Should you buy a CBD apartment?

CBD apartments have received some bad press of late, with risks of oversupply the primary concern shared by most analysts. However, a quick snapshot of median unit price growth in Australian CBDs provides further cause for alarm. While prices for houses and suburban apartments continue to rise across Australia, in our CBDs apartment prices have dropped – in some cases considerably – over the past 12 months.

Source: Corelogic

To say that all apartments located in Australian CBDs have the same investment metrics ignores the diversity of demand and market conditions. Not all apartments are of equal risk and despite the numbers, there are even some that may be worth considering.

What are the main concerns?

The unprecedented numbers of new apartments in our CBDs is the main area of concern. Never before has the country seen so much residential development in the inner city and there exists a reactionary fear of the unknown.

The sheer amount of development is eye watering. In Melbourne alone, there are over 18,000 apartments under construction and scheduled for completion within the next 18 months. Historically, Melbourne CBD has added 1500 apartments every 18 months for over a decade, so we're currently seeing numbers which are more than 10-fold on past trends.

In Brisbane, construction has started on over 10,000 apartments but, unlike Melbourne, Brisbane has a relatively low number of inner city apartments. A bigger challenge may well prove to be lifestyle related. People are simply less used to apartment living than their eastern seaboard counterparts in Sydney and Melbourne. 

Chart 2: Apartments under construction by CBD (November 2016)

Source: City of Melbourne Development Monitor, Corelogic, Colliers International

Dropping prices and the large pipeline of new developments are alarming enough, however we need to recognise that there are further challenges facing the CBD apartment market. There are three main risks that should be considered:

1. Default risk

The number of apartments which are being given lower valuations on completion than what purchasers initially paid for them is rising in some cities. While this is clearly not an ideal scenario, it is not a problem for many buyers. However, those who are marginal in terms of receiving bank lending may struggle if the apartment drops in value prior to settlement. We're not currently seeing many defaults, but if prices continue to drop across all CBDs it is possible that this will increase.

2. Occupational risk

CBD apartments are selling, so there is still a market for buyers, however the question is now who'll be living in these apartments. Such high levels of development will put pressure on rents and this is already happening in Brisbane and Perth CBDs. While declines in rents are not great for investors, a large increase in the vacancy rate is even worse; no tenant equals zero rent, and therefore no return on investment.

Source: Corelogic

1. Secondary market risk

Many CBD apartments are being purchased by offshore buyers, although the exact percentages are unknown. In Australia, offshore buyers are restricted to buying only new dwellings. Given the demand for CBD apartments appears to be higher with overseas buyers, there will potentially be a shortage of local buyers once these apartments are re-sold in years to come.

Are all apartments equal?

In the current climate caution is advised when looking to buy, however there are still a number of opportunities which could be considered:

1. Sydney CBD

Apartment prices in Sydney CBD are currently declining, however the longer-term outlook for this market is more positive than the rest of Australian CBDs. There's been far less development in wider Sydney and in the Sydney CBD over the long term. In addition, Sydney CBD has a far less aggressive pipeline and the stock being developed in Sydney is different to other markets, with far fewer student apartments and more high-end development. Sydney CBD is also seeing very strong white collar growth and strong demand from people wanting to live in, or close, to the CBD.

2. Unique apartments

Unique, older style apartments in CBDs can offer good opportunities, even in Melbourne with its enormous pipeline. For example, consider a low rise apartment block in one of Melbourne's laneways, or converted factory space. Another example could be a higher end development in a CBD populated primarily with apartments aimed at students. As is the case with real estate more generally, uniqueness is often sought after.

3. CBD markets in three to five years

A challenge for CBD markets right now is that there is still a large pipeline of new development, which will continue to put negative pressure on prices. Eventually the pipeline will clear and there will be growth in values, the challenge is picking the bottom of the market, and it's different for each city. My view is that Brisbane and Melbourne will take longest to resume capital growth in CBD apartments, while Sydney will pick up sooner.

4. Owner-occupiers

If you are looking to buy as an owner-occupier, CBD markets can offer benefits like close proximity to retail, workplaces and public transport. If you do want to live in a CBD, then there are certainly some good value apartments available. And, provided you are looking at a longer-term investment, you should be able to ride through the cycle. 

Nerida Conisbee is Chief Economist of REA Group.