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Old Properties versus New Properties – Part 1

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old versus new property part 1

There’s no argument if investors should buy new properties or opt for the existing ones.

“It is mathematically impossible for new properties to outdo old properties.”

It has always been a conclusive case.

This two-part presentation will show what the math predicts with past information, including those contentions that the new property advocates often like to put forward:

  • Vacancy;
  • Rent;
  • Depreciation;
  • Repairs and maintenance;
  • Savings from Stamp Duty.

Why are there two sides to this argument? Mainly because there’s a small group of experienced property investors on one side – who can ably present logic, math, and relevant historical evidence.

Conversely, on the other side, there’s a considerable number of property developers and their network of several partners spinning their marketing charm to earn cash.

Depreciation

Perhaps, the most notable selling point for new properties is the huge depreciation benefits. But you may have to reconsider this intention.

When you’re buying as an investor — you certainly look for an asset, not a liability. An investment is an asset growing in value – it APPRECIATES, unlike a liability that depreciates. So, how can one treat depreciation as a type of “benefit”?

Example:

Which property has a higher depreciation?

Property A – old

  • Total value: $600,000
  • Land value: $400,000
  • Building value: $200,000

Property B – new

  • Total value: $600,000
  • Land value: $200,000
  • Building value: $400,000

Both properties are of the same value. However, the property with the highest depreciation “benefits” is Property B, the new one. It has a brand-new home that costs $400,000 to build. The old one, Property A, has not much depreciation.

This is what property developers want investors to see:

Property A – old

  • Total value: $600,000
  • Land value: $400,000
  • Building value: $200,000

Property B – new

  • Total value: $600,000
  • Land value: $200,000
  • Building value: $400,000 ➜ BIG DEPRECIATION BENEFITS!

But as an investor, this is how you should be looking at it:

Property A – established

  • Total value: $600,000
  • Land value: $400,000 ➜ MORE ASSET
  • Building value: $200,000 ➜ LESS LIABILITY

Property B – new

  • Total value: $600,000
  • Land value: $200,000 ➜ LESS ASSET
  • Building value: $400,000 ➜ MORE LIABILITY

Looking at this, which turns out as the better investment? When someone buys a new property, he is likely paying more of his money for a liability. But if one purchases an old or established property, he is paying more for an asset. Right, isn’t it? Each property investor wants to buy assets, not liabilities.

BUT…

“Every rental property comes with a liability (the building) sitting on top of the asset (the land).”

If an investor wants the best capital growth, he wants the most significant ratio of the asset and the most negligible percentage of liability. So, which means he should be buying old or established properties rather than new ones.

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Land appreciates

It’s a known fact that land appreciates while buildings depreciate. So, let’s see what happens to the value of Properties A and B over time.

*The assumption is that land for both Properties A and B appreciated within the span of the same period, eight years. Think of the land having the same appreciation rate for these two properties. The land for both properties has doubled in value for the eight years.

*8 years later

  • Established/Old Property = Property A

Land value doubled: $800,000 ➜ ASSET

  • New Property = Property B

Land value doubled: $400,000 ➜ ASSET

The established property’s land would now be worth $800,000. It doubled from $400,000. The new property’s land is only worth $400,000. It doubled from $200,000. Both doubled in value over the same timeframe.

Buildings depreciate

By factoring in depreciation, for the same period of 8 years — assuming that both properties’ depreciation rate is at the same rate, which is 20%.

After 8 years:

  • Established/Old Property = Property A

Building value: $160,000 ➜ LIABILITY

  • New Property = Property B

Building value: $320,000 ➜ LIABILITY

To summarize:

The old/established property’s loss is $40,000 for depreciation of the building and gained $400,000 in land appreciation. On the other hand, the new property has lost $80,000 in depreciation but has $200,000 in land appreciation.

*The calculated values 8 years later:

Property A – established

  • Total Property value: $960,000
  • Land value: $800,000 ➜ ASSET
  • Building value: $160,000 ➜ LIABILITY

Property B – new

  • Total Property value: $720,000
  • Land value: $400,000 ➜ ASSET
  • Building value: $320,000 ➜ LIABILITY

The established property A has grown to $960,000 from $600,000 – a gain of $360,000. However, the new property has increased by only $120,000 over the same period.

Both were of the identical prices and got the same appreciation rate and depreciation rates over the same period (8 years). Yet the difference is an overwhelming $240,000 in that time frame.

Capital growth

If we view this from a capital growth perspective, we can observe the surprising difference:

After eight years –

Property A – established

Total value: $960,000 (up 60%)

Property B – new

Total value: $720,000 (up 44%)

Property A looks better than property B despite having the same appreciation and depreciation rates. The reason is simple: a combination of having the higher land value and lower building value.

With the two properties in the same market exhibiting identical growth rates – one has performed doubly well vs. the other because it is not new – this looks remarkable.

But it’s not that significant if we consider the tax.

Check out “Everything you need to know about Buying Off-Market Investment Properties”

Tax

In this category, the advocates of buying NEW property start talking about this depreciation that one can claim.

Property A (the established property owner) has only claimed $40,000 for depreciation (and likely lesser due to different rules for depreciation claims in established properties). Therefore, for the purpose of this example, we will assume that the owner was only able to claim half of the depreciation loss, that is $20,000.

But the amount of depreciation is not some money in one’s bank. It’s just an allowable deduction from the investor’s taxable income so they will pay less tax. For this example, to maximize tax savings, let’s assume the tax rate of 40%.

What happens after 8 years?

