Articles Property Buyer Guide Dangers of Overcapitalising Real Estate Investment

Dangers of Overcapitalising Real Estate Investment

Although there may seem like smart actions when it comes to property investing, putting a lot of money into the renovation is not one of them. Here's why.

The ideal investment property is as elusive as the dream house, yet the hunt for both is vastly different, and it is this disparity that can lead many first-time investors to over-invest. What exactly is overcapitalization, and how can it be avoided? Any property investor faces the danger of overcapitalization. This is when you spend more money on improvements or additions to a rental property than the value brought to the property. Consider spending thousands of dollars on high-end bathroom fixtures when the bathroom is in bad shape, or undergoing so extensive renovations that your home's worth exceeds what purchasers would pay to live in your neighborhood.

Overcapitalizing is a word that refers to a situation in which the money spent on a property, both on the initial purchase and on upgrades, exceeds the property's resale value. In other words, the money invested on the property at the time of purchase or on improvements will not be recouped when it is sold.

Table with blueprint of a building and a drill, screws, measuring tape and a cutter.

Creating a "Home Sweet Home" of Your Own

We all want our houses to be pleasant and convenient; if not the home of our dreams, then at the very least one that we like and that is furnished according to our preferences. Who hasn't fantasized of a pool and air conditioning on a hot summer day, having an additional bedroom or two for visiting family, or sipping wine in a groomed garden with a water feature? While some of us purchase to increase our home worth, sell, and move up the property ladder, many of us go through the hard and stressful process of house searching with the hopes of remaining put for a long time.

Such plans include the danger of overspending, with high-end fittings and amenities like pools pushing the total cost of the property well beyond what it would sell for if it were sold. The reasoning is that we will not be relocating anytime soon. However, we never know what the future holds, and unforeseen circumstances may compel us to sell. Bereavement, divorce, a job move, or an international opportunity are many reasons that your "permanent" home may become a stopover. As a result, it's always a good idea to make sure your house isn't overvalued. That includes ensuring that any renovations or enhancements will increase the property's worth enough to pay their costs and, perhaps, generate a profit.

Sample colors and sample tiles laid out on a table

More renovations may imply a higher danger.

An increase in renovations puts more individuals at danger of overcapitalizing their investment property, and new information from the Housing Industry Association reveals that we are spending more on our properties. Renovation activity climbed by 4.5 percent in 2015, and by 3.3 percent last year. Detached properties older than 30 years are becoming a popular target for refurbishment.

So, now that we know what overcapitalization is and who it might affect, how can you prevent doing it to your own rental property? Here’s how you can avoid:

#1 Don't make a purchase based on your emotions.

Tim's first piece of advice for buying investment houses is to avoid buying with your heart. Investment properties should be treated as a transaction, not a heartfelt purchase." You shouldn't acquire investment properties just because you like them; you should buy them because they're profitable. Similarly, when it comes to remodeling, don't go overboard on new fixtures simply because you like them.

Old building with old windows being renovated and a red broom at the center of the image

#2 Make use of a buyer's agent.

Purchasing an investment property in one's own neighborhood is a typical blunder. While if you've done your study, this might be an excellent purchase, you're likely to be blinded by your personal circumstances. Typically, individuals buy relatively near to their home without giving it any attention. They purchase what they want to live in rather than what would provide the most growth and income, which is not necessarily the best investment. Using a buyer's agent can help you avoid this by pushing you out of your comfort zone.

A smart buyer's agent will guide you to a region that is going through a property growth cycle that you aren't aware of or that your present location isn't experiencing. This place might be some distance away or in another state. Be careful of Google if you're looking for a buyer's agent. Request a reference from your broker first, then from relatives and friends.

Building being built with lots of ladders and construction debris

#3 Keep an eye out for yield and growth.

If not bay windows and a built-in fireplace, what should first-time investors seek for in an investment property? Priority should be given to yield and growth. If your cash flow isn't as tight, you'll be more concerned with yield; if it is, search for a property that will provide long-term growth.

#4 Consider whether renovating is right for you.

It isn't for everyone to renovate. While the concept may be romantic, the reality may be unpleasant and time-consuming, and if you're not cautious, it can eat into your profits in the long run. Frequently, individuals will pay a high price for a home, spend a lot of money remodeling it, and then sell it for only a little more in five years. What they don't comprehend is that the land's value would have grown anyhow, so they go through all the effort and worry of upgrading for no additional profit.

Black man with green gloves drilling a fastener onto a wooden panel

#5 Do your research on the area.

Do your homework if you're going to remodel. You must have proof that your hard work will bear fruit in the place you are purchasing. If you're seeking to buy a house that requires renovation, make sure you do your research and speak with local real estate professionals before making a decision. To make a comparison, look at comparable houses in the neighborhood that are on the market or have just sold and ask your realtor, "Could we obtain what 'that' property just sold for if we completed 'this' renovation?" Do it if it will increase your earnings.

#6 Factor in all of the expenses.

You must include any remodeling charges in your profit margin if the property requires repairs. This comprises the cost of renovations, repairs, and upkeep, as well as the cost of interest on the money borrowed to complete the renovations over time.

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