One of the worst reasons to buy an investment property

Every week, without fail I speak to prospective investors who wish to purchase investment properties with high depreciation benefits. Likewise we get targeted by marketing groups offering lucrative commissions for their brand new, Off-The-Plan stock.

Explaining why we don’t target brand new comes as a shock to some, but the reason is simple.

When depreciation is high, the property is often making a loss.

This may seem simple logic, but it is quite challenging to explain to someone who either promotes this stock for a living or tells their clients to target a cashflow saving for accountancy reasons. I recall a conversation I once had with a client’s accountant after their advice was clashing with my property investment advice. The accountant told me “Cate, my job is to save them tax.”

I said “no, our job is to help them build wealth.”

To illustrate the rationale why depreciation should never be a reason to buy an investment property, we focus on the other three important attributes that investors should be focusing on;

1. Long term, sustained capital growth
2. Reliable and consistent rental yield
3. Tight vacancy rates

There is no amount of depreciation benefit that can override the upset that is caused by any of these three attributes underperforming. If the property is difficult to rent out due to either an oversupply of similar properties in the area, or a limited tenant pool, the depreciation will only help the cashflow so much. Eventually the investor will need to sell the property if the holding costs are too great. Problems often arise for investors when they haven’t held the property for ample enough time for capital growth to be positive.

In other words, if the property is worth less than what they originally paid for it at the time of sale, they will incur a loss.

When purchase and selling costs are overlaid the whole exercise becomes even more painful.

Not all brand new and Off-The-Plan properties lose value immediately after purchase, but most do. The reason for this is that the “Land to Asset Ratio” is too low. This is particularly problematic if the land component as a factor of the overall purchase price is under 50%. When the dwelling is worth more than the land component, the rate of depreciation of the dwelling can easily be greater than the rate of appreciation of the land component. Sure, the investor may enjoy the depreciation benefit as a tax rebate in July, but what is the point of sustaining out-of-pocket costs, carrying the risk, and wasting mental energy on a property that is worth less a year later? Surely a different type of investment with a more likely return on investment is a better idea?

Below is an example of this point. This block of apartments in Yarraville were sold Off-The-Plan in 2012 and construction was finalised in the two years following.

These sales dates and results are for one apartment in the block that was purchased initially for $509,000 and later resold twice. 

It could be argued that the original purchaser paid a premium price (and this does happen often when developers employ marketers to sell), but it is fair to say that the purchaser’s rate of building depreciation was so great that it exceeded the property’s attributed land value growth for the period of their ownership.

Depreciation amounts vary depending on the Quantity Surveyor’s determination of the plant & equipment and building value. A rough guide however for this particular apartment would have potentially been around the $10,000 mark for year one and diminishing incrementally year after year.

Had this particular investor targeted a higher capital growth property, they’d have forfeited the attractive depreciation incentive, but experienced some capital growth (as opposed to losses as shown above).

Not only was the property costing them in out-of-pocket cashflow, but it also cost them in lost opportunity.

We always remind our clients that depreciation isn’t a bad thing, but it’s a benefit, not a reason.