Podcast: What is Overcapitalisation? And What Do Investors Need to Know? | Ep. 251

Posted by Ed McKnight on 21/05/20
What is Overcapitalisation And What Do Investors Need to Know 001
Listen to the Show

Listen to the Show

Show Notes

What's Covered in the Show?

In this episode, we discuss the concept of overcapitalisation, what it is and how you can avoid it. In simple terms, overcapitalisation is where you spend more money to renovate a property, but you get less out of the property than what you've spent.

This applies to any dollar that you've spent on a property and not seen a return on that dollar (that is anywhere, where you have spent a dollar and not seen your property increase in value by a dollar).

We also mention our property investor quiz, this is where you can answer 7 quick questions and you'll get an instant 'yes', 'no' or 'maybe' answer about whether you are in the position to invest or not just yet.


Transcript of the Podcast

Ed McKnight: Hello and welcome along to the Property Academy podcast. I'm your host Ed McKnight, and I'm Andrew Nicol, and today on the show, we're talking about over capitalisation.

Now, so often when we talk about running numbers on the show. We'll say cool, you're going to buy a house for 400 K you might renovate it for 50 K it's now worth 500 K.

Look, you made 50 K on that. But the big question is, how do you know that any money that you spend, either renovating or developing a property is actually going to turn into value for the buyer?

Because of course, value for the buyer equals whatever your sales price ends up being. So you've got to make sure that any money that you're putting into a development or a renovation is going to turn out into value at the end of the day for somebody who's going to purchase it, because otherwise you're going to end up overcapitalising that property.

Andrew, just give us a rundown or a soundbite about what that actually means. What is it over capitalisation?

Andrew Nicol: So I guess the big thing when you're looking at property for investment, is all going to come down to the bottom value and so many people will spend extra money.

And I can think of one particular case at the moment, I know who's a person close to my family who is doing renovations to their own home, so that it's a future investment, but due to the time that it's taken and hopefully she's not listening, given that she is my mother-in-law, due to the time that it's taken, and due to the amount that they're spending, it's probably got to the point where it hasn't really been worth doing because the value at the end versus the cost of the project, she might as well have just gone out and done something else.

And so this is something you've got to be really, really careful on. And you know, there's that old adage: buy the worst house on the best street. You don't want to end up with the best house on the worst street, because you're going to lose money doing that.

Ed McKnight: Yes, and you are much more likely to overcapitalise if you're doing it for your own home, cause you're going to, you potentially going to spend the extra money in order to get the nicer taps or the slightly better fittings.

And that may not end up being valuable for the buyer, but you just like it because it's your house. So essentially over capitalisation is when you spend 10 grand on your house, but it only creates five grand worth of value or increase in value for the buyer. Or you know, similarly, even if it's. You spent 10 grand but get 10 grand worth of value.

Well, you've done the work, but you've also spent time and you've spent that money that you could've done something else with, and you've really lost out on that opportunity because you've spent money but haven't got a real return out of it, which is, I guess what

Andrew, you're talking about there, but walk us through Andrew, what are some strategies as well to make sure that you're not overcapitalising if you're doing a renovation. I know this comes back to I guess a central idea that nobody's really created a good model for, which is, you know, what should I spend on, where should I spend it?

And if I spend 10 K, 1 K, whatever it happens to be, what is the additional value I'm going to get out of it?

There's no fixed way, because really you've got to spend the money, do the renovations, and kind of see what happens at the end and see the value that's created.

So it's going to be different in each individual situation, but give us some principles about how to avoid over capitalisation and how we can make sure that any investment we make in our properties is actually going to turn out into value at the end of it.

Andrew Nicol: Well, there's two parts to this, I think. And so the first part might be if well, first you got to realise what your purpose is for doing the renovation. So if you're renovating a rental property and you are adding another room for example, you're separating off one of the living rooms or making another bedroom out of that so you can achieve more rent then that's based on a yield calculation.

If you're doing it to add value to the property, then really the best value add is usually those of a cosmetic nature, and certainly anytime that I've done renovations that I've added better value than the cost is when I've done cosmetic things.

So, no removing load bearing walls. No doing anything that requires a council consent or anything like that, things that you can turn around really quickly and change the aesthetics of the house, and so a bathroom or a kitchen, they can add really good value, new paint, new carpet, all of these kinds of things.

But if you're borrowing money from the bank to do these things, generally a bank will ask you to get a valuation. Now the valuation will be in two stages. It will be now the property as it stands today based on its current market value, and then it will be the value after you finish based on those alterations that you've done.

