A lot of people we have worked with up until now have not been certain in their response when we have asked them, “What causes Real Estate to rise in value?” It is surprising, because this is fundamental to property investment success. Therefore, I wanted to address this question and help others to understand the principles around this.
Generally, real estate consists of a land component, and a building component. For example, in residential real estate, a house sits on its own block of land, a townhouse sits on a smaller parcel of land, and even a unit has a small component of land in its purchase price – regardless of how many units exist in a unit block.
When we purchase a property, we are paying for the building (ie: the house, townhouse or unit for example), as well as the land component, within the purchase price. Generally, the larger the block of land, then the greater portion of the purchase price is made up as land value. Think acreage properties for example, which are mainly valued based on the land content and much less emphasis is placed on any improvements in the form of a dwelling house.
In the case of units where there is a very small component of land, the larger greater portion of the purchase price is usually attributed to the building (ie: the improvements on the land) and not the land itself (especially in the multi-storey higher density unit blocks).
So you may still be asking what causes real estate to rise in value because I have not yet answered this.
It is very important to understand what portion of the purchase price of a property is made up by the land, and the reason for this is simple.
It is only ever the land component of the property that appreciates, or goes up in value. The building component actually depreciates, or goes down in value, over time as it gets older and wears out, eventually requiring repair, renovation or replacement.
Of course you can “manufacture” value to a property by doing renovations or a complete new development, which also forces more value into the building component. But remember as soon as the renovation or development is complete, depreciation on the building starts again.
So, when you are buying a brand new property, you are paying more for the building component (which depreciates over time) and less for the land content (which appreciates over time).
It means that if you do not buy in an area that demonstrates good capital growth, your property may actually lose value because the building is depreciating at a faster rate than the land itself is appreciating. Interesting, but very true fact.
Another important consideration is that not all land is equal. Depending on the use of the land (ie: the council zoning for how the land can be used) and where it is located, the value of the land differs greatly.
So now you should have a better understanding of what causes real estate to increase in value over time. Always consider the land content and how much it contributes to the total purchase price of a property and understand that brand new properties, with smaller land sizes may not always perform well in the short term.