Overall return

We get our return on investment from property from two major areas - rental income and growth in the value of the asset (capital growth). Finding the balance between these two forms of return has generated a ongoing debate between ‘capital growth’ and ‘cashflow’ strategies for property investment. The reality is, you need both if you’re going to generate an investment-grade return, and it’s a case of getting the balance right to suit your individual situation.

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The Components of an Investment Property

At its simplest, and investment property is a piece of land with a building on it. If it’s a house, you’ll own the block of land and the house sitting on it (in what is called ‘Torrens Title’). If it’s a townhouse or apartment, you’ll own the inside of the unit itself and a share of any common areas, and a share of the land it sits on. A body corporate will administer these common areas; you’ll pay levies to fund this body corporate, and will can attend meetings and vote. This is known as ‘Strata Title’. The distinction between Torrens Title and Strata Title is different to that of Freehold and Leasehold. Freehold means you own the property, leasehold means you are leasing it long-term from another entity. Both Torrens Title and Strata Title are forms of ‘Freehold’ title.

intrinsic value

The land (or share of land) you own will hold a certain value, based on what it would sell for if it was a vacant block of land. The building will also hold value, based on what it would cost to build an equivalent structure. This is what we call Intrinsic Value. Over the long-term, a property can never be worth more than what it would cost to buy an equivalent block of land and build an equivalent structure. If a property can be replicated at a lower cost than its market value, then over the long-term, it will be, and the market value will reduce as a result. Never forget this - this is a golden rule of successful property investment.

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Land value

Every property, be it a detached house or high-rise apartment, sits on a block of land. Land is often regarded as the true ‘investment’ component of any property, because, as they say, ‘they’re not making it anymore’. While this is self-evidently true, the reality is that there is no genuine scarcity of land on planet Earth, or even in Australia. You can, for example, buy or lease large swathes of land in Australia for next to nothing. What gives land value is where it is located and what can be done with it. For example, a small block of land in the inner suburbs of one of our capital cities can be far more valuable than many thousands of hectares in the outback. If, on that small block of inner-city land, you can build not just a single house but a block of apartments, it will be worth substantially more again.

Land has some unique characteristics as an investment:

  • Land doesn’t age

  • Its physical location never changes

  • The way it can be used, however, can change dramatically

  • In almost all cases, land without a building is not capable of producing an income

Historically, well-located land has provided the primary source of capital growth in property investment. Understanding what creates value in land, now and into the future, is crucial to successful long-term investing.

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BUILDING VALUE (IMPROVED VALUE)

The second component of a property’s value is the building itself. In residential property investment, there are three major types of buildings:

  • Detached Houses

  • Townhouses (semi-detached)

  • Apartments (attached)

    • low-rise

    • medium-high rise

Detached houses, townhouses and low-rise apartments all use similar building materials and methods of construction. Townhouses and low-rise apartments will cost more per square metre to build than a house, usually around 50% higher. This is because they require common areas to be built, need greater fireproofing, and have expensive fixtures such as kitchens and bathrooms as a higher percentage of the overall build (a 100 sqm 2 bedroom 2 bathroom apartment has the same number of kitchens and bathrooms as a 200 sqm 4 bedroom 2 bathroom house).

High- rise apartments cost more again per sqm to construct. The higher the building, the more space is taken up on each floor by structural supports, lifts, plumbing etc, so the floor space is less efficient than a house or low-rise apartment. Additionally, it’s more expensive to build at height, for obvious reasons. The average high-rise apartment costs 100% more per sqm to build than a house.

While a property will cost a certain amount to build, this won’t necessarily be the value of the building to the market. There are four main areas that will determine how a building is valued:

  • Configuration - The basic size and layout of a building - i.e a 3 Bedroom 2 Bathroom 2 Garage House, or a 2 Bedroom 1 Bathroom 1 Garage apartment.

  • Design - The function and aesthetic of the building - i.e. natural light, flow, room size etc.

  • Build - The quality of the materials and workmanship used in the construction of the building

  • Age - How long ago a building was constructed

How these four areas affect the value of a property will depend on how the market values each of these aspects at the time: in some markets, design may play a greater role than size, while in others, a solid long-lasting build may be more valuable than a more modern one. The rental return on a building will also play a role in its value: a building will be worth more to an investor if the configuration allowed for a higher level of occupancy and thus a higher level of rent.

These variables mean that the value of every building is unique, at least in some way. However, it’s important to remember that in residential property, unlike land, any building can be replicated given time and money, so it’s important not to overestimate a building’s unique qualities when it comes to determining its value.

Even La Sagrada Familia could be replicated, given the time and money.

Even La Sagrada Familia could be replicated, given the time and money.

The Building Life Cycle

Unlike land, every building has a life-cycle, beyond which it becomes either structurally uninhabitable or functionally obsolescent (no longer fit for purpose). How long is this life-cycle? Well, it depends on the property. The Australian Tax Office depreciation rules state a property will be written off in 40 years. Clearly, some properties last longer than this. Most post-war homes built in Queensland between the 1940s-1960s remain standing without a great deal of maintenance. Many Queenslanders, some built before the 20th century, remain standing. However, it’s important to remember that these properties have required major renovations and improvements, costing hundreds of thousands of dollars, to make them modern and attractive. Even if the shell of a building remains, bringing it up to the standard of a modern house can cost as much or more than simply scrapping it and building a modern house instead. Good design and a quality build can prolong a building’s life cycle, but like death itself, it can’t be escaped.

For the long-term investor, understanding the building life cycle is critical. If you’re in the market for 5 or 10 years, the building life cycle probably won’t affect you. But if you own property for 20 years or more, you’ll need to be thinking of renovations, improvements, and potentially an endgame for when the building reaches the end of its functional life.

do buildings increase in value?

This is a good question. In our research, the answer is yes - to a point. The first factor here is the cost of construction. This has consistently risen throughout modern history, even when improvements such as size and new technology are taken into account. As the costs of constructing new buildings has risen, the value of existing buildings has also increased, although not as quickly - which makes sense - as a new building is likely to be have better design, more modern fixtures and a longer lifespan versus an existing one.

For example, over the last 30 years, the cost of building the same-sized new house has increased by over 4% per annum (from $71,000 to $247,000), a well-maintained, modernised house built 30 years ago has increased by approx 3% per annum (from $71,000 to $180,000). The modernization of the property (likely conducted at the 20 year mark) would have required an complete update of the kitchen and bathrooms, repainting and reflooring, involving a significant capital injection in today’s dollars of $50,000 or more. So realistically, the value of the building has only doubled in the 30 years through natural increase.

After 30 years, the building may also getting close to the end of its life-cycle. Depending on the quality of the build, the property may have another 20-30 years in it It is likely to require another significant renovation in 10 years time, and the owner of the property will need to work out