In the ever-present words of Mark Twain:
"Buy land, they're not making it anymore" - Mark Twain
Why are we quoting Mark Twain? Well, years on, this advice rings true for property investors because one of the biggest drivers of capital growth is land appreciation.
There are two types of assets, ones that appreciate in value, and ones that depreciate in value.
Take cars for example, as they say, as soon as your drive a new car off the lot, it instantly loses about 10% of its value. So, from a lifestyle point of view, you might have a flash new car, but from an investment point of view, this isn't a smart financial choice because you didn't generate any wealth - in fact, you lost wealth because the car depreciated in value.
On the other hand, real estate is a classic example of an appreciating asset because it generally goes up in value over time. Where cars lose value over 10 years, real estate prices tend to go up at around 6% per year.
Investing for wealth is all about investing in appreciating assets and using the increase in value (capital gain) as the source of wealth. This relates to real estate investment because there are two components to real estate; the land, and the physical house.
Without a land component, the value of your investment would likely fall over time as the building itself generally depreciates in value over time unless it is maintained and renovated.
One of the worst property investment choices an investor can make is to invest in properties that are on leasehold titles.
What's leasehold?
In New Zealand, there are four main types of property ownership:
Freehold - also known as fee simple, is the most common type of ownership
Unit title - also known as "strata title", you own your particular unit and a share of the common property (e.g. driveways, gardens)
Owners of leasehold properties generally own the building, but not the land so they have to pay rent to whoever the owner is. Generally, leasehold properties are apartments and they're often in city centers.
Leasehold - you own the building and have a right to occupy the land it sits on for a specific period of time according to terms set out in the lease
As it says above, owners of leasehold properties generally own the building, but not the land so they have to pay rent to whoever the owner is. Generally, leasehold properties are apartments and they're often in city centers.
An example of this is Auckland CBD where you can find lots of leasehold apartments for sale.
The vast majority of your wealth in property investment is generated from capital gains so without the gains, cashflow is your only saving grace.
With leaseholds, the deals often look too good to be true on the surface because rents are high and prices are low, but the underlying costs hide a much darker picture.
It can be tricky to find the underlying costs with just a surface check of the property, but it is incredibly important to do thorough due diligence. Let's look at a real-life example of a leasehold property currently for sale in Auckland CBD.
Property details: 2 Bed | 1 Bath | 0 CP | 69sqm int. | Asking price $90,000
On the surface, this looks extremely cheap for a 2 Bed apartment in the city, and it is currently rented for $520/w so the gross yield is incredibly high.
What's the problem then? Well, the issue lies in the underlying costs that are associated with this property and the lackluster capital gain projection. Because you don't own the land, you are required to pay a "ground lease" to the owner of the land which is usually one of the biggest costs.
In this case, here are the main costs that aren't documented on the listing:
Ground lease - $11,600 per year
Body corporate - $5,300 (Opex) per year
Rates - $1,300 per year
These costs are well above what you'd pay for a fee simple property simply on the fact that you have a lease and body corporate that you need to pay.
One of the fundamental drivers of capital gains is land value, and without it, there is little to no capital gain to be made - in fact it can often be negative due to the depreciating asset which is the apartment itself.
This property is currently listed for sale at $90,000 but the last time it was purchased was in 2020 for over $150,000 which means the owners have made approximately -50% capital gains over this term (assuming it sells for the list price).
There is a very real danger this ground lease can increase too.
When you purchase the property, details of the lease will outline what the cost of the lease is and how often the ground rent is reviewed by the freehold owner, and how long the lease is for. At the end of the lease period, you need to return the land and the buildings to the freehold owner in the way specified on the lease.
The lease reviews generally result in higher costs to the leasehold owners and with an ever-shortening lease term, this can inhibit the ability to sell your leasehold property at a later date.
Even if you do all your due diligence on a leasehold investment and you're still interested, the last hurdle you'll face is getting bank lending.
Banks don't look fondly at leasehold properties and will often require a 50% deposit as their main condition for lending. The banks will also consider the remaining term of the lease and if it is due to lapse soon, they will likely consider it a risky investment which makes acquiring finance even harder.
The good news for property investors is that most new build developments that come to market (including apartments) are either fee simple or unit title which means you aren't impacted by any of the factors outlined above.
As always, seek advice from a property investment advisor as well as legal advice for further details on titles and their impact on your investment.
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