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Renovation Risk

Despite its popularity, renovation isn’t the right strategy for everyone, writes Andrew Nicol.

By: Andrew Nicol

1 November 2019

Property investment tends to have two schools of thought buy new properties and hold, or buy older properties and renovate.

While renovation is a popular strategy it’s not the right strategy for all (and I would argue, many) Kiwis.

That’s for two reasons:

1) renovating is more cash-intensive, equity-intensive, time-intensive, knowledge-intensive and stressful than buying new. This means that some Kiwis will put off getting started. And 2) because renovation projects require more capital, they tend to produce a lower return on that capital.

Let’s compare the two strategies. Take the example of a couple who have the choice of investing in a $500,000 new property, versus a $400,000 existing property. Let’s say the renovation would take $50,000, which will increase the existing property’s value to $500,000, resulting in a $50,000 immediate net equity gain.

Let’s look at three key differences between the two strategies.

Initial Set-Up Differences

New properties are exempt from the loan-to-value ratio (LVR) restrictions, which means they only require a 20% deposit. The investors will, therefore, need $100,000 of cash or useable equity to invest in the new property.

In contrast, the renovation will take $170,000 worth of cash or useable equity – $70,000 more. This is because

existing properties have LVR restrictions in place. This property will require a deposit of $120,000 (30%) and a further $50,000 for the renovations. The cash for these renovations can sometimes be leveraged against your existing portfolio, or own home, but they can’t be leveraged against the property you are renovating. That brings the total capital risked for the renovation project to $170,000.

This is one of the reasons that renovation projects may not be the right strategy for many New Zealanders –

they require more equity to get started (hurdle #1), then even if the investor has the capital, renovations require the investor to risk more capital (hurdle #2).

Cashflow Over 10 Years

Once the renovations have been completed and a valuation has been ordered, the renovated property could be refinanced, so that you have total lending of $450,000 against the property, which is now worth $500,000.

The new property would still have $500,000 worth of lending.

Assuming both properties rent for $500 per week, use a professional property management company, and have similar rates, insurance and accounting costs, we would expect the new property to cost $75 a week to hold, and the renovated property $46. The differences being that the existing property has a smaller mortgage and slightly higher maintenance costs, given its age.

With rents and costs increasing at the rate of inflation, I would forecast the new property would have total holding costs of just under $24,000 and the renovated property would have holding costs of just over $9,000 (both over 10 years).

The Returns

Over 10 years, both properties would be worth just shy of $815,000 (5% growth per year).

After accounting for holding costs, the new property would have total gains of $291,000, and the renovated

property would have gains of $355,000 a $64,000 difference

But you also need to assess your return on the capital you’ve risked to achieve those gains. Because you risked $100,000 for the new property, your return on capital is 291%. On the renovated property, you risked $170,000, so your return on capital is only 209%.

This is why both new investors and those who already have a portfolio should consider a strategy of buying and holding new properties. They require less capital to get started, and provide a better return on the capital that you’ve had to risk. ■

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