Now, even if you aren't borrowing the money from the bank, if you're using cash to do this or you've already got a facility in place, I would highly recommend using a registered valuer to actually help you assess what the value looks like when it's complete.

And if you're going to spend 50,000 to make 50,000 you might not do that, well as in, sorry to add the value of 50,000 so, so no actual benefit.

If, on the other hand you're going to spend 50,000 and you're going to add a hundred thousand worth of value then you may consider it. Another thing that you might do is bring in a local real estate agent and get them to tell you what you're likely to achieve in the area.

Now again, always take a real estate agents word with a grain of salt and don't go listing a property just because they've told you can get a million dollars for it. A registered valuation is the better way, but obviously an agent doesn't necessarily cost you, so that's why people probably prefer those.

But any of those cosmetic things, lifting values through things like the garden, the paint, the carpets, those are all really good things to do and get a valuation to ensure that you're not overcapitalising and you know, one of those things that jumps into my head is one of the first properties I ever bought, we probably did a little, we added value, but we probably overcapitalised somewhat because it was in a very rough neighbourhood and we put things like a clawfoot bath in it because we thought that that was cool and we repainted and we re-carpeted and did all these things we really probably didn't need a whole lot of that stuff.

Ed McKnight: Yes. And the interesting thing about capitalisation is it does depend on area. So we were just talking offline, Andrew, that if you were in say, Auckland and going to do a renovation in Remuera, you can probably spend that extra money to get some really nice fittings to put the claw foot bathtub in the bathrooms, because that's something that that market and that target customer is going to want and pay up for.

Now if you were to go to a slightly poorer area or lower socioeconomic area, if I can call it that, you're potentially going to have customers who are more utilitarian. So if money's a bit tighter, they're not going to necessarily shell out for that. And you're not going to have the buyers who are going to pay the premium for those extra renovations that you've done.

And I think the best way to do it in almost any situation is to think back to, I think it was about episode 80 or 120 or something along these lines. I should probably know all the episodes, but I think this is going to be episode 251 so please forgive me.

There was a great episode we did with Tim Weston, who's one of our property coaches at Opes and he was talking about becoming a suburb level expert.

If you are going to do the kind of renovation development path where you take a look at okay, I know where I can get this property too if I renovate it.

Let me go out and look in the suburb at similar properties, at properties at the level where I believe I can renovate this property to whichever one that you've just invested in, because that is probably going to give you a better mark for, okay, if I can make the property and bring it up to this particular standard, this is the value that I'm probably going to be able to extract for the market.

This is what I'm going to be able to sell it for. Then you can go away and price up whatever it would take to make that property up to that standard. And you can see what those level of margin would be within that.

And that's probably a slightly more scientific or data driven way, even though it is relatively qualitative, to be able to go out and figure out, well, what do I have to spend?

What is the level that of value that I'm going to be able to extract from the market to make sure that you aren't overcapitalising to make sure that you are hitting the market and understanding what properties are selling for within that market and who that target customer would be.

And that's how you're going to make sure that you're not going to overcapitalise because the worst thing for a property investor obviously is losing equity.

f you spend five K and get nothing in return, then you've lost five K worth of equity that you could have done to either do a higher quality renovations that you're going to be able to pull the equity out of or to invest in another property if it's going to push you over the line to be able to invest in the next property.

So we do have to be really strategic, and if I can say this, think like an economist, being one I have to think like that. What is the opportunity cost or what am I losing out on if I spend this five K over here. Yeah. What am I not spending that 5k on somewhere else and what is the return I could have otherwise got somewhere else?

This is really important to start to think about, but hey, anything else before we wrap up Andrew?

Andrew Nicol: No, that's everything from me.

Ed McKnight: Fantastic. Well, let's wrap it up there, but please don't forget to rate, review and subscribe to the podcast. It really does help us get the message out to more and more people and hey, if you've been listening for a while and you're thinking, hey, I might give this property investment thing a go, then why not check out our property investment quiz.

In just seven questions it is going to give you a yes, no, or maybe answer about whether you're in the right financial position to invest in property. I'm going to link to that in the show notes, so just tap or swipe over their cover art it'll take you right there. Or you can also see that at Opespartners.co.nz.

Thanks for listening to the Property Academy podcast. I'm your host Ed McKnight, and I'm Andrew Nicol, and we're going to be back again tomorrow with even more daily strategies, tactics, and insights to help you in the most out of the New Zealand property market.

Until next time.