Most people would be familiar with the phrase ‘land appreciates, buildings depreciate’. While this is a little simplistic, the statement generally holds true. It is surprising then how many investors, armed with this knowledge, still manage to get it wrong.
Real capital growth is derived from the appreciation of land. This is because land is a commodity that is in limited supply and always in demand. Buildings, however, lose value over time because the physical materials deteriorate and the appeal of their style and function diminishes as buyers’ tastes change.
Some people argue that the cost to build rises each year meaning replacement of the same building would cost more in today’s dollars, thus buildings appreciate. Yes, the cost to build increases with inflation but this is irrelevant. If you were to sell a once new property in 10 years, the fact is a buyer is buying the land with a 10 year old depreciated home on it – not buying land with a home on it valued at the replacement cost of building it today. That is why you find many old properties selling at practically land value. To think today’s costs are relevant is no different than trying to argue that your 10 year old Toyota Carolla is valued at the same price as the current year model! Having said all that, it is possible to retain some value in the building if you regularly maintain and update it. However, this obviously costs money and does not simply come about with time.
Many assume therefore that the message from all this is that the more land you have, the more capital growth you will be rewarded with. While there’s some truth here, this is where many investors tend to become unstuck. Let’s use an example to explain. Do you think the value of 500sqm of land in the heart of a major metropolitan city is the same as 500sqm of land in a small country town? Or even 1000sqm in the country town? Of course not.
Land is valued at a different rate per square meter depending on its location. Therefore the lesson is if you’re after strong capital growth, don’t base your buying decision on where you get the largest quantity of land for your money. Instead, focus on the proportion of value that the land component contributes to the overall purchase price of a property. This is what is sometimes called the land-to-asset ratio. Good purchases tend to be those that have a high land-to-asset ratio, that is, ones in which the land accounts for most of the property’s value. Although in many instances this directs investors towards older dilapidated houses in established areas close to the city, if you’re on a budget or need stronger rental income do not discount strata-title properties. If you do your homework and purchase carefully, you can find strata properties with a high land-to-asset ratio that perform just as well.