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Depreciation is a tax benefit often chased by investors, recommended by planners and revered by tax accountants – but it’s not necessarily a good thing when it comes to real estate investing.
Blogger: Cate Bakos, director, Cate Bakos Property
While depreciation helps with cash flow, it should never be the reason for investing in property. In this pre-election period, when negative gearing and investor tax benefits are featuring daily in the media, it helps to put perspective around the issue. After all, why do most investors choose property as an asset class? Surely not just for tax breaks?
All too often, I meet investors who have a sad tale to tell about the limited value growth their brand-new or newly refurbished apartment has sustained. Whether it be in Melbourne’s Docklands, an outer-ring Sydney refurbishment or a southern Queensland coastal off-the-plan development, the stories have a lot in common. Many purchasers find themselves making a loss when they sell their property within a few years of the initial purchase.
Why so some properties sell at a loss within a few years after they have been purchased brand new?
The obvious consideration is that perhaps the vendor overpaid at the time, but in fact this is not the reason. Comparable sales evidence often suggests that purchasers all pay reasonably similar prices for comparable units within similar developments. Presumably, they bought with enthusiasm, whether the purpose of their purchase was for occupation or for investment.
Nobody ever purchases property and anticipates that over a seven-year period they will sustain a capital loss. In fact, a common misconception is that property doubles in value every seven years. Yet in many popular, inner-ring areas where amenity, public transport, lifestyle and desirability reign, certain blocks can perform counter to other properties in the same suburb, and these poor-performing investments are heart-breakers for investors.
One common but rarely mentioned factor plays a significant part in the negative capital growth that new apartments sustain: depreciation.
Quality finishes, trendy spaces, great fixtures and fittings, and high depreciation schedules entice many investors to consider opting into brand-new developments. Many investors get excited over these types of assets, particularly when hefty tax deductions through depreciation are on offer. We often have clients coming to us with clear instructions from their accountant to pursue a new property for tax-saving reasons.
This strategy can often present a serious roadblock to immediate capital growth, though.
When the value of the dwelling and improvements is greater than the land component, the impact can be more costly than the short-term tax savings. In the case of an apartment block, it is more difficult to exactly determine the land ownership percentage that can be allocated to one particular owner. Common areas in strata developments are often considered ‘undivided and equally shared’ among residents, but for the purposes of calculating the ‘relative share’ of the land value, apartments of varying sizes may be determined to have unequal ownership of the land. It varies between complexes. What is important to note, though, is that the relative land ownership per resident in terms of land value would be distinctly lower than the value of their dwelling. After all, the brand-new fittings and fixtures, quality build and exciting interiors have had zero depreciation at the point of occupancy.
From the moment of settlement, the calculated rate of depreciation will be quite high, and any investors in the block will presumably enjoy some decent tax savings. But as we know, depreciation is an inverse-compounding situation. As the years go by, the tax write-downs diminish, until one day they are negligible. What investors often forget is that depreciation means losing value. It is only acceptable for a dwelling to lose value if the land it sits on is growing at a strong rate; strong enough to offset the rate of the depreciation.
Sadly, the first few years of ownership can see a new property diminish in value while depreciation runs high.
However, with the slowdown in the rate of a dwelling’s depreciation at around three to five years, and particularly in tightly held, inner-ring locations where capital growth of established property is tracking positively, original owners in a new or redeveloped block can likely expect that their asset will start to turn the corner in terms of capital growth.
Often this three-to-five-year mark is the best time to buy for investors who value low maintenance, some depreciation and positive-trending capital growth prospects. The property is usually still glossy and fabulous, and the key to this is the land-to-asset ratio.
The land-to-asset ratio underpins so much of our decision-making as advocates and investment property advisers, and it’s always disappointing to see situations where vendors could have invested their savings differently at the time, but instead have sustained a market loss. We are often asked why new and off-the-plan investments decline in value in the early years – a low land-to-asset ratio is one key reason.
My most valuable tip I can share on this matter is for investors to always aim for a land-to-asset ratio of greater than 50 per cent. Try to ensure that the dwelling component represents no more than half of the value you are about to pay, and ensure that the land is supported by multiple genuine growth drivers. Ideally, the location should be supported by more than one major employer, and lifestyle features such as cafes, schools, transport and community. It should be obvious that desirable tenants will be easy to find, and likely to love the property in question.