Getting hot spots wrong

One publication investors should read upside down

The Housing Industry Association (HIA) publishes a report listing the top residential property markets around Australia which they call "Hot Spots". But they are not hot spots for investors. On the contrary, investors should probably avoid these locations.

What is a hot spot?

My definition of a hot spot for property investing is based on supply and demand. I want high demand and low supply:

      High demand relative to supply = capital growth oh-la-la

A hot spot is one in which demand exceeds supply by such a significant degree that there is tremendous pressure on prices to rise in the short term.

According to HIA hotspots are:

      "...areas which enjoy a combination of rapid population growth as well as high levels of residential building"

I love the use of "enjoy" in that definition.

To the young investor these 2 definitions might seem like the same thing. But they are closer to being the complete opposite.

Table 1 shows HIA's "National top 20 building and population hotspots". I've also added an extra column on the right called, "DSR" - Demand to Supply Ratio. This is a score out of 100 reflecting how much demand exceeds supply.

Table 1 HIA's hot spots and their DSRs

Some investors might read that report and assume these are good investment locations. But these are not hot spots for future capital growth. Some of these markets (not all) are actually terrible investment locations.

Investors should be careful to read these reports upside down. You need to know who HIA is and then you'll understand why they call these locations hot-spots.

About HIA

HIA are not evil, not to everyone anyway. They do serve a useful purpose.

They have an excellent page on their website declaring their purpose, vision, history, structure, initiatives and more. At least they're relatively transparent.

However, HIA represent builders. That's builders of property. Building creates extra supply which helps to keep prices down.

For us evil property investors, we want low supply. We want to target locations in which everything is pointing towards high capital growth.

So HIA actually support our enemies - developers. Their idea of a hot spot should be an investor's idea of a not-spot.

What's wrong with residential building?

Oversupply is the worst thing that can happen to a location in terms of capital growth potential. And there's very little you can do about it after you've bought. Your only option might be to sell.

Investors need to make sure they don't buy into oversupplied areas. Recognising the characteristics of an oversupplied area is not that hard. The percentage of stock on market (SOM%) for example is a great indicator and freely available.

But investors also need to monitor areas they've already bought in, to make sure oversupply isn't on its way. If so, they can at least sell before things get ugly. Monitoring regional markets is especially important since their prices movements are so volatile.

Keep in mind that every new property built represents a pin-prick in the capital growth potential for that area.

What's wrong with population growth?

I wrote an article on this topic for YIP magazine called, "The great population growth myth". It was published in April 2015 and was 5,000 words. I know, right? So to summarise...

Population growth often indicates higher supply NOT higher demand of property. Many property professionals get this round the wrong way.

Those locations in which population growth is impossible are the ones in which supply is the most constrained. These have much better capital growth potential.

The greatest population growth that indicates the possibility of oversupply is the kind that occurs with heavy developer activity.

New housing estates are a classic example. They are also usually the furthest distance from the CBD where land supply is plentiful and infrastructure and amenities threadbare.

But even CBD locations can be tarnished with high developer activity - in the unit market. Just remember that population growth at a micro level, like suburbs, is not an indicator of increasing demand, but increasing supply.

Two sides of the equation

Note that supply is not the only side of the equation - demand is equally important. Developers have a tendency to focus on demand more so than supply. Although they may get the supply side wrong, they can often find areas with decent demand.

So some of the markets mentioned in HIA's report will not have the lowest demand to supply ratios (DSR). In fact, the average DSR was 56 which was the median DSR for Australia at the end of April 2016. In other words, the average HIA "hot spot" was really just an "ordinary" spot.

The highest DSR in HIA's report was 69 - for the Melbourne CBD. Some of the markets in the HIA report had a DSR less than 40. This is in the bottom quartile or "red" area of the graphic above.

There were over 1,000 property markets around Australia with a DSR of 73 or higher. In other words, there are literally tens of thousands of better investment locations than the ones appearing in HIA's report.

DSR vs HIA

Table 2 shows the top 20 investment markets in Australia by DSR as at the end of April 2016.

Table 2 - High DSR locations

Gauging performance

Note that new properties are more expensive than old ones. Developers never build old properties. So where there is heavy developer activity, the median climbs.

But this is not capital growth. It's median growth - not the same thing. If you're ever to find a market with negative capital growth but rising medians, it's one with heavy developer activity.

So don't come pointing your finger at me 12 months from now saying I was wrong. Capital growth is not accurately measured in markets with heavy building using medians.

Who loves HIA?

Obviously HIA is a good thing for developers and their builders. And the more development, the more supply which keeps a lid on prices. So, first home buyers might respect them.

The report might also come in handy for real estate agents selling developer stock. In fact, the marketing arm of many a developer jump on these sorts of reports.

I've even noticed one award winning buyers agent in QLD referring to this report as a plus to invest in some of these locations. Hmm.

Not all buyers agents are created equal. Before enlisting their help, check if they understand the concept of supply and demand. Most buyers agents I know totally get it. In fact, a lot of DSR Data members are buyers agents.

Conclusion

Sure it all comes down to supply and demand. But how you interpret the statistics to come up with a demand to supply ratio (DSR) is crucial. Far from being top spots, heavy developer activity actually creates "bot-spots".

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