4 Local Components Of A Depreciating Property

By on July 16, 2013

Yes. Property depreciation is not just a fantasy we read about in fiction novels found at the library. So spoilt are we on the sustained increase in property prices that has become too easy to forget that real estate values can depreciate as well. Although the usual cause for a drop in property value is due to macroeconomic factors that are out of the control of an individual investor, having knowledge of the basic causes of falling valuations can help you navigate around a bad investment choice.

The 4 key components that can wipe off all your gains and give you negative cash flow as a Christmas present are:

  • Availability
  • Transferability
  • Usability
  • Supply

At times, just one of these factors going full steam can take down your balance sheet. But it is when 2 or more of these components work together like synchronized swimmers where the negative effects multiply. How much a property drops in value is usually a big concern for any investor. However, more alarming action has to be undertaken by active investors when the speed of the drop is more dramatic than a Korean drama series. Here is a closer look into the 4 factors.

Availability. When something is scarce, inevitably the value is more likely to increase than decrease. Take artwork by Picasso for example. If there is only 1 painting that is unique in the whole world, that scarcity alone can drive up the painting’s value tremendously. Well of course your property is not a piece of art. But if properties in the location you are eyeing is readily available, it does not make your property scarce in anyway unless you have oil underneath your house.

"I'm going down with a soft landing"

“I’m going down with a soft landing”

In prime areas, it is almost impossible to find undeveloped land to build more properties. The only way to buy into these areas are usually from existing owners or from a developer who has bought out existing projects via en-bloc. An exclusive area might have a few thousand apartments. But how many are available for sale? You would be lucky to find an owner in these areas willing to sell who is not in the books of the neighbourhood psychiatrist.

So if you are considering to buy an apartment in an area where there is no shortage of home owners making their homes available for sale, the lack of scarcity is not going to help your property value. A vicious cycle of depreciation can occour. As more home owners make their properties available for sale, it could trigger a price competition among them to attract genuine buyers. As this happens buyers are encouraged to make lower offers. The downward spiral  continues unless there is something about a particular neighbourhood that makes it attractive to mass buyers.

Transferability. If transferring ownership of real estate is as easy as a phone call, property transactions will multiply ten-fold minimum. It’s a good thing that that is not so. Or we will be looking at online market places for real estate whereby speculators can easily cause property bubbles in places halfway around the globe from where they are. Property transactions take time. Time is needed to view homes, arrange financing, get the legal work done, etc. Properties with less mass market appeal will also experience muted responses when listed. If it is not easy to find buyers who are eligible to buy your property, you are looking at a smaller pool of potential buyers for it. This is a reason why mass market homes tend to sell above valuation while niche homes tend to sell below. How many people can afford a $25m bungalow? So such homes usually sell below $25m even though that is what it’s value is. There is limited number of buyers. This is just a simplified to drive home the point.

Usability. There is a reason why en-bloc deals are always associated with windfalls for both home owners and developers. The reason is that the existing property is not making full use of it’s potential. A land parcel that is approved for a 500 unit condominium might currently just have 200 units built on it. This could be because the existing project did not make full use of the available land or did not build up to it’s maximum height allowed. There might also be restrictions laid down by authorities on what can or cannot be built on the property. This means that if your property is standing on land that does not have additional usability, investors will not see a great potential in it and devalue it. They might as well invest in projects that are under used. Avoid rumoured en-bloc potential properties when it’s usability has reached it’s limit.

Supply. Common sense tells us that when there is a huge demand for a limited product, prices will increase as buyers outbid each other. And when there is huge supply for limited buyers, prices will decrease to entice more buyers into the market. You might think that buying an apartment in a new neighbourhood with a small number of properties will be a good bet for appreciation. But if there is ample land available in the area, there is every likelihood that more properties will be build on the land. So while your purchase looked like a good appreciation play initially, by the next year you could be looking at thousands more apartments being built at adjacent land. This does not really do wonders for your property value.

While looking at supply, it is important to explore the particular type of properties that you are vested in. For example, if you are the proud owner of the only landed home in an area filled with sky scrapers, you are looking at a winner even though a huge supply of apartments are pouring into the area from a kettle. Scarcity and usability factors will come into play. But if you own just one of the thousands of shoebox apartments in a particular neighbourhood, start praying for divine intervention.



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