Buying ‘below market value’: What it really means

Think about the people you know who have bought investment properties. Chances are that at least one of them claims to have bought their property ‘below market value’.

Strictly speaking, it’s impossible to buy below market value, because a property’s market value is ultimately determined by one thing: the price you pay for it. When someone says they’ve bought below market value, what they really mean is that they purchased the asset for a lower price than other properties in the area, or that they bought it at a lower price than would have been possible six or 12 months previously.

Let’s take the first scenario. If you buy a property for less than others in the area are worth, that doesn’t mean you’ve secured a bargain. It may just mean you’ve bought a second-class asset. For example, if other properties in the area have sold for around $450,000, but you buy one for $400,000, perhaps its value has been compromised by a poor structural condition or noisy main road location.

Under the second scenario, buying a property for less than it would previously have been worth doesn’t necessarily mean that you have bought well. It could simply mean that property values in the area are declining. There are two possible reasons for this. First, there’s less demand than supply. In this situation, vendors are competing strongly for the attention of fewer buyers, so they’re more likely to discount their asking price.

If you buy into a market like this, it’s vital to ask yourself two questions: how much more will prices fall, and how long will it be until the trend reverses? In other words, how much money will you have to lose, and for how long, until your asset starts working for you?

The second possible reason for buying a property for less than its previous market value is that the asset has a low land-to-asset ratio – in other words, the building makes up the bulk of the asset’s value.

Land appreciates (grows) in value, whilst buildings depreciate. If you buy a property for less than its original sale value, chances are that the building’s value is falling faster than the land’s value is growing.

The net result? An asset that will continue to lose value after you’ve purchased it, until all the depreciation has been used up. Meanwhile, you’re paying holding costs like interest, rates and maintenance, on a property that’s delivering nothing in return.

Instead of buying property that is cheap and will remain so because of poor location or high depreciation, focus instead on researching the market to identify properties that represent good investment value.

What does this mean?

First, it refers to the quality of the asset. Properties in established areas with adequate infrastructure like public transport, shopping precincts and leisure facilities tend to have a limited supply of properties in the face of strong demand from investors, home buyers and tenants alike. This supply–demand ratio increases land value and improves capital growth potential.

Second, good investment value means researching the local market to find out the recent sale prices for properties of comparable land size, number of bedrooms and degree of renovation. Once you have determined what you believe is the property’s fair value as an investment asset, stick to that limit and walk away if the bidding or negotiation goes beyond it. Overpaying never represents good investment value, no matter how high the asset’s quality.

It’s true that high quality assets generally cost more than poor ones, so if your research shows that you may be priced out of a certain type of property, it’s better to compromise on the size of the accommodation (e.g. two bedrooms instead of three) rather than the location.

Mark Armstrong is a director of iProperty Plan, which provides independent analysis and tailored advice to investors and home buyers.