If we buy well, our home can often be one of the best investments we make in our lifetime. Any capital growth is tax-free and there are not many things in life that are tax-free. Also, if we experience some good growth in our home’s value, we can borrow against that equity to buy other investments. Buying well (i.e. as close to an investment grade asset as possible) can make a massive difference to our financial position, lifestyle and retirement plans. Making smart financial decisions when it comes to your home can pay big dividends.
Should you renovate your home or are you better off to sell it and buy another home? This is the question I would like to address in this article. Even if you don’t have a home (yet), this article will still be relevant for future decisions.
Why the change?
Whilst there may be many reasons why we may want to change homes the two most common are that we want to move to a different area (because of work, schools or to be closer to family) or maybe you have outgrown your accommodation and you need more space. This article will focus on the second reason (i.e. more accommodation) but if you are moving to change location, read on because you still need to decide if you should sell your existing home or retain it as an investment.
Reminder: what makes a property good?
This is a good time to remind you what makes a property a “good property” (insert: investment-grade property). Residential property is a growth asset from an investment perspective. That is, good property will deliver most of its return in capital growth, not income. The true value of an asset is in its future value – i.e. the likelihood of the value of the property doubling in value every 7 to 10 years.
The best investor of our time, Warren Buffett believes that most investors produce poor quality returns because they over-think and over-complicate their investment decisions rather than sticking to simple, safe, proven fundamentals. Click here to read an article that he wrote last week for Fortune magazine about property investing (if you are short of time, scroll down and read the four bullet points in the middle of the article).
So what factors do we need to focus on in order to assess the likelihood if our property will double in value every 7 to 10 years? I believe that there are only 3 simple factors you need to focus on:
- Past performance – there is a disclaimer often used by financial services businesses which says “past performance is no indication of future performance”. However, when it comes to property, I believe that past performance is a very good indication of future performance. The reason for this is that the factors that are responsible for driving a property’s value up over time are often static and factual. For example, things like the land size, organisation of the land, architectural style, amenities such as schools, hospitals and shopping that surround the area are some of the things that will drive value up. These things rarely change over time. What’s more, they are objective and factual – not subjective like many things that drive the value of a share price – so they are easier to ascertain and assess. If a property has grown in value by 8% p.a. compounding over the last 30 years and the reason for that growth is due to the aforementioned factors, then there’s a good chance that the growth over the next 30 years will be similarly healthy (assuming there’s no evidence that the fundamentals will change). If you can’t ascertain past performance or its poor, move on as Buffett recommends in the above Fortune article.
- Land value proportion – in simple terms, land appreciates in value and most buildings depreciate in value over time. Renters will pay more for more/better accommodation whereas investors should pay more for more land value. Every property’s total value is a combination of building plus land value. There needs to be a sufficient proportion of land value for there to be a good prospect of the overall value of the property doubling in value every 7 to 10 years. For example, if a property worth $500,000 has a building value of $400,000 and a land value of only $100,000, what has to happen to the value of the land for the overall value to double in 10 years? Well, assuming that the building value doesn’t change (as it will likely depreciate), the land value will need to increase from $100,000 to $600,000 in only 10 years so that the total value will be $600,000 for land plus $400,000 for building. That is a 6 times increase which would be very unlikely for most properties. You need to have a land value proportion of 50% or more of the total value – otherwise there’s just not enough land to push the total value of the property forward.
- Scarcity – scarcity is present when you own an asset that will always benefit from more potential buyers than there are sellers. Compare two situations as an example. Firstly, consider owning an apartment in a high-rise block containing 200 or more apartments. At any one time, there may be 10 or more people trying to sell their apartment. Therefore, in this situation, it is the person that drops their price first that will get the sale. Secondly, consider owning a single-fronted, 2-bedroom Victorian cottage. The amount of Victorian cottages available in the market is declining the reverse is true for high-rise apartments. Victorian cottages are becoming scarcer and benefit from strong buyer demand. In most markets, there are more potential buyers than there are sellers for Victorian cottages and other period properties. It is this imbalance in supply and demand that will help prices perpetually increase.
So if you are considering spending renovating:
- investigate the past growth rate of the property;
- estimate the current proportion of land value; and
- consider how scarce your property is.
This will help you ascertain if its investment grade or not.
Constructing doesn’t change future growth
Some people incorrectly think that renovating a property might change its future capital growth rate. Often, it is not the case. Renovating a property may result in improving its value by more than the cost of the renovation (i.e. creating some equity) – but even that’s less likely these days. However, any boost in equity is likely to be a once-off event and it won’t change the property’s future growth rate. Remember, land appreciates and buildings depreciate.
Some other important considerations
- If you are considering spending a reasonable amount of money on a renovation, be careful to not overcapitalise. Over capitalising means spending too much money on a property such that its completed value is less than what it has cost you. To guard against this we typically research the median value of similar properties in your area using RP Data (a free service we provide). For example, if the current value of your 3-bedroom home is $1.5 million and it will cost you $500,000 to renovate it including adding an extra bedroom, you need to make sure that there are other 4-bedroom homes in your area that have sold for $2+ million.
- When doing your numbers, add an additional 20% onto your budgeted renovation costs – even if you think you have been thorough. Murphy’s Law suggests that there are always going to be cost blowouts and unknown expenses when you renovate an older home.
- As discussed above, you need to try and ensure that the land value proportion of the property’s value doesn’t fall below 50%. If it does, it might impair overall growth as there just won’t be enough land to propel the total value forward. Therefore, work out what your land value is now and estimate how much the building value will be when the renovation is completed.
- When assessing the likelihood of your property doubling in value every 7 to 10 years post renovation, work out what needs to happen to the per square meter (p/sqm) land value over that period to drive a doubling in value. Speak to some local real estate agents and they will tell you what the p/sqm current value of land is in your area. Then you can work out how much the p/sqm value of land needs to increase by for the property’s value to double – and if that’s a reasonable expectation.
- Buying costs such as stamp duty and selling costs such as agent fees are relevant in your decision to love it or list it. However, more important is if your home is an investment-grade asset. If it is, it’s going to be cheaper to renovate. If it’s not, then the transactional costs of buying and selling are very likely to be a lot less than the opportunity cost of holding onto a non-investment-grade property.
But it’s not a financial decision
Some people will say that they don’t care if they are (for example) over capitalising on their home because it’s a lifestyle decision, not an investment decision. I think that approach is fine as long as people are fully aware of the implications of their decisions. For example, for every $1 you borrow to renovate, it will likely cost you $2 in total once you have repaid the debt – so the ultimate cost of renovating (including interest on borrowed funds) is double the hard cost of the renovation assuming you take 20 or more years to repay your home loan.
Love it or list it… the answer is
From a pure financial perspective, the decision to love it or list it comes down to whether your home is an investment-grade asset or not. If it is, love it. If not, list it and go and buy an investment-grade asset (or as close to as possible). Your home can be the best investment you have from an after-tax perspective so making smart financial decisions about where to live can turbo charge your net worth. We are here to help you make smart decisions so if you are contemplating changing your home, speak to us first and we will help you.
