Everyone has heard the old cliche that the three keys to good property investment are "location, location and location". This is true to a certain extent, price trends clearly show that median prices rise at a generally faster rate than inflation in areas that are exceptionally well located due to their view or their central location, but this is not always the dominant factor.

Real estate does exhibit a strong cyclical pattern and capital losses can be severe for those that buy at the wrong time.

Leverage, common in real estate, only magnifies the losses you can make.

Areas that exhibit the highest volatility in prices tend to be the areas most beloved by real estate speculators. During a real estate boom prime property can make substantial price advances that are not grounded in reality.

Out in the suburbs values are relatively steady and price falls are mild, yet "hot" areas can fall substantially if they were not priced rationally during the previous boom.

You can approach real estate investment from two viewpoints: you can be a "growth" investor or a "value" investor. These definitions will be revisited in the portion of this FAQ devoted to shares but for those that already know the meaning of these categories the meaning is used in the same way here.

A "growth" property, just like a growth stock is one likely to give above average returns due to its exceptional characteristics. Such characteristics are exactly what you might expect when the property is very well located and good tenants can be found.

A "value" property offers superior rental yields and therefore a better ongoing return. This is the same as the common practice used by value investors in stocks that purchase stocks for their attractive dividend yields.

The pitfalls for each type of property are also the same as the pitfalls of growth and value investment in shares. Growth investors may find that they have paid too much for their property, exceptional characteristics notwithstanding and as a result will achieve lower investment returns in the future while the market tries to catch up with the inflated purchase price of the property.

Value investors may find that capital growth is slow because their investment has been made in something that is genuinely mediocre to the core. One has to wonder sometimes why some investments offer better yields initially than others, the reason is commonly that expected capital gains are minimal.

There are a number of factors that may retard capital growth. The first is obviously that when an investment is made at very high prices it takes time for inflation to catch up and restore affordability.

Another factor that harms capital growth is oversupply. In outer suburbs the supply of land frequently outstrips demand. As soon as prices look like they are going to rise a developer will be there with another development and a hundred new blocks. This tends to work against the effects of population growth because prices are able to rise most easily when supply is very limited compared to demand.

Oversupply can happen even in inner city areas, in particular with grouped dwellings. When demand for rental accommodation picks up in a city area many developers will move in and demolish older buildings to install higher density housing. Human nature being what it is developers won't know when to stop and demand will often be more than sated by supply, leading to vacancies.

When there is a high rate of vacancies landlords will need to lower their rents in order to attract tenants. Low rental yields make property less attractive from an investment point of view and therefore prices won't be very good.

Property should always be viewed as a long term investment. Speculation on the near-term movement of prices is always a dangerous business as it depends on the application of the "greater fool theory". The greater fool concept means you are willing to pay a foolish price because you anticipate that an even greater fool will be along shortly to buy off you at a higher price.

You will not always be so fortunate as to have a greater fool lining up to buy from you right at the end of a boom so my suggestion would be to avoid that hope entirely. Transaction costs in real estate (particularly direct real estate) are very high and liquidity is low. Even if you do manage to pick the top of the boom you will lose a lot of your profit on the various fees and taxes that apply to real estate transactions and all of this will take time.

A poorly located property will generally have the most steady appreciation. Little speculative activity will drive prices and so cyclical effects will be slight. As a rule you can expect capital gains from these areas to be equal to the rate of inflation minus the rate of depreciation on the buildings.

When buildings are getting very old they may need replacement or alternatively very expensive ongoing maintenance. If rental income is low to start with and unlikely to improve by this refurbishment because the suburb in general is considered quite rough and rowdy this investment may not pay off.

There is no point building the best house on the street if the general character of the area will detract enormously from the value of the home. In such a case you may have to wait for many years before the area starts to improve either spontaneously or by a deliberate urban renewal program by the local government.

The risk of investing in poor quality areas is that your investment will have low appreciation, poor income and high costs for many years while you wait around for the area to improve. In general, unless you happen to know that an improvement program has just been announced or soon will be you may lose patience waiting for such a long time for your investment to get moving.

The property cycle, which as I have stated lasts approximately seven years on average has its most obvious effect on prices in "blue chip" areas. Prices may be bid up to unreasonable levels when things boom and then have sharp falls when rationality is restored.

Timing is very important in both up market areas and in less prestigious neighbourhoods. In the case of blue chip areas the secret is not to buy during property booms. In poorer neighbourhoods the time to buy is in the early stages of a renewal project when the area is just beginning its upgrade.

In both cases timing mistakes can be very costly. In one case you will soon face large capital losses, in the other you will have to wait for many years to make a profit - and even after many years nothing is assured. Whichever type of real estate you are going to invest in it is clear that there is more to it than simply buying a property in an area that has historically gone up a lot.

Charts stretching back over the last 40 years show an interesting trend in residential real estate prices. Although it is common for real estate exponents to talk of a 7 year cycle or a cycle going over some other number of years, there have been only two significant bull markets in property prices in all that time.

Graphing real returns (after inflation), the periods between 1969 and 1974, and 1985 and 1988 were the only periods of significant upward movement in prices with respect to inflation, the late 90s showed some gain against inflation, but nothing spectacular.

At other times the market has lagged inflation, often quite badly. The trend is upward, but the bull periods are short and sharp, followed by heavy losses immediately afterward, the market consolidates for several years until the next bull period.

Bullish signs for real estate include: (from Realistic Real Estate Investing by Austin Donnelly)

Improving local and world economy.
An increase in the corporate share in the Gross Domestic Product (GDP) leading to business expansion and greater demand for offices, shops and other property.
Improvements in productivity and technology leading to the same result.
Indications that relatively easy money policy will remain, so the market will not be hurt by interest rate rises and tight money.
The overall property market position is reasonable in relation to cyclical patterns, and the long-term trend of values in the past.
Individual property prices are also attractive on the same basis.
The relative cost of property is low, ie there is not a large difference between interest rates and rental yields.
There is no significant evidence that the above have already been included in market prices through the actions of speculators and over-enthusiastic buyers.
On the normal cyclical pattern, a cyclical slump does not appear to be due or overdue.
Relatively high inflation appears likely in the years ahead.
Supply locally is below demand. It is usually the case that very high demand precipitates a rush of building, leading to massive oversupply, demand alone is not enough!

Bearish signs generally are the reverse of the above circumstances.