What Actually Decides Property Prices (It Is Not Supply and Demand)

Every property commentator in Australia will tell you the same thing: prices go up when demand exceeds supply, prices go down when supply exceeds demand. It sounds logical. It is also woefully incomplete. If supply and demand were the whole story, every property in every high-demand suburb would trade at the same price. They do not. Not even close.

Two houses on the same street in Narre Warren — same number of bedrooms, same age, both recently sold — can trade $80,000 apart. Same supply conditions. Same demand pool. Same interest rate environment. Same macro factors. Different prices.

Why? Because supply and demand set the range. They determine the general direction. But they do not determine the specific price of a specific property. That is determined by something more fundamental: the intrinsic value of the asset.

I spent the first decade of my career as an actuary, building valuation models for financial assets. When I moved into property strategy and co-founded Optima Real Estate, I brought that analytical framework with me. What I discovered is that most property investors never think about property the way institutional investors think about equities or bonds — in terms of intrinsic value versus market price 1.

This article is about what intrinsic value means in property, why it matters more than supply and demand, and how we use it to identify undervalued assets across our 350-plus transactions.

The four pillars of property value

When I assess a property's intrinsic value, I look at four components. Supply and demand is not one of them — it operates above these components, influencing the market price but not the underlying worth.

Pillar 1: Land value. This is the single most important driver of long-term property appreciation. Land is finite. In established suburbs within 40 kilometres of the Melbourne CBD, no new land is being created. Every block that exists today will exist in fifty years. The house on top of it will deteriorate, require maintenance, and eventually need replacement. The land will not 2.

At Optima, our core investment principle is that land value should comprise at least 80 per cent of the total property value. When you buy a property for $600,000 and the land is worth $500,000, you are paying $100,000 for the building — the depreciating component — and $500,000 for the appreciating component. That ratio is what drives sustainable capital growth.

When you buy an apartment for $600,000 in a tower with 200 units, your land component might be $30,000 — the tiny fraction of the total land parcel attributable to your unit. You are paying $570,000 for concrete and glass that depreciates every single year. This is why apartments in oversupplied corridors can fall in value even when the broader market is rising.

Pillar 2: Replacement cost. What would it cost to build this exact property from scratch today? This is the floor beneath the market price. If a house with land could be replicated for $550,000 (land at $400,000 plus construction at $150,000), then paying $700,000 in the open market means you are paying a $150,000 premium for location, scarcity, and convenience. That premium needs to be justified by the other pillars 3.

Pillar 3: Income yield. What rent does this property generate relative to its value? This is the cash flow return on your investment. It is the equivalent of a dividend yield in equity investing. A property generating $40,000 per year in rent on a $700,000 value delivers a 5.7 per cent gross yield. That yield tells you something fundamental about how the market values the property's income-producing capacity.

In Melbourne's southeast, where we focus our acquisition activity, we regularly achieve gross yields of 5 to 7 per cent through strategic renovation and tenant placement. The Hampton Park case study is a good example: $590,000 purchase price, $850 per week rent after renovation, delivering a 7.5 per cent gross yield 4.

Pillar 4: Location premium. This is the qualitative overlay. Proximity to transport, schools, employment centres, shopping, and healthcare. The things that make a location desirable to live in — and more importantly, desirable to rent. Location premium explains why two identical houses in two different suburbs trade at different prices. It is real. But it should be the last pillar you assess, not the first.

Why supply and demand fails as a framework

Supply and demand is a macro indicator. It tells you whether the overall market is heating or cooling. It does not tell you whether a specific property at a specific price is a good investment.

Consider this scenario. Melbourne's population grew by approximately 2.4 per cent in 2019 — the fastest growth rate of any major Australian city. Housing completions did not keep pace. By the supply-demand framework, every Melbourne property should have increased in value.

But they did not. Many apartments in Southbank, Docklands, and inner-city towers fell in value during this period. Oversupplied product types in oversupplied locations declined even as the overall market tightened. Because supply and demand operates differently at the macro level (city-wide population growth) versus the micro level (how many two-bedroom apartments exist within a 500-metre radius of this specific building) 5.

Conversely, some suburbs in Melbourne's outer west and southeast experienced price growth of 8 to 12 per cent during periods when the broader Melbourne market was flat. These suburbs had specific micro-level demand drivers — infrastructure projects, rezoning, major employer expansions — that the macro supply-demand narrative missed entirely.

The supply-demand framework also fails to distinguish between asset types. A three-bedroom house on 600 square metres of land in Hampton Park and a three-bedroom apartment in a 15-storey tower in Box Hill are both "Melbourne residential property." They respond to completely different supply and demand dynamics, attract completely different tenant and buyer profiles, and have completely different intrinsic values.

Relying on supply and demand to make investment decisions is like relying on the weather forecast for the entire state to decide whether to bring an umbrella to a specific suburb. It is directionally useful. It is practically insufficient 6.

How we value properties at Optima (the practical framework)

When we assess a property for a client, we build a valuation model that incorporates all four pillars. Here is a simplified version of what that looks like.

Step 1: Establish the land value. We check the council valuation for the site value (unimproved land value). We cross-reference this with recent vacant land sales in the same suburb. If the council values a 600-square-metre block at $420,000 and recent vacant land sales show $440,000 to $460,000 for similar blocks, we use the market evidence rather than the council figure.

