Is this the magic formula for capital gain?

[DennisLeung]

Hi guys,

Was reading Gavin McPherson's book regarding a "value" approach to investing in property (he sells it as if Warren Buffett was to invest in Australian residential real estate). Anyway, he outlines the old mantra of "land appreciates, houses depreciate" and tries to quantify this in a formula which I found quite interesting.

Basically he says a property's value derives from a combination of its land component and the fixtures component as shown below

X (land) + Y (fixtures) = approximation of the true value (price)

So basically then you calculate the approximate value of a property today and then calculate the approximate value of the property in 10 years, and if the growth stacks up, it's one more 'tick in box' to buy that property.

For example:

A unit in Ashfield, NSW. Sold price of 446,000 in 2013. Contained in a block of 2000sqm with 20 units in total. Firstly, to establish the price per sqm on Ashfield. Search re.com for land sold prices and divide by sqm, take the average of large number of land figures. Works out to be about 2300 per sqm. Then working backwards we have:

approximation = X + Y
446,000 = [2300*(2000/20)] + Y
So basically we can deduce the value of the fixtures by knowing the total sqm of the block pro rata'ed by the number of units in the block and approximate the value of the land and then subtract it from the value of the price paid to get:
446,000 = 230,000 + Y
Y = 216,000

So then in this unit you've basically bought $230,000 worth of land and $216,000 worth of building. Next, using the mantra of land appreciates and buildings depreciate, we use a compound growth calculator to separately calculate the value of the land component in 10 years along with the the value of the building component in 10 years and then add that up to have the total projected value of the unit in 10 years.

Land component (growing at 7.5%pa - you can be optimistic or pessimistic)
230,000*(1+0.07)^10 = 474000
Building component decreasing in value at 3%pa
216,000*(1-0.03)^10 = 159,000

Add the two up and you get $633,000, the estimated value in 10 years time.

Obviously this will not be the only thing you look at when purchasing the property, but I'm wondering whether or not it could be a guaranteed win when you combine it with the following criteria:
1. within 10km of a capital city CBD
2. growth drivers such as high income, population growth, low unemployment

What do you guys think? Good, bad, indifferent? Or am I just crazy?

 

[D.T.]

Or am I just crazy?

Sorry, but this.

 

[spludgey]

If the value of land is X, the value of fixtures is Y and the combined value is Z, then most of the times you'll find that X+Y<>Z.
If you put a $200k house on a $200k block of land, it might not be worth $400k together.

But I agree with the general idea, houses that have a higher percentage of land value will probably increase more. This is why I buy old crappy houses on large blocks.

 

[one world]

You are overthinking OP.

Just go out there and buy cheap stuff, in the lowest decile of local prices. Using this simple logic, it is almost impossible to go wrong.

Of course, you are better off doing it when the market is not as hot as it is now.

 

[Propertunity]

...Building component decreasing in value at 3%pa .......

Building depreciation is 2.5% pa for 40 yrs - so at the end of 40yrs it has been depreciated away to $0.

This is for accounting purposes only. In the real world, buildings last for longer than 40 years. In the UK there are some homes many hundreds of years old.

You need to be looking at "replacement" costs not some accounting figure. It costs more to rebuild a building as each year passes.

 

[spludgey]

Building depreciation is 2.5% pa for 40 yrs - so at the end of 40yrs it has been depreciated away to $0.

That's not compounded though. If you depreciate in the way as suggested above, the house value will never actually reach $0.

 

[Propertunity]

That's not compounded though. If you depreciate in the way as suggested above, the house value will never actually reach $0.

You're probaby right - I'm no accountant. I just make money out of buying (sometimes old) property.

The point is, that you can't value property into the future by claiming the land goes up in value (which it does), whilst the building goes down in value (as it costs more to build, usually, at some future date - because labour & materials suffer from 'inflation', not 'depreciation').

 

[redwing]

Of course, you are better off doing it when the market is not as hot as it is now.

Everywhere

 

[zed_kid]

X (land) + Y (fixtures) = approximation of the true value (price)

In a perfectly rational world this would work a treat, but we don?t live there do we?

 

[Aaron_C]

To the OP - you are overthinking it. There is no magic formula to real estate. The properties that I have made the most on didn't require a formula. My latest purchase - I bought it because:
a) The market was **** due to the Euro situation;
b) The property generated strong income and was neutrally geared at low fixed rates;
c) The property is on a massive 1,500 block in a high development location; and
d) It was cheap.

If I stopped to analyse every little detail and second guessed everything - like the building being quite old - I would have done nothing and I wouldn't have made money. Once I develop this property it will make what I paid for it look like a drop in the ocean.

 

[see_change]

Dennis

It's not magic , maybe over analysis .,but it would be one way of analysis things.

Cliff

 

[alexlee]

If I actually did that much analysis I would never have bought anything.

 

[devank]

I don't think it is over analysing for a number person. You could use this to compare two different deals

 

[truong]

The premise is wrong. Both land and building appreciate, otherwise how can high rise apartments (where the land component can be as low as 5% of the total value) increase in price?

A real life example: CBD apartment, price 360K, building 340K, land 20K.

If the building depreciates by 3% it would require the land to appreciate by 51% just for the property to maintain its value, which is nonsense.

 

[Ajax]

Dennis,

you like numbers. Why not have a go at an equation to show annual rental income for a particular house or unit?

I've seen this done for other businesses (particularly in the mining industry). Each mine had its own income equation.

 

[Deltaberry]

The magic formula for capital gain is probably more like salt, pepper, a tanuki from Japan, a drop of magic potion from Getafix, a mermaid and some boiling water and stew and stew and stew.

The other formula is probably by writing a book like Gavin.

 

[Scott No Mates]

Ah Grasshopper, the danger of using such formulas as you constructed in your OP is that first you must understand that the existing building may or may not be the maximum development potential of the block according to the zoning, transferrable floor space benefits, concessions etc granted to the developer ($$$ ) etc.

You would be better off using a valuer's approach using highest and best use ie separately calculate the building cost (less depreciation for age of building) and then work out number of units to determine a land value for the area.

 

[Tony3008]

The premise is wrong. Both land and building appreciate, otherwise how can high rise apartments (where the land component can be as low as 5% of the total value) increase in price?

A real life example: CBD apartment, price 360K, building 340K, land 20K.

If the building depreciates by 3% it would require the land to appreciate by 51% just for the property to maintain its value, which is nonsense.

Arguably for this type of IP the value is a function of the income generated, as for established commercial property.

It won't be my problem, but I wonder what will happen to a building like my PPOR (Melbourne Docklands tower) in 50-60 years (or less) when its age depresses rents and maintenance costs have escalated. Perhaps you could even end up with a negative value if rents didn't cover costs and demolition cost exceeded site value (there are Melbourne high rises being built on 300-400m2 sites).

 

[Deltaberry]

Unfortunately Docklands is such a failed planning episode, that I begin to wonder whether it'll bounce at some point because it can't be trashed much more than it has been. Because if it will, it's probably a good time to get in.

Then again, why take the risk when there are much better opportunities.

 

[see_change]

Arguably for this type of IP the value is a function of the income generated, as for established commercial property.

It won't be my problem, but I wonder what will happen to a building like my PPOR (Melbourne Docklands tower) in 50-60 years (or less) when its age depresses rents and maintenance costs have escalated. Perhaps you could even end up with a negative value if rents didn't cover costs and demolition cost exceeded site value (there are Melbourne high rises being built on 300-400m2 sites).

Tony , wondering how you find living in the docklands area . It seems to receive so much criticism , but on the one occasion we stayed there I quite liked it . Very close to CBD etc.

Cliff