Property A (established)

  • Start: Building value is $200,000
  • End: Building value is $160,000
  • $20,000 depreciation (as claimed only 50%)
  • 40% x $20,000 = $8,000 (tax savings)

Property B (new)

  • Start: Building value is $400,000
  • End: Building value is $320,000
  • $80,000 depreciation (as claimed 100%)
  • 40% x $80,000 = $32,000 (tax savings)

If the marginal tax rate was 40%, the property owner claimed $20,000, and tax savings would be $8,000.

If another claimed $80,000 for the same tax rate – the tax savings is $32,000.

That’s quite a big difference!

After-tax cash-flow, the buyer of the NEW property buyer looks better off than the old buyer by $24,000 ($32K – $8K). However, considering the net position and net wealth created – the overall winner is the old property buyer due to the property’s capital growth.

Worse off, not better off

By looking at depreciation and disregarding capital growth, the buyer for the new property is still not better off by $24K. On the contrary, one who ignores inferior capital growth is worse off.

This scenario shows that depreciation is not a benefit. The tax that one can save is simply diminishing the amount lost.

When an owner claims $12,000 in depreciation and pays $5,000 less tax, this doesn’t mean he is better off by $5,000, but worse off by $7,000. The property has depreciated by $12,000, and he has claimed that loss. The loss is not worse after the tax, but it is still a loss. One should not consider depreciation as something that an investor would prefer more. Instead, he should try to cut it.

Capital growth easily beats the presumed tax benefits of depreciation. So, at this point, the old property buyer is better off by more than $200K even after considering the $60K difference in the claimable amounts of depreciation.

The situation even gets worse once the NEW property buyer decides to sell. Every cent claimed in depreciation over the period of ownership is taken off the base cost upon selling. This means, you will be left with more capital gains tax to pay. ATO typically gets back some of the tax savings in capital gains tax.

Yet, it doesn’t mean that one should not claim depreciation. It just means that one can identify better investment options based on how small amount of depreciation that can be claimed.

“A higher depreciation means the investment is worse off.”

Cash Flow

Up to this time, we’ve assumed that the two properties had the same income and expenses for the period of eight years. But the established properties will incur higher maintenance costs vs. the newer ones. On the other hand, the newer properties may have higher rental income vs. the older ones.

After eight years…

Property A (established): Expenses is higher by $2,500/annum for 8 years = $20,000.

Property B (new): Rent is higher by $50/week for 8 years = $20,800

(This has sealed the disparity by over $40,000, but it’s still well in favour of the old property by about $175,000).

PLUS, there is one other consideration:

Older properties’ higher maintenance costs are tax-deductible. Government fulfills its role in alleviating the burden with one’s marginal tax rate percentage.

Just as the developers’ crazy marketing pitch is – these are called “high maintenance benefits.”

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Renovate or rebuild

So, in the end, the old and established properties will require a complete renovation. Yes, a rebuild will be sooner for older properties than new ones. But the need to renovate can be a benefit rather than a disadvantage. Indeed, it can be a BONUS!

For example:

  • Spend $60K on renovation
  • $100K value increase
  • $40K profit
  • 67% return on investment (40/60 = 67%)

If one thinks in annualised terms, this is wonderful and this still doesn’t even consider the potential increase in rental income. But…

“You can’t renovate new properties.”

When you purchase new – this means there’s a missed opportunity to make those excellent returns. If the growth comes slower than expected, there is no other strategy to fall back on such as manufacturing growth by way of renovation. Based on the data, capital growth doesn’t come as naturally easy for new properties compared with older properties.

Yes, one can even knock down the present dwelling to build a new property, more so if it turns out to be commercially feasible.

  • Rebuild for $400K
  • $500K value increase
  • $100K profit
  • 25% ROI (100 /400= 25%)

Truth to tell, this is what the developers are doing. But if the investor does the rebuild or renovation himself, the profit will go to his pocket, not theirs (the developers).

If you buy new, you’re not just paying cost; rather, you’re paying for both the cost and the developer’s profit.”

The value you’re adding to your property through renovation is your profit alone while in new properties, that yield goes to the developer and his business partners.

Vacancy

Many would claim that the demand for new properties is greater, thus resulting to lower vacancies. But some would attest that they have higher vacancies because most of these properties are launched in large lots at a time. Therefore, competition for the suitable tenants is evident among the landlords.

With bigger developer activity, the tendency is higher vacancy rates. There is historical data to support this. But it makes a negligible difference to the bottom line anyway. Ultimately, it will create a difference of just a few thousand dollars over a number of years.

*In summary – 8 years later:

Property A (Established)

  • Total Property value: $960,000
  • Land value: $800,000
  • Building value: $160,000
  • $20,000 depreciation claim (and more, perhaps…)
  • 40% of $20,000 = $8,000 tax savings
  • Higher expenses of $2,500 per annum for 8 years = $20,000

$360K capital gain + $8K depreciation tax savings – $20K extra expenses = $348K

Property B (New)

  • Total Property value: $720,000
  • Land value: $400,000
  • Building value: $320,000
  • $80,000 depreciation claim
  • 40% of $80,000 = $32,000 tax savings
  • Total after tax gain = $152,000
  • Higher rent of $50/week for 8 years = $20,800

$120K capital gain + $32K depreciation tax savings + $20.8K extra rent = $172.8K

Indeed, there’s nothing to contend here. The older/established property is a better option than the new property. The difference to the investor for the eight-year timeframe was $175K.

Nothing like rent, expenses, depreciation, etc., can be significant to thump capital growth.

“Undoubtedly, it’s the capital growth that beats everything!”

So, the KEY takeaway is this:

“Mathematically speaking, the new properties cannot beat old properties with all other things being equal.”

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