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Property investors are justifiably nervous in this market. Higher interest rates, the credit crunch and an uncertain economic outlook make shopping for property a more daunting task. However, some experts argue that there are still hot spots for property – it’s just a matter of knowing where to look.

Inner city residential property remains a choice pick for potential capital growth and rising rents. And inner urban property close to water also tops the sought-after list for homebuyers, investors and renters in capital cities.

Property on the outer fringes of capital cities along the eastern seaboard, however, will struggle in terms of capital growth and rental price increases, experts say.

Commercial property posted bumper returns for the 12 months to March 2008 on the back of low vacancy and unemployment rates. But the outlook is more subdued going forward (but more on this later).

Capital growth and rental increases are very much driven by supply and demand. Notably, declining loan funding (on the demand side) and a shortage of stock (on the supply side).

The consensus among property analysts is that buying a detached house with land, within 10km ring of a capital city is a premium long-term investment – both for capital growth and rental increases. Demand for inner city property exceeds supply and the imbalance is unlikely to correct anytime soon given the nation’s population growth. About 176,000 migrants arrived in Australia last year and a further 200,000 people are expected this year.

Tim Lawless, a director of property research firm RP Data, says buying inner city property means buying an asset in demand and this ongoing demand will push prices up over the long term. He says Brisbane, Melbourne, Adelaide and Sydney top his list of capital growth prospects, mostly based on population growth and accompanying strategic plans.

Lawless says Adelaide’s residential capital growth will be primarily driven by a stronger resources sector rather than migrant population growth. Adelaide is still the most affordable capital city despite median house values rising by 18.7 per cent and units skyrocketing 26.2 per cent for the 12 months to May 31, 2008. Lawless says between June 2007 and May 2008, Brisbane’s median house values rose 13.3 per cent and units were up 14.4 per cent. Melbourne median house values jumped 10.6 per cent and units were marginally higher on 11.8 per cent. Sydney’s median house values rose 3.2 per cent and units a more modest 2.1 per cent. But Lawless warned that capital growth had since slowed and he expected flat to modest growth for the next 12 months.

The Lawless view on slowing capital growth is supported by an Australian Property Monitors report released on July 31 that shows median house prices fell in five of Australia’s eight capital cities in the three months to June 30, 2008. But short-term findings need to be kept in perspective as another report by the Real Estate Institute of Victoria showed that Melbourne median house prices posted modest growth in the June quarter after declining in the March quarter.

In terms of rental yields, Darwin tops the list with houses returning 6 per cent and units 6.1 per cent. Canberra is next with a 5 per cent return on houses and 5.9 per cent for units. Lawless says Canberra and Darwin investors benefit from low vacancy rates and a high transient rental population.

Sydney returned investors 4.3 per cent on houses and 5.3 per cent on units. Melbourne posted a 4.1 per cent return for houses and 4.6 per cent for units. Lawless says the rental supply shortage close to capital cities is pushing up rents, and properties close to public transport, shops and schools will offer the best returns in the future. Lawless says any cut in interest rates will boost confidence in the property market and lift capital growth over the longer term.

According to property consultant Monique Wakelin, a director of Wakelin Property Advisory, good quality residential property in sought-after suburbs generally doubles every seven to 10 years. She says the higher interest rate and living expenses environment are slowing capital growth and this provides good buying opportunities for those “who do not over-borrow and possess realistic expectations”.

Wakelin says Victorian, Edwardian and Art Deco houses built between 1880 and 1940 will boost long-term capital growth in response to demand. There is also a limited supply of apartments built between the 1930 and 1970 and this is another driver of capital growth.

“Scarcity value is king for capital growth,” she says. ” A finite supply is the name of the game for making money out of property.” Wakelin prefers inner city houses, units and apartments to vacant land, as land is not an income-producing asset and offers no tax relief. She says regional areas likely to offer the strongest capital growth and rental returns are the bigger centres experiencing population growth and offering a diversified economy and workforce.

The Housing Industry Association expects property investors to continue benefiting from a shortage of rental stock boosted by a building shortfall and over-stretched borrowers forced to sell their homes. Ben Phillips, HIA assistant director of industry and policy, says about 150,000 residential dwellings are built across Australia each year, but 190,000 are needed to keep pace with population growth.

Phillips says the higher interest rate environment is a disincentive for investors to build more stock. He says a rental return of between 5 and 6 per cent lags the 7-to-8 per cent investors can comfortably get from a bank without having to take the risk involved with building, general maintenance, body corporate issues and bad tenants.

He also subscribes to buying inner city property, whether to live in or let. But choosing one inner city suburb to out-perform a similar one for capital growth is guess work as statistics can vary greatly from month-to-month. An exorbitant price for one property can lift the averages of others in the same suburb.

Building approvals, released on July 30, show a 0.7 per cent decline in June on top of a 7.2 per cent fall in May. Despite this, Craig James, of CommSec, says excess housing stock for buying or renting exists on the outskirts of Melbourne, Sydney and, to a lesser degree, Brisbane because demand is soft. Buyers and renters want to live close to infrastructure and the CBD to reduce their reliance on cars guzzling higher priced fuel.

Real estate company Knight Frank says commercial property investors in Perth and Brisbane enjoyed bumper returns averaging 42 per cent and 34 per cent respectively, made up of a combination of capital growth and income, for the year ending to March 2008. Knight Frank associate director Richard Jenkins says low vacancy rates combined with a mining boom in these two states drove exceptional returns.

Commercial investors in Melbourne and Sydney enjoyed returns averaging 21 per cent and 20 per cent respectively. Melbourne also outperformed Canberra and Adelaide. According to Knight Frank, Melbourne office in the 12 months to March 2008 also outperformed Victorian retail and Melbourne industrial, which recorded returns of 14.9 per cent and 12.3 per cent respectively. Jenkins paints a more subdued outlook for the commercial sector going forward in response to tightening credit and contracting employment in Melbourne and Sydney.