Smart Property Investors Manufacture Equity Through Development

Smart property investment is not this: buy a property, wait for it to increase in value, then draw down equity from that property to use as a deposit on another investment property, wait for them both to increase in value, then repeat. I know some people make this work, and congratulations to them, but it’s always felt like a ponzi scheme to me.

The critical flaw in this approach is obvious – what happens if the market doesn’t go up? Is the investor expected to fund the rental shortfall each week indefinitely? And, when interest rates eventually rise, what then? We know that high and/or rising interest rates adversely affect median $ price growth, so things can get very tough very quickly for people subscribing to this approach.

I’ve lost enough money in the share market to know that I don’t know nearly enough about shares. I do know an awful lot about real estate though, but even then, there are so many market forces that impact the broader market: interest rates and exchange rates and unemployment rates, consumer and business confidence, immigration and new housing supply, GDP growth in Australia/China/US/Europe, fluctuations in natural resource prices, government budgets, taxation policy, etc, etc. We understand all of this better than most, but still, markets turn and growth cycles inevitably come to an end.

So what do smart investors do to hedge against the market?

First and foremost, it’s about buying in the right area. You can read more about our predictive analyses here, but in short, it’s about purchasing in areas that are statistically likely to outperform the market in the future – not necessarily those areas that have performed strongly in the past.

Then, it’s about buying the right type of property in that right area. Again, more on some of our philosophies here. In short, why buy a small apartment in an area with a great school zone, when that great school zone attracts family buyers not interested in living in apartments? There are countless other examples of buying badly, but that’s not the purpose of this post…

I strongly advocate property development to clients as a means to manufacture equity growth and build a portfolio more sustainably.

Even in poor market conditions, you can dramatically improve your equity position and Loan to Value Ratio through modest townhouse developments. I helped a client purchase a ripper little site last month…

We traded emails for about 6 months. Aden is a smart guy, pretty conservative by nature, and he was full of insightful questions and legitimate concerns. He’s exactly the kind of person I like dealing with, and I was very happy to build a dialogue and mutual trust over time. He met with a few other buyers advocates, and in the end chose to appoint us – mainly, from what he said, due to the analytical approach we take with everything.

Aden’s brief: $1.2m – $1.5m purchase price; reasonable sized block not too far from the CBD; in an area statistically likely to outperform the market; rentable as-is with the option to develop in the short- to medium-term.

He lives in Singapore, but visits Melbourne every month or so. In anticipation of his visit, I inspected about 20 properties, and narrowed things down to 3. Each was in a different suburb, with each suburb offering something slightly different:

one had great growth drivers and was slightly undervalued in my opinion;

another had experienced strong growth in recent years, primarily due to East Asian demand, but what it lacked in near-term growth prospects, it more than made up for in potential development gains;

and, the third was very popular with families, tightly held, and being further from the city, offered more value for money.

In the days before he visited, a couple other properties came up for sale (one off-market) and we inspected all 5 together.

We both decided on the property that allowed for immediate dual occupancy.

A dual occupancy development is one where you keep the existing dwelling, and build a second in the backyard. This is an ideal scenario for a buyer whose main motive is long-term investment. It provides a rental return immediately and throughout the entire construction phase; the new dwelling provides tax benefits through depreciation; and, the dwelling kept could ultimately be demolished at a much later date, meaning that you continually maximise the potential of the site.

When considering a site for dual occupancy, you can generally afford a higher purchase price than a typical home buyer or investor.

The numbers stacked up really well…

Market value @ time of purchase = $1,400,000, with Minimum Equity @ time of purchase = $280,000 (20% of Value).

Estimated Market Value with Permit for 2nd dwelling = $1,600,000.

Equity with Plans & Permits = $480,000 (30% of Value)

Estimated Fixed Price Build Cost = $485,000

Estimated Bank Valuation of completed development = $2,300,000, with Total Debt for Purchase + Build = $1,605,000

Equity Position = $695,000 (30%)

Look at how Aden will manufacture equity proactively with this property…

Within 12 months, he will increase his equity by $200,000 by spending about $25,000 on design and permits. His 20% equity turned into 30%.

That 30% equity allows him to engage the bank regarding construction. In this scenario, the bank will look at his income, credit history, and strong equity position, and should lend him 100% of construction costs, based on the conservative valuation above of a completed development.

In 24 months, Aden will have two properties (1 brand new), and will have increased his equity position by over $400,000. The rental return on the brand new property, combined with the depreciation benefits, will make it an ideal long-term investment.

All of the above assumes 0% growth in Median $ House Prices over 24 months. With interest rates likely to remain at record lows, and sustained demand from investors, homebuyers and foreign purchasers, that is extremely unlikely in Melbourne.

We purchased the property for $1.385m at a competitive auction. It has nearly all the growth drivers we look for in an area: very desirable primary and secondary state schools, strong and improving demographics and socio-economics, close proximity to transport and hospitals, widespread gentrification, etc.

Yes, Aden bought in a great area, at a good price. But, importantly, he’s taking control of his investment, and growing his wealth proactively, with advice from experienced professionals.

Don’t simply put yourself at the mercy of market forces. I firmly believe that Property Development is less risky than Property Investment.

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