. It’s easier when one is close to a beach or has water views, but to an outsider the market valuations are sometimes hard to understand.

When property investors are often making the decision on the yields alone, perhaps it’s because they are looking at it for short-term gains. The capital return may take longer to be realised (it used to be that property would double every seven years; now in many areas it is closer to 10 years).

Often, however, in my experience, the people buying the lower 4%pa return are smarter and more experienced than those buying the higher 5%pa return. They have calculated the overall returns on their investment and are making a savvy long-term decision.

So, before you make the decision on property – whether to buy one or many, or in one area or another – do your research fully.

Don’t get fooled into buying a higher percentage return thinking that you can outsmart the market, especially in sophisticated markets like stocks and real estate. We call this being penny wise but pound foolish.

Bottom line

My key takeaway from this is for you to focus on buying a good-quality investment with a higher rate of growth and putting into place a patient and strategic plan that will see you reap rewards over many years.

The 19th century British art critic and social thinker John Ruskin put it this way:

“It’s unwise to pay too much, but it’s worse to pay too little. When you pay too much, you lose a little money – that’s all. When you pay too little, you sometimes lose everything, because the thing you bought was incapable of doing the thing it was bought to do. The common law of business balance prohibits paying a little and getting a lot – it can’t be done. If you deal with the lowest bidder, it is well to add something for the risk you run, and if you do that you will have enough to pay for something better.”