Have you updated and renovated a room multiple times? Have you spent too much already on tweaking your kitchen or bathroom? If your answer is yes, then you may be guilty of overcapitalising.
So, what exactly is overcapitalising? And how can Australian homeowners avoid this risk when looking to upgrade their home? Let’s explore how to walk the fine line between renovation success and failure.
What does overcapitalisation mean?
Overcapitalising refers to when more is spent on a property (purchase price and home improvements) than the property’s resale value.
It can occur when homeowners make improvements that exceed the value of the property, and these funds are not able to be earned back upon selling the property. This can cause considerable financial stress, as well as heartache, for homeowners who have spent time and money renovating a home, only to find those funds were spent in vain.
Australia is a nation of renovators. Between our popular reno-TV shows, and endless images on social media of attractive interiors and landscapes, it’s no surprise that the risk of overcapitalisation could occur to any unsuspecting owner-occupier or investor.
How does overcapitalisation occur?
While it can be a joy to turn your dream home into a reality, you must avoid overcapitalising when it comes to renovating your own property. Some of the most common renovation reasons overcapitalisation occurs includes:
- Going overboard with extras – Does your dream home design feature a new swimming pool, tennis court, home theatre and bowling lane? While this could be great for your personal needs, if it sticks out like a sore thumb in the neighbourhood, it may be difficult to gain back the money spent on these features.
- Style over substance – Sometimes homeowners can fall in love with a scarce floorboard wood, an expensive light fitting for the living area, or a bathtub that costs more than 6 months’ rent. All of these extra splurges can easily cause the amount of money spent on your renovations to skyrocket. Plus, it may not have as much impact on the value of the home as you suspect.
- Falling for trends – A certain style that is all the rage today could quickly look outdated in five or ten years time, even if it cost an arm and a leg to import and/or install. You may find that homeowners are put off by your favourite features and design styles, making it difficult to earn a profit from your improvements.
Is overcapitalisation always a bad thing?
Overcapitalisation isn’t always a crisis situation for homeowners. If you are planning on holding on to the property for some time, there is a chance that growth in property values over time could cover the gap of extra funds you invested today.
Keep in mind that there is nothing wrong with customising and modifying your home to suit your needs, especially if it is the family home. The biggest risk of overcapitalisation occurs when you renovate to boost the value of a property, only to find that property prices have fallen in your area and/or the amount you spent won’t be recouped by selling the property immediately.
This can be considerably risky for investors looking to flip a property in a short period, only to spend too much on the investment property and the renovation projects, and get little in return. If you took out an investment home loan to purchase the property, you may even be at risk of not making enough back to cover the cost of the mortgage. This could leave you in a position where you’ve sold the home but still owe money to the bank or lender.
How homeowners can prevent the risk of overcapitalisation
Before you pick up the sledgehammer, it may be worth thoroughly reviewing your plans, the property market and your budget. Consider reviewing the following factors to potentially lower your risk of extreme overcapitalisation:
1. Is renovation necessary?
If you’re an investor and not planning on selling the home immediately, you may want to ask yourself, is a major renovation necessary if growth in value is expected over time? While return on investment is never guaranteed, it is expected in Australia that a home value often doubles over a ten year period. So, say you purchased a home ten years ago for $350,000, and after a decade it sold for $700,000, the growth in the market may mean additional renovations wouldn’t have made that much of a difference in the property’s sale price anyways.
2. Professional valuation
It may be worth paying for a home valuation before proceeding with the renovation, so you know exactly what the value of your home currently is, and what your return on investment may be. By better understanding the market value of your property today, and how much it may have changed since you purchased it, you may have better control over how much to spend on a renovation. You may also want to speak to a real estate agent about how much other properties are currently selling for – renovated and un-renovated.
3. Set a budget (and stick to it)
It’s no secret that renovation budgets can easily balloon out of control. If you’re looking to sell a home right away, then keeping a tight leash on your budget could be necessary to avoid overcapitalisation. Take additional time to source quotes, and research exactly how much the renovation should cost you. Also, be firm with what exactly your upper-limit is for your budget as it can be extremely difficult to make this back in a short-term investment.
4. What is your suburbs’ pricing disparity?
There is more that impacts the value of your property than the home itself. The range of prices within the suburb your home is located in, also known as the pricing disparity, also plays a role in what you could earn at auction.
Say that your home is worth $500,000 and you spent $250,000 on renovations – you may be expecting the home to be worth $750,000 or more at completion. Before you begin your improvements, look into how much comparable houses in your suburb sell for, and if this is a realistic expectation. After all, the nicest house in a bad street will still need to find a home buyer willing to live in the bad street – and pay a premium for it.
What can you do if you have overcapitalised?
The worst has happened and your home renovation budget has exceeded your expectations. Worst of all, you find yourself at risk of extreme overcapitalisation, as market conditions have changed, such as rising inflation or rising interest rates, and property prices have begun plummeting where your property is.
Unfortunately, it may be worth waiting until market conditions improve and enough time passes that growth in the property market helps cover the costs of your purchase and renovation.
This option may be easier for owner-occupiers, but investors – particularly those on interest-only loans – may struggle to hold on to a property longer to wait for a decent return. Investors may find themselves losing even more money through ongoing expenses, such as mortgage repayments and general upkeep, resulting in stagnant cash flow.
However, if you are an investor that still has equity in the home, but just not enough to justify selling, it may be worth considering refinancing to a more affordable investor home loan. You may be able to switch to a lower-rate home loan, or even start another interest-only term with a new lender, while you wait for property prices to grow.
Reduce Home Loans offers some of the most competitive investor loans around. Take advantage of our interest rates, and generous features, such as offset accounts and a redraw facility.
For more information on competitive investor home loans, please don’t hesitate to speak to our team of experts today.
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