02/12/2011

Question: I own an investment property valued at $500,000 and I’m looking for more. The property has a large backyard area and a friend has suggested subdividing the land and building a two-three bedroom house behind the one already there. I’ve almost paid off the mortgage and have estimated the costs of building and dividing the land to be around $400,000 to $500,000. Is this likely to be a good long-term investment for me, or would I be better off buying a new property altogether?

Answer: Here’s the choice as presented: buy the property under consideration, subdivide and build a home on the back and hold both. Or buy a different investment property as is, and hold that.

If we drill right down to the fundamentals, all investors invest for the same reason:  the money, and what it can do for us! I’d like to suggest that you are no different. To this end then, the best choice you can make here is the one that yields you the most amount of money in the shortest period of time!

In order to determine the best outcome for you, we need to cover off some of the basic assumptions for your situation, like:

  • You have the cash/equity and borrowing capacity to see the deal through
  • You have the time and skill to organise and oversee the project
  • You have a solid enough grip on the area, market values, market tastes and desires, and the numbers in the deal to create a profitable outcome

If all this is looking good for you, then the best choice is obvious... buy the property under consideration, subdivide and build!

But why?

This might best be explained by example. Let’s assume that the property you’re interested in has an asking price of $470,000. If we follow the deal through to completion, based upon a 12-month project time, with current interest rates, being able to value the front block with the original dwelling for about $440,000 (after all, it’s on a smaller block), and the home on the back for about $630,000 (after all, it is brand new and in a desirable location), then you’d have spent about $950,000 to own assets worth $1.07m.

In a table:

 

Item

Costs

  

Buy Price

$470,000

  

Buy Costs

$23,500

  

Hold (12 months)

$29,500

  

Rent for Front Home

-$20,000

  

Subdivide

$30,000

  

Build Costs

$390,000

  

Build Loan Costs:

(6 months)

$14,000

  
 

Finishing Costs

$13,000

  

Total Costs

$950,000

  

 Asset

Value 

  

Front Home Value

$440,000

  

Back Home Value

$630,000

  

 Total Asset Value

$1,070,000

  

Created Equity

$120,000

  

Please note: GST and tax have been ignored for simplicity

This means that for your efforts and your ability to create more perceived value than what it actually cost you to make, you have improved your equity position buy about $120,000. You spent $950,000 and now own assets to the value of $1.07m.

If you were to go and buy a property valued at about $950,000 to simply rent out, then you wouldn’t have had the advantage of that $120,000 in sweat equity. The effect here would be less rent and higher LVRs for the same capital injection into the project.

Even if you were to go and buy two properties at about $480,000 each, the result would be similar. By improving your property (now worth $1.07m), your rent will be justifiably higher, your debt to equity ratio will be lower, and therefore your cash flow would be closer to being neutrally geared.

One possible ‘left of centre’ idea might be to sell either the front or the back property, and to put the proceeds of the sale into the remaining house. This would further reduce the debt and improve cash flows on the remaining property.

Of course, you could always draw down on this equity to preserve some of your working capital for other projects and may be able to go again sooner! Either way, you can make more money, faster, by adding value to a property than simply by purchasing property to hold.

  • Answer provided by Brendan Kelly