The changing face of Sydney property (and two stocks with the pricing power to play it)

In 1827 private land holders were selling into a very weak Sydney property market. The Colony of NSW was in depression following a fall in wool prices. Borrowing money was difficult due to a bank liquidity crisis. Free land grants were still available, the Sydney population was a mere 10,000 and the average income was £46 pa ($92). William Charles Wentworth paid £1,500 ($3,000) at auction to buy Vaucluse House with its 145 acres.

Today the average Vaucluse block size is 614m² and sells for $9.1m. Wentworth’s landholding amounted to 956 Vaucluse blocks, so he was paying $3.14 per block. Yes, you read that right. Three dollars and fourteen cents instead of $9.1m.

Or to put it another way, if he had to pay today’s prices for his land, he would be paying about $8.7 billion instead of $3,000.

Converting this to an annual percentage increase makes it sound less impressive. Over the last 195 years the land value went up 8% pa. That’s a bit of a shock too. Those vast increases in value over 195 years were due to compound growth of only 8%.

But this was way better than wages growth over that period - it was 3.3% pa. And co-incidentally Sydney’s population growth has also been 3.3% pa.

So apart from land no longer being given away for free, what explains the long term outperformance of the property market? It’s a favourite conversation topic of Australians and readers will have their own views. There are many things that contribute: the impact of government regulations and taxes, building costs, access to credit, to name a few. But there are two things that trump all else. People numbers and wealth.

At the limit (as mathematicians say) if there were no people the land would be worth nothing. As people begin to populate the land they start to compete for the more desirable places. Sydney harbour front land is very desirable. 

Today 9,500 people live in Vaucluse. At that density it could have housed 95% of Sydney in 1827. Today it houses 0.14% of Sydney.

Land is a very clear example of an asset that is only worth what someone will pay for it. As desirable land becomes relatively scarce (through population growth) its price rises at an increasing rate due to unequal wealth distribution. When Vaucluse could accommodate half of Sydney, most people had enough wealth to buy a block. But once it could house only a fraction of a percent of Sydney, purchases become the preserve of the “top 1%”, who are disproportionately wealthy relative to the rest of the population, and who compete with each other for the blocks when they become available.

While this population and wealth effect is extreme in a Vaucluse, it also impacts the city more broadly, as a growing city changes both the absolute and relative amenity of its suburbs.

Ok, so we have established that so as long as our population is growing, and our wealth is rising, we should see land values increase faster than wages growth and population growth, other things being equal. Is there another way we can make money from this as investors? Well, yes.

In the days before the internet, the classified sections of Australian major daily newspapers were called “the rivers of gold” by investors. They were a reliable source of constantly growing revenues. When it came to advertising homes for sale those classifieds, and the display ads in local newspapers, were a mandatory expense for vendors to attract buyers.

They have now been replaced by an internet duopoly in Australia – realestate.com.au (ASX: REA) and Domain (ASX: DHG). But the same network effect applies. These are pretty much the only place buyers visit to discover properties because they know almost all the sellers will advertise there.

The average cost to vendors of an REA property listing is about $800, while the average value of dwellings in Australia (rather than just Vaucluse) is $721,000. So the on-line listing costs only 0.11% of the price, but it’s vital in maximising the sales result. It’s also a pretty small part of the average vendor’s $5,400 total marketing costs which include photography, floorplan, signage and brochures, but excluding the agent’s commission.

This provides enormous pricing power to REA and DHG. 

They can put their prices up and it will have very little effect on demand by vendors to advertise on their sites. The demand for their service is inelastic. Their price could rise from 0.11% to 0.13% of the home value and there would be very little fall, if any, in the volumes advertised.

But REA and DHG also benefit from the fact that property prices rise so reliably over time, too. Using that long term price growth of 8% as a guide, they could put their prices up by 8% per year, and still be that same 0.11% of the total.

Porter’s 5 Forces model is a great way of working out how competitive an industry is, and its implications for a business. Suffice to say, these two firms are in a very strong position to maximise their profit margins.

1. Competitive Rivalry is weak. It’s a duopoly.
2. Supplier Power is weak. Their “suppliers” are principally the staff required to manage the websites, and they can be easily replaced.
3. Buyer Power is weak. There are a very large number of vendors, but only two providers.
4. Threat of Substitution is low. Unless there is a revolutionary change in technology.
5. Threat of New Entrants is low. The industry is protected by scale economies and the network effect though this is the most real, if unlikely, near term threat.

It’s no wonder that even in the midst of a property market downturn they still trade at valuation multiples well above market. Despite being in a mature industry these businesses should be able to achieve well above-market earnings growth rates for years to come.

Benefit at every stage of a cycle 

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