Step 2: Estimate the improvement value. What is the building worth? For a standard three-bedroom brick veneer house built in the 1990s, the replacement cost is approximately $1,200 to $1,500 per square metre. A 120-square-metre house costs $144,000 to $180,000 to replace. But the existing building is not new — it has 25 years of depreciation. Applying a straight-line depreciation schedule (40-year effective life for a residential building under ATO rules), the building has roughly 37.5 per cent of its value remaining. So the improvement value is approximately $54,000 to $67,500 7.

Step 3: Calculate the intrinsic value. Land value ($440,000) plus improvement value ($60,000) equals $500,000 intrinsic value. If the property is listed at $580,000, the market is applying an $80,000 location and scarcity premium. Is that premium justified?

Step 4: Test the income yield. At $580,000, what rent does the market support? If comparable properties rent for $480 per week ($24,960 per year), the gross yield is 4.3 per cent — below what we consider acceptable for an investment grade property. But if we can renovate for $15,000 and increase the rent to $650 per week ($33,800 per year), the yield on total cost ($595,000) rises to 5.7 per cent. Now the numbers work.

This is the framework that drives every acquisition recommendation we make. It is not glamorous. It does not make for exciting dinner party conversation. But it has produced consistent, repeatable results across 350-plus transactions 8.

The land-to-price ratio (our most important metric)

Of all the metrics we track, the one that correlates most strongly with long-term capital growth is the land-to-price ratio: land value divided by purchase price.

Our historical data shows:

• Properties with a land-to-price ratio above 80 per cent have averaged 7 to 9 per cent annual capital growth over a five-year hold period.
• Properties with a ratio between 60 and 80 per cent have averaged 4 to 6 per cent.
• Properties with a ratio below 40 per cent (most apartments and units) have averaged 1 to 3 per cent, with some recording negative growth [9].

This is not surprising when you think about it from first principles. If 80 per cent of your purchase price is land, you are overwhelmingly invested in the appreciating component. If 80 per cent of your purchase price is building (as with apartments), you are overwhelmingly invested in the depreciating component.

The land-to-price ratio also explains why our focus on Melbourne's southeast and eastern suburbs consistently outperforms. In suburbs like Cranbourne, Hampton Park, and Narre Warren, a $600,000 house typically sits on a $480,000 to $500,000 block. The land-to-price ratio is 80 to 83 per cent. In inner-city apartment markets, the same $600,000 buys a unit with $50,000 to $100,000 of attributable land. The ratio is 8 to 17 per cent.

Same price. Completely different asset class. Completely different growth trajectory.

This is what I mean when I say supply and demand is not the answer. Two properties in the same city, at the same price, subject to the same broad supply and demand dynamics, will produce wildly different returns over a ten-year hold. The difference is not demand. The difference is intrinsic value.

When the market price diverges from intrinsic value (that is when you buy)

The best investment opportunities exist when the market price of a property drops below its intrinsic value. This happens during three scenarios:

Scenario 1: Distressed sales. The vendor is under financial pressure, going through a divorce, settling an estate, or relocating urgently. The property is priced to sell fast, not to maximise return. We see this regularly in our acquisition pipeline — roughly 15 to 20 per cent of the properties we purchase involve some form of vendor distress 10.

The Boronia case is a good example from our portfolio. We identified an off-market property on a 730-square-metre block listed at $660,000. The land alone was worth approximately $550,000 based on vacant land comparables. The building was functionally distressed (significant maintenance backlog), which scared away most buyers. We purchased at $660,000. Four weeks later, the bank valued the property at $890,000 — a 34 per cent uplift, driven almost entirely by the market recognising the land value that the distressed listing price had masked 11.

Scenario 2: Information asymmetry. The broader market does not know something that we know. This is most common with planning overlays, rezoning potential, and infrastructure announcements. A property near a planned train station or freeway interchange will appreciate significantly once the announcement is public. If you can identify the asset before the announcement, you are buying intrinsic value that the market has not yet priced in.

Scenario 3: Cosmetic distress. The property looks terrible but is structurally sound. Peeling paint, overgrown garden, dated kitchen, dirty carpets. These cosmetic issues suppress the market price without affecting the intrinsic value. A $15,000 renovation can close a $60,000 gap between the distressed market price and the true intrinsic value. This is our bread-and-butter strategy — and it is why our renovation team is integral to our acquisition process, not an afterthought.

In each scenario, supply and demand conditions are the same for the distressed property and the well-presented property next door. The difference is that one is priced at intrinsic value and the other is priced below it. Recognising that gap is the skill. Acting on it is the strategy.

What this means for your investment decisions

Stop asking "is the market going up or down?" Start asking "is this specific property worth what they are asking for it?"

The market will do what it does. Over long time horizons, well-located land in Australia's major cities will appreciate. That is the macro trend, and it is driven by population growth, immigration, and finite land supply. Supply and demand at the macro level supports the thesis.

But within that macro trend, individual properties will outperform or underperform based on their intrinsic characteristics. Land-to-price ratio. Income yield. Replacement cost. Location premium. These four pillars determine which properties build wealth and which ones stall.

When someone tells you that supply and demand determines property prices, they are giving you a weather forecast for the entire state. Useful for general planning. Useless for deciding whether to invest $600,000 in a specific house on a specific street.

Do the work. Run the numbers. Understand what you are actually buying — and why that specific asset, at that specific price, on that specific piece of land, is worth your capital.

The data tells a different story to the headlines. It always has.