The value of a property consists of two components being the land plus any improvements i.e., the dwelling. Generally, land appreciates in value whereas buildings depreciate over time due to wear and tear.
It is possible to manufacture equity in a property by making improvements e.g. renovating/rebuilding the existing dwelling or constructing multiple dwellings. This occurs when the end value of the property exceeds its cost e.g. spending $100,000 on a renovation improves its value by $150,000, thereby “creating” $50,000 in equity.
This blog considers the merits of this strategy.
The theory (maths)
As noted above, a property’s value is the aggregate of the land value plus the building value. In investment-grade locations, it is not unusual for the land value to represent at least 60% of the total value and the improvements 40%.
If we assume the long-term capital growth rate for these types of assets is likely to be in excess of 7% p.a. (which isn’t uncommon), then the land must appreciate at a higher rate to offset the building’s depreciation to result in an overall appreciation rate of 7% p.a. If we assume that the building depreciates by 2.5% p.a., then the land must appreciate by 13.3% p.a.
For example, if a property is worth $100, then the building value is $40, and it will depreciate by $1 p.a. (being 2.5%) and the land value which is $60 will appreciate by $8 (being 13.3%). Therefore, its total value after one year will be $100 – $1 + $8 = $107, being a 7% p.a. growth rate.
Therefore, to maximise your expected rate of capital growth, you must spend as much as possible on the land in return for spending as little as possible on the building.
Renovate or develop property: may create equity but one time only
It is common for the market value of a newly renovated or constructed property to exceed its hard cost. This occurs for a few reasons:
- Completing building works takes several months or years. In addition, there’s a lot of work involved in coordinating and meeting with architects, buildings and so forth. Not everyone wants to go through that process. As such, buyers may pay a premium to secure a move-in-ready dwelling.
- Undertaking building works is not a riskless exercise. Things can go wrong including cost blow outs and so on. As such, some purchasers will pay a premium to avoid these risks.
- Newly constructed or renovated properties are more marketable/appealing because they are in better condition. Their improved marketability means they will attract a higher price.
- Subdividing creates value because you create more affordable parcels of land. For example, a developer might construct 4 townhouses on a 1,000 sqm block of land. There’s a lot more people that can afford to buy a townhouse on 250 sqm of land compared to a house on 1,000 sqm of land.
The market will discount properties in disrepair
For the same reasons that newly constructed or renovated properties command a premium, properties that are in disrepair tend to attract discounts. That’s because fewer buyers have the time and appetite to buy a property that needs refurbishment.
To maximise your capital growth, it is best to maintain the dwelling in a state that is in keeping with buyer expectations.
Renovate or develop property: potential benefits
Renovating or rebuilding an investment property can give rise to a few possible benefits:
- Improved rental yield – typically tenants will pay a higher rental rate for dwellings in better condition, larger accommodation or more amenities.
- Depreciation benefits – capital works can typically be depreciated at a rate of 2.5% p.a. and plant and equipment (i.e., fixtures and fittings) over its useful life (which typically ranges from 6 to 10 years) – see here. For example, a $250,000 renovation that includes $70,000 of plant and equipment could result in an annual depreciation deduction of $11,500. This would result in a $5,400 p.a. tax saving if you are on the highest marginal tax rate.
- Value appreciation – as discussed above, it is not uncommon for the value uplift to be greater than the construction cost, thereby improving your equity position.
Of course, funding the cost of the renovations gives rise to a higher interest bill (if funded via a loan).
Financial analysis: 3 scenarios
Using actual properties/situations, I considered three different scenarios that involve making capital improvements to investment properties. The key financial modelling assumptions are listed at the end of this blog.
Scenario one – cosmetic renovation
Purchase a single-fronted, period house in Fitzroy North for $1.5 million and spend $250,000 on a cosmetic renovation e.g. new bathroom, kitchen, floor and window coverings, paint, etc. The unrenovated rental income would be $500-$550 per week. Post-renovation, the rental income would increase to $750-800 p/week.
The alternate to this strategy is to purchase a house for $1.725 million that is in good condition, doesn’t need any renovations and rents for $600 per week.
The chart below illustrates that both options are relatively similar from a financial perspective, and it really depends on the opportunity to add value/create equity. The greater the scope to do that, the more favourable the renovation option will be.
Scenario two: full rebuild
Purchase a rundown house on 800 sqm in the blue-chip suburb of Indooroopilly, Brisbane for $1.5 million. Demolish and build a 4-to-5-bedroom family home with a pool at a cost of $1.2 million. The completed value of the property is estimated to be $3 million. Its rental income will increase from $400 per week to $1,500 per week.
The alternate to this strategy is to purchase a second investment property for $1.1 million (total cost of $1.2 million).
The chart below illustrates that the rebuild scenario is better in the shorter term (over first 8 years), which makes sense due to instant equity and improved cash flow by circa $26,000 p.a. (due to higher rental income and depreciation tax deductions). However, in the long run, buying another property with a strong land value component creates a lot more wealth. About $1 million (approximately 30%) more wealth in today’s dollar over 20 years, due to the power of compounding capital growth. Land compounds in value, buildings don’t. This aligns with the theme in last week’s blog about playing the long game.
Scenario three: small development
Purchase a development site for $1.5 million. Demolish the existing dwelling and construct two townhouses for a total cost of $1.2 million. Completed townhouses will be worth circa $1.7 million each and will rent out for $800 per week (each).
The alternate to this strategy is to purchase two investment properties for $1.3 million each (total cost of $2.8 million, which is the same as the development option).
The outcome is like scenario 2 but not as stark. The develop option is better over the first 11-12 years. But over 20 years, the ‘buy and hold’ option creates more wealth by circa $640,000 in today’s dollars (or 16%).
You can make capital improvements in the future
You can always renovate or rebuild a property at any time. However, one thing you cannot change is the land size, orientation and location. Whilst the cost of building does increase over time (partly driven by tighter building regulations), the cost of land increases at a much faster rate. Therefore, at least initially, I always counsel clients to invest most of their money in land as reasonably possible.
Future use of your investment properties
One advantage of developing, rebuilding and renovating properties is that you can ensure you have a sustainable and desirable building style that align with modern requirements. This will ensure it appeals to tenants and maximise your rental income. And if you plan to bequeath your property(s), your beneficiaries may enjoy a higher quality of accommodation e.g. for some people a newer townhouse may be more desirable than a 100+ year old Victorian cottage. This is a matter of personal preference.
Improving the property is different from maintaining it
It is important to maintain your investment property so that it’s in good tenantable condition. It also needs to be in the condition that buyers expect. As I have written in this past blog, you can delay maintaining a property but never avoid it. A poorly maintained property will eventually demand repairs (otherwise it becomes untenantable) or if you sell it in disrepair, it’s likely it will sell at a discount.
Building deprecates. Land appreciates.
The outcome of my analysis stands to basic logic. If buildings depreciate, then it stands to reason that you should invest as much as possible in the land value. Firstly, you want the highest quality land. Secondly, you want as much of it as your budget will allow.
Financial modelling assumptions: Financial projections include current property rental incomes appreciating by 3% p.a., less related property expenses (higher expenses are included for older dwellings), land capital growth, interest expense at 5% p.a., tax benefits and depreciation deductions on capital improvements, and building improvements are depreciated at 1.25% p.a. to determine future value (which is half of the tax rate of depreciation to reflect rising replacement costs over time). Investment value is calculated as the aggregate of net equity plus cumulative negative cash flow which is discounted back in today’s dollars.