Building Long-Term Wealth: Mastering Land to Asset Ratio & Paying Down Your Home Loan Vs Investing Surplus Cash Flow (Ep. 243)

This week’s episode features a two great listener questions, the first from Catherine.

Question 1 – “My husband (39) and I (32) are doing well financially and trying to decide our next move. Our goal is to pay off our mortgage but we feel like maybe we should be buying an investment property. In SA western suburbs, our house is worth around $900k and our mortgage is sitting at $290k. We have a spare $3000 monthly (after bills and allowances) that we are putting on our mortgage. If we buy an investment property it will be negatively geared but we aren’t sure whether it is worth buying now as we will have to contribute to repayments. To buy a house with some land in a decent area is around $600-700k+. Will the tax deductions be worth it or should we wait and keep smashing our mortgage, pay it off in 5 years?”

Dave warns that tax deductions are not the primary reason to invest, find out why!

Many people feel compelled to pay down debt, but this isn’t necessarily the optimal way to build future wealth. The Trio share their individual thoughts around Catherine’s dilemma, explaining leveraging, setting financial goals and discussing the positives of good debt.

Where do you want to be financially and at what age do you want to scale down or slow down work?

Dave also includes a scenario to illustrate the potential in store for Catherine and her husband.

Dave acknowledges the strain and subjectivity of such a personal decision. Debt aversion can strike many, and as he points out, understanding our surplus cash flow is a critical step to getting it right. The scenario Dave cites is modest, and the modelled outcome spells a $500,000 superior net asset position for our listener couple.

Question 2 – I was pondering the land to asset ratio metric as a measure of ‘investment grade’ property and I think it warrants more consideration. I’d love to know your thoughts, but my musings are below. 

If more land is better, then that would imply buying vacant land would be a superior investment than buying something with a dwelling on top  

The answer is usually no, because vacant land:

1. Generates no rental income – you need a dwelling to house a tenant.
2. The debt is not tax-deductible because the asset is not an income-earning investment.
3. Your pool of potential buyers for selling a vacant block of land will be reduced.
4. Furthermore, the scarcity factor that helps drive up land values is usually lacking, and spare land is rarely available in highly sought-after locations.

The ideal land to asset ratio for YOU, will depend on your goals for the property

1. 95% land to asset ratio – you might assume it’s really great – BUT if it’s a property that you are putting a tenant in, that means the dwelling is only 5% of the price you pay (you can imagine what that dwelling looks like – not very appealing to most tenants) and that dwelling is likely to be a huge pain for maintenance works.
2. HOWEVER –  if you are looking to knockdown and rebuild, then 95% is probably a good idea for this purpose.
3. Generally from a buy and hold investment perspective with capital growth potential, you should strive to select an asset where the land represents around 70 per cent of the value of the property for capital growth potential.
4. 75-80% can be really good, if you’ve got an older property that has been nicely renovated internally and get you a bit of higher yield as well and potentially a higher quality tenant.
5. 50 per cent as the minimum if you are going for a property with a mix of yield and capital growth.

From a tax point of view – building’s have a 40 year life.

The metric also implies that $1m of land in the middle of the desert is of the same quality as $1m of land in an infill blue-chip suburb. 

Land to Asset ratio is just ONE factor (out of dozens, maybe hundreds) that will impact the ‘investment grade’ of a particular property.

Land to Asset Ratio is a good guide to selecting an investment grade property that is optimal for your goals (whether that is capital growth, yield or balanced)

If your goal is capital growth, it is important to remember that there are MANY things which can impact capital growth. The LAR is not the be all and end all:

1. Location (perhaps if you’re looking at a particular suburb) – the historical performance of that suburb could indicate future growth potential, BUT then you also have to consider that within a suburb there are:
   1. Highly sought after pockets and less desirable pockets
   2. Main roads vs quiet streets
   3. Desirable amenities within walking distance vs being too close to something (train station, petrol station, bars/night clubs).
2. The availability/scarcity of land – goes to demand – eg: a property within 10km of the city vs in the desert (or in these new estates)
3. Then looking at the individual property – orientation, architectural appeal, floor plan

These are just some examples of the things which can impact capital growth, aside from Land to Asset Ratio. There are many more!

When a property transacts, how do you even assign a value attributed to the land versus the dwelling?

Yes, so how do you get the exact land to asset ratio?

Well, it’s easier said than done, but here are some helpful tips

• You just need to know the average land value per sq metre for the location.
• Find examples of vacant blocks of land that have sold in the suburb or location.
• Most real estate agents will know this for the local area or at least have a reasonable estimate. Many will publish this information
• But remember – it can change from street to street and some real estate agents will even go further with estimates for different streets in a suburb.
• You can also track comparable sales, assign a value to the dwellings, and then estimate land value per square metre.
• Core Logic and other property data providers will also provide this information.
• Another thing to consider, is that the land value of a 600 square metre block is not necessarily double the value of a 300 square metre block – because the bigger the land, the rate of value per square metre drops

It cannot be an exacting science. If you can get close, then you’ve done well.

For example, property transacts for $1m, assuming “fair value” based on all comparables. Let’s say there was a reliable way of attributing value to the land $600k, and dwelling $400k.  If all else were equal and an identical property B sells to a more emotional buyer who overpays an amount of $1.2m, how is the additional $200k “emotional value” attributed to land and dwelling? 

Yep, we are dealing with people here, making one of the biggest decisions of their lives, in a high stress environment. Emotions will be running high.

