When buying an investment property, there are two components that make up the price you pay – the value of the land and the value of the building. As a general rule of thumb, over time the value of the land tends to rise, while the value of the building tends to fall.
This typically comes down to supply and demand.
Think of a house located in a capital city’s inner or middle ring. The land is most likely already taken up with parks, schools, shopping centres and other houses.
As the city’s population increases over time, there are commonly two options to accommodate the growing number of people – build on the suburban fringes, or build more high density dwellings (like apartments) in established suburbs.
This means that demand rises for the land, while supply of land in these areas typically remains limited – which can force up prices.
Buildings are a depreciating asset because they generally have a limited lifespan as they age. They become run down and outdated, and end up being demolished for new housing.
That’s why you need to be mindful of the proportion of the purchase price that comprises the value of the land and the proportion that comprises the value of the building, as not all properties are created equal. Have a think about which investment property type is right for you.
How well your property performs - whether that’s through capital growth or rental income – all depends on supply and demand.
Typically, if the demand from people is higher than the supply of housing stock, then property and rental prices will rise.
However, a common mistake is to only focus on the demand-side drivers and not consider the supply-side drivers.
For example, just because a suburb has the fastest growing population in a city and boasts new schools, parks and shopping centres, it doesn’t necessarily mean property prices will rise there. If there’s nearby land that can be easily developed for new housing, this will help supply meet the growing demand – and subsequently limit property price and rental rises.
The supply and demand dynamics also mean that property markets typically run in cycles. Supply and demand fluctuates through population rises and falls, which is subsequently driven by job growth, lifestyle offerings and other factors.
This means that property and rental prices won’t necessarily rise consistently, but ebb and flow over time as supply and demand goes up and down.
This can be at a city-wide level, but there are also markets within markets – such as at a suburb level, or even pockets within suburbs.
Unlike some other investments (such as shares and bank deposits), the entry, exit and holding costs for investment properties can be significant. It’s important to consider all the costs involved – not just the loan repayments.
For instance, when buying you’ll have to pay stamp duty, and when selling through a real estate agent you’ll also have to pay the agent a fee.
You also need to consider things like property management fees, insurance, council rates, maintenance costs and strata fees - among others. To make a profit on property, it will have to rise in value more than these combined costs. Find out how much buying a property will potentially cost you with our home loan fees calculator.
This means earning interest on interest. If a property rises in value over the years, you’ll earn interest on the previous price growth as the property continues to increase in value.
For example, if you buy an investment property for $400,000 and it increases in value by 6% every year, after 10 years the property will be worth $716,339.
And the more time that passes, the higher the compound growth. If you hold the same property for 20 years and it increases in value by 6% every year, it will be worth $1,282,854.
In this scenario, the compound growth from years 1 to 10 is $316,339, but from years 11 to 20 the compound growth is $566,515.
That’s why it could pay to take a long term view if you’re after capital growth.