Are you overcapitalising? - December 2018
December 21, 2018 / Written by Rich Harvey
It should really go without saying that in the world of property, numbers count.
Yet, despite the certainty of figures, the emotional struggle around choices can see even level-headed owners make lousy financial decisions.
One primary source of concern is an eight-syllable word which can cause headaches for those on a building budget – overcapitalisation.
Avoiding overcapitalisation takes a little effort, but applying the right principals will ensure you don’t pay too much for something that adds so little.
Understanding the “O”
Overcapitalisation refers to paying more for an element or improvement than it adds in value to your asset overall.
The effect is best illustrated by giving a ridiculous example.
Let’s say you’re a keen amateur astronomer who lives in suburban Australia. You decide your typical tripod and iPhone camera set up is a fail when it comes to capturing the best possible views of the night sky.
The solution is to construct a three-story viewing platform – complete with bolt-mounted commercial-level telescope and internal lift – which will take up most of your back yard. Let’s set aside the building approval process for this hypothetical, and assume you can get the job done for $200,000 – brilliant!
While you’ll probably enjoy spending hours taking in the constellations from your construct, when it comes time to resell, how many local buyers will be willing to add $200,000-plus to their offer because of your star-tower?
Very few. In fact, some may even want a discount so they can have the thing removed.
The important concept that drives overcapitalisation is that, in property, the cost of something does not always equal its value.
The best test of whether you’re about to overcapitalise, is to study your neighbours.
Ask yourself, ‘What sort of improvements are typical in my suburbs and are buyers willing to pay for them?’
Take the study further. Inspect open homes and track sale prices. Are purchasers paying a premium for homes with special elements and improvements?
Think hard about the demographics of your location. Will family buyers be demanding more rooms and better landscaping? Are you in a blue-collar suburb where the basics of functionality are fine for most residents?
The best way to avoid overcapitalisation is to gain an intimate understanding of your market and its buyer’s expectations. That means you need to inspect a large number of houses in a pre-renovated state and many that have been full renovated.
It takes time and effort, but can save your thousands in avoiding poor decisions.
Where it’s found
Overcapitalisation is most typical in the process of building, extending, improving or renovating a property, and its effect can be compounded by what will seem like many minor choices throughout a project.
For example, new builds are an exciting prospect for owners. The chance to be part of creating a structure is a thrill.
But overcapitalisation in new builds is disturbingly common and has even led to the best laid plans having trouble finding finance for their construction costs.
The danger is as a homeowner or investor, you can get caught up in the specifications and finishes without thinking about the practicalities of what people will actually pay.
It’s easy to see why it happens. You’re sitting with a builder or designer who is showing off beautiful, top-quality items each costing just little above average.
It’s enticing to say, ‘Yes!’ to everything, but these can quickly add up, and if you’re building a blue-chip home in an area dominated by secondary real estate, then expect to be hurt on the balance between cost and added value.
The same principals apply when renovating. Why would some choose a designer-level European kitchen tap for $700, when a perfectly adequate $100 domestic fixture is available?
It would be even more foolish in an investment property as opposed to a home.
As with new builds, renovation works have the ability to compound on themselves too. Every little compromise on style over substance is chipping further into your added value and can result in major headaches.
Finally – there are those major additions we are convinced will be ‘smart financial options.’
Classic examples include in ground pools and tennis courts. There are absolutely suburbs in Australia – usually where the average land size is half an acre and homes are of top-tier quality – where including a pool and/or court will be seen as a decent bonus… but they aren’t the norm. In most instances, these works will cost more than they boost in equity.
When is overcapitalisation OK?
To answer this, you must define the purpose of the property before you start any improvements.
Is the asset for basic investment purposes? Is the renovation for resale at a profit? Will this be a home for years to come?
This final example is where overcapitalisation is most acceptable. It’s a situation where the added value of the improvements is about a lifestyle, not a spreadsheet.
For example, you’re a young family who have bought a forever home… but there’s something missing.
Will major works in the backyard result in a space for spending long-summer days creating memories by watching the little ones grow up?
Then sinking money into a pool-zone is not a bad idea.
You’ll might overcapitalise by spending a little more on the pool, deck and pergola, but the holistic benefits will outlay the losses – and by owning the home over two or three property cycle, you’ll dilute the overcapitalisation effect.
Overcapitalisation isn’t great, but there are ways to spot it early and decide when to take it on or let it go.
Experience is the best teacher, so if you’d like to draw on a team that has the years to back up their opinion on how to spend wisely, call us. We know how to spot true value in an unrenovated property and we’ll ensure your decisions help realise your goals.
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