Cate mentioned in our episode on this, that you can auction a property on two different days and get two different prices, depending on who shows up!

This all comes out in the wash over many sales.

Occasionally you might have an outlier but that is why you need to look at and track multiple sales.

However, a jump in price is what the market has dictated, and if it is an auction, then that means two buyers were willing to pay this price.

This may be the case even with a private treaty negotiation. What has happened is that the price has actually hit a new level potentially.

This is why we look at medians and mean averages and things like standard deviations to remove outliers and have different ways of assessing the average of something or what is reasonable.

However, at the end of the day there is no exact price for any location, land or property.

Every property is unique, every dwelling has different characteristics and is located at a different part of the street so I would suggest that our thinking needs to be more malleable and flexible when it comes to these assessments.

In short, this isn’t black and white or perfect analysis.

Most importantly, the saying “Land appreciates and buildings depreciate” I think is short sighted. 

I wouldn’t say that it is short sighted. It is overly simplistic!

Unfortunately or perhaps fortunately, we humans often break down large swathes of information into byte size statements or sentences for ease of remember and summing up information, but almost always the level of depth required to understand it is much complex.

The Dunning Kruger effect posits something along the lines of –

1. when we know little about a topic, we automatically presume we know more than we do,
2. when we start to research and understand a topic, we can then feel overwhelmed and like there is so much to learn and we will never fully understand the topic,
3. and once we become an expert, we can lose sight of how much knowledge we have and assume others already have a lot of the knowledge (when they don’t) which can result in experts not explaining things as well as they should, which is probably a trap that we have fallen into at times on this topic.

Overall, I find that understanding this natural way of thinking is helpful to keep us in check when we are going through the process of learning a topic of any kind or coaching and educating others.

What I will say about this, is that there has been significant international research to suggest that 80% of appreciation in a property’s value comes from the land appreciating in value.

Depreciation is merely an accounting concept, and it does not necessarily mean that something loses its value as it grows old. A heritage/character home with unique characteristics would surely be more valuable than a new, cookie cutter style apartment. Other examples – vintage wine, cars, antiques, etc. 

It isn’t merely an accounting concept.

It is a concept used by accountants because it happens in the real world.

Yes, vintage cars can hold a lot of value, and in fact can increase in value over time. However, more commonly – a brand new car will lose its value as soon as you drive it out of the dealership.

Talking about dwellings and depreciation, we can look at brand new builds.

They often come with an Inflated value on purchase price, which has a lag effect on capital growth. The price on purchase is inflated because:

1. You are not just paying for the land and the completed dwelling, you are also paying for…
2. All brand new materials – door handles, oven, stove, etc – the value of which goes backwards naturally as soon as it’s lived in and no longer ‘new’.
3. Time of labour – builder, tradesmen (50% of the value may not actually be the raw materials costs of the finished product)
4. Profit and costs of developer
5. New property is sold by developers and project marketers, so they often come with strong sales pitches and incentives to purchase that you need to be weary of which require profit for the Project Marketers and salaries for the sales staff commissions that come out of the cost of the property.
   1. With established property, the vendor pays the sales person – the real estate agent – not you.

A good example of how to think about how the land to asset ratio –

• A new build on the same street that may have cost $1million to build or more, sitting next to a dwelling with the same land size, orientation and slope or non-sloping land that some may consider a knockdown and have value of $300k will have a completely different land to asset ratio.
• At some point in the future that $1million build will be outdated, have significant issues, some may even want to knock it down and it will have depreciated.

The dwelling decreases from the moment it is built until it may get to a point in time where it perhaps plateaus, and may even possibly increase in value, but that is over many years, and by then the overall land to asset ratio will have increased, probably substantially.

Inflation will naturally fight against the deflation or reduction in value of the dwelling, but a totally unkempt dwelling could literally be worth zero and be unlivable at the extent of this line of thinking as it depreciates.  In fact, it could have a negative value becuase the would-be owner needs to factor in the demolition costs if it is unliveable, or if it was to be restored, this often will be more expensive than a new build.

A slightly absurd counter example would be: Let’s say there was a block of land in a quiet, leafy suburb valued at $1m. If for some reason council approved construction of a main road that cut through that suburb and would go through the frontage of the block, wouldn’t you say the value of the land has depreciated? 

Absolutely, and therefore the land to asset ratio would change, and they can and will change over time as prices might fluctuate in a location, and certainly with changes to the actual dwelling

• as the dwelling becomes more run down – the land to asset ratio increases
• If you renovate – you increase the capital in the dwelling and the land to asset ratio decreases
• Or if you knock it down and news ones are built.

I can only make sense of the above when viewed with the broader lens of supply and demand factors.

Ultimately it is the scarcity of the asset (supply), its desirability (demand) and the ability of the prospective buyer (also demand) that determines value – all of which have little (or no) relation to the proportion of land against the total asset.

In fact this is the exact approach that professional valuers take with every residential valuation that they complete.

But, that value will not be precise, as with yours. It is always an estimate and it will be the random individuals that actually compete to purchase the property that will determine the market value based on their own assessments of value which will have varying degrees of knowledge.

2. All of that determines the value of a property at a particular moment in time and we should be really clear that land to asset ratio is actually a tool to help you determine the propensity for future capital growth – not value as alluded to!

This is because overall, land value increases, and the dwelling decreases generally speaking.

And remember, that assessing land to asset ratio is a moment in time event. It isn’t a set in stone number that will be the same in the future. As touched on, it is always changing.