A property’s value is typically divided into two components: the land value and the value of any improvements, such as the dwelling. Conventionally, land tends to appreciate over time, while buildings depreciate as they get older and suffer more wear and tear.
However, the rise in construction costs poses an interesting question: what impact does rising construction costs have? For instance, the average cost of constructing a house has surged by almost 30% between 2021 and 2023, equivalent to an annual increase of 12%. There is even anecdotal evidence suggesting even higher cost increases in certain areas.
So, when the cost to replace a dwelling significantly outpaces depreciation, how does this impact property investments?
Long-term trend in construction costs
The chart below illustrates the home construction index since 1966, showing that construction costs typically rise at an approximate rate of 5% per year. However, there has been a substantial increase in construction costs since 2021, around 30% or 12% annually. This surge is due to various factors, including demand-side factors like low interest rates and financial stimulus, as well as supply-side factors such as disruptions in supply chains due to COVID-19 lockdowns.
You must consider that dwellings require maintenance
While the cost to replace a dwelling may increase by 5% annually, the value of a dwelling naturally depreciates due to wear and tear. A 10-year-old dwelling won’t hold the same value as a new one. The Australian Taxation Office (ATO) allows you to depreciate the cost of a dwelling over 40 years. Hence, a decade-old dwelling might be valued at 75% of a new one. I’ve previously estimated that maintenance costs could range from 0.40% to 0.75% of a property’s total value, assuming that the building’s value represents around 40% of the property’s overall worth. This translates to about 1.5% of the building’s value.
Therefore, based on historical data, it’s reasonable to expect a 5% annual increase in the replacement cost of a dwelling. However, factoring in maintenance and depreciation, the net increase may be around 1% per year. Please note that this is a generalisation, and different types of dwellings and locations may perform differently.
How does this impact your overall investment return?
As I’ve previously emphasised, for a property to be considered investment-grade, it should have a significant proportion of its value in land. This is because the return from the building component is considerably lower than the return from land, as demonstrated in the table below:
The table below illustrates how a property with a higher land value produces a superior investment return on a $1 million investment property compared to one with a lower land value.
However, the crucial difference lies in the long-term capital growth. Investment-grade assets can potentially double in value every 10 years, whereas non-investment-grade assets may take 15-16 years (or longer) to achieve the same growth.
Therefore, when investing in property, allocating a larger proportion of the purchase price to land can maximise your investment returns.
When is it wise to invest money in improvements?
While there are exceptions to most rules, it can be wise to invest in property improvements through renovation or rebuilding in some situations.
Regular maintenance is essential to keep your property in good condition, minimise vacancies, and maximise its value, as I have explained here.
Investment-grade properties often have older and more modest dwellings which attract lower rental yields. This presents an opportunity to make improvements that significantly enhance rental income.
My wife and I own a property in Brisbane. The dwelling is in basic condition (the underlying land value is probably 80% or more of the property’s overall value), so the current rental income is only $400 per week, as the tenants have occupied this property for many years. The existing tenants have given notice, so we are taking the opportunity to make some improvements to the property such as painting, carpets, blinds, updating the kitchen and so forth. We expect these improvements to cost approximately $90,000 and increase the rental income from $400 to $700 per week.
That equates to a return of 17%, being $15,600 of income on an investment of $90,000.
The cash flow impact is projected to be more substantial since we will be able to depreciate these improvements and we will fund the cost of the renovations through additional borrowings. I estimate that our cash flow will improve by more than $8,000 p.a. after-tax.
An undercapitalised property is financially inefficient. The dwelling doesn’t need to be high end, but it should be functional and enjoyable to occupy.
In certain circumstances, redeveloping a property can be economically beneficial, whether for long-term holding or to maximise investment returns before selling. However, it’s important to be mindful that substantial improvements may alter the property’s nature and potentially disqualify it from being an investment-grade asset due to the building value portion being more than 50% of the property’s overall value.
Land is still king
In conclusion, while construction costs have surged in recent years, it’s likely that they will normalise, with underlying land values remaining the primary driver of long-term price growth. Therefore, when considering property investments, prioritising a higher proportion of land value remains a key strategy for maximising long-term returns.