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.
Capital improvements create a once-off value appreciation
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 propert
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