A critical driver of capital growth!
The ‘Land to Asset Ratio’ is a phrase we have been using since the early 2000’s to describe one critical assessment we undertake when reviewing the quality of investment properties. This phrase has steadily crept into the vernacular of other property professionals, but is not yet readily understood by most investors.
What is Land to Asset Ratio?
The Land to Asset Ratio is the proportion of the overall property value made up of the land component.
For example, if a property has a purchase price of $1 million, and the land value alone is $500,000, the Land to Asset Ratio ratio is 50%.
Why is Land to Asset Ratio important?
Knowing the Land to Asset Ratio is important because increasing land value is a primary driver of increases in overall property values. On most occasions, the dwelling is actually depreciating in value. For this reason, it pays to have an optimal percentage of the property made up of the land value.
What is the ideal Land to Asset Ratio?
From an investment perspective, you should strive to select an asset where the land represents 70 per cent of the value of the property, with 50 per cent as the minimum.
In the case of a renovation, the Land to Asset Ratio at purchase could be slightly higher, as you will pay less of a premium for a dated or rundown dwelling. As you renovate you will naturally increase the dwelling value, therefore reducing the Land to Asset Ratio.
Renovators should estimate the current land value, the current dwelling value, and the estimated value of the dwelling once completed.
This will enable you to determine your expected Land to Asset Ratio, which helps avoid overcapitalisation, which is common when renovating or completing small-scale developments. It’s important to remember that you are not increasing the land value by renovating the dwelling.
People often focus emotionally on the dwelling without understanding the land value of the property. This comes at the detriment of successful investment decisions.
Focusing on the Land to Asset Ratio can help remove or reduce emotion biases and attachments to the superficial or changeable aspects of the property, often the interior of the dwelling such as the kitchen, bathroom, flooring or wallpaper.
Thinking about the Land to Asset Ratio often leads to a logical question – should investors just purchase a block of land?
The answer is usually no, because vacant land generates no rental income and the debt is not tax-deductible because the asset is not an income-earning investment. Furthermore, the scarcity factor that helps drive up land values is usually lacking, and spare land is rarely available in highly sought-after locations.
What drives a high Land to Asset Ratio?
You can have a high Land to Asset Ratio due to:
- Large land size
- A high land value per square metre
- An older dwelling
A high land value per square metre is better to focus on as it is more likely to occur in highly sought after locations. This often means that the land size can be a lot smaller, while still purchasing a property with a high Land to Asset Ratio.
Visualise a standard home on 300 square metres vs 600 square metres. The property with less land, but in a superior location, can have the same Land to Asset Ratio as one in a poorer location with twice as much land.
In superior locations (which is regularly closer to the CBD’s) you have more established suburbs, and therefore, a higher percentage of older dwellings and period homes.
In these situations, you are more likely to have a superior Land to Asset Ratio than a newly completed property because the new property is yet to complete its depreciation phase.
– By David Johnston, Founder and Managing Director of Property Planning Australia, and Co-host of the mini-series ‘The Property Planner, Buyer and Professor’ which is currently on the Mentor List Podcast.