Is property development an effective way to build wealth?  

There are generally three ways to make money: through passive investing, starting, and building a business, and speculation. This blog primarily focuses on pure investing, which in simple terms, involves investing capital to achieve high returns with the least amount of risk. 

It’s crucial to distinguish between these approaches because they can sometimes overlap, complicating risk assessment. For instance, property development is often more akin to running a business than passive investing, due to its time-intensive nature and higher potential for complications, which some investors overlook. 

Investment fundamentals often remain unchanged. For instance, a buy-and-hold strategy for property investing is premised on the belief that well-located land is scarce, supply is fixed, and land value will appreciate over time due to increasing demand. This principle has held true for decades. However, strategies that mix elements of business or speculation introduce more variables, potentially reducing their effectiveness over time. 

A real-life, 20-year property development case study  

Towards the end of 2024, my firm worked with a new client, and I took the opportunity to assess the effectiveness of an investment they held. Back in 2006, with the help of an experienced buyer’s agent specialising in small-scale property developments, the client purchased a house on a 893 sqm block of land for $540,000. Over the next few years, they demolished the house and built three townhouses at a cost of $645,000. Fast forward to today, and those three properties are worth around $3.2 million in total, generating just over $2,000 per week in gross rental income. 

Luckily, the client kept excellent records, allowing me to analyse the financial performance of the investment over the past two decades. I was able to calculate the exact after-tax holdings costs, including any depreciation benefits, over the holding period.  

Based on my analysis, I estimate that this client would have achieved an internal rate of return (IRR) of 14.8% p.a. after tax if they sold all three townhouses. This is, without a doubt, an excellent return! 

The reason for such a high IRR is that the nature of this property meant that cash flow holding costs were relatively low. Because the properties were newly built, they attracted strong rental income. Over the 20-year period, the capital growth rate was 5.8% p.a. Therefore, in essence, the investor did not need to spend much on holding costs (a total of $270,000 in today’s dollars) to benefit from a 5.8% p.a. growth rate over two decades, which would realise an after-tax cash gain of almost $1.4 million today. In short, he’s turned $270,000 of after-tax cash flow (capital contribution) into a lump sum of $1.4 million.  

Cost of land has increased substantially  

The client purchased an old house on a 893 sqm block of land in a quality bayside suburb in Melbourne, just 15 km from the CBD. In today’s dollars, the cost of that land is circa $1,000 per sqm. To find land at that price now, you would likely have to look much further out into Melbourne’s newer, outer suburbs – perhaps 30kms or more from the CBD.  

Land prices have, of course, increased over the past two decades. This means that would-be developers now face either higher land costs, which can adversely affect the viability of their development, or they must consider locations further from the CBD to make it work financially. However, infrastructure development has not kept up with land price increases, making outer locations less desirable and investment-worthy. So, when investing further out, the trade-off is clear: the investor is likely to experience lower capital growth. Achieving a 5.8% p.a. growth rate, as the above-mentioned client did, is probably not realistic in these outer locations. 

Cost of construction  

It’s well documented that construction costs have surged, especially since the onset of Covid. According to the ABS’s House Construction Industry Index, construction costs today are over 15% higher than they were in 2006, in real terms. This increase directly impacts property developer margins. Many residential developers believe costs have risen even by 20% to 30%, compared to pre-Covid levels. 

If it had cost this client an additional 30% to construct the three townhouses (i.e., $840,000 instead of $645,000) back in 2007, which is probably more realistic, the internal rate of return (IRR) would drop to 11.7% p.a., which is still attractive.  

If we further adjust for higher land costs or a lower capital growth rate, the IRR would decrease even further, to the point where a traditional buy-and-hold investment could deliver the same return with less risk. 

Case in point: the client’s second development  

Back in 2008, this client completed his second small-scale property development. He purchased a property for just over $1.1 million, demolished the existing dwelling, and built two 4-bedroom townhouses at a construction cost of just under $1.2 million. Today, these properties have a combined value of around $4.2 million and generate approximately $110,000 in gross rental income each year. 

However, this development has not performed as well as his first one. The key reasons are higher acquisition and construction costs, greater negative cash flow due to higher debt levels, and a more modest capital growth rate of around 3.9% per annum. I estimate the after-tax IRR on this investment to be 11%. 

Maintain the IRR but look to invest more capital  

The IRR is just one measure and should not be used in isolation, as it does not account for borrowing capacity, which is a limited resource. You also must consider the amount of wealth that will be accumulated.  

Let’s say your borrowing capacity limit is $2 million, and you are comparing two investments using this borrowing capacity with similar IRRs: 

1. A small-scale property development of 2 to 3 dwellings, like the examples above, or 

2. A buy-and-hold property investment. 

The small-scale development will have lower holding costs, as I mentioned earlier. However, if the IRR is the same as the buy-and-hold option, it means you will build less wealth in the long run because you are contributing less capital (lower holding costs). 

The buy-and-hold investment, on the other hand, requires a larger investment to cover higher annual holding costs. If it delivers the same IRR, you will accumulate a lot more wealth over time, in dollar terms. But this comes with a caveat; you need the cash flow to manage those higher holding costs. 

When comparing investment options, it’s essential to consider both the IRR and the level of capital you are expected to contribute to ensure the investment is the best fit for your circumstances. Choosing an option that requires a lower ongoing contribution might not be the most efficient use of your limited borrowing capacity. 

Put another way, an after-tax IRR of 14.8% sounds incredibly attractive, and I would love to invest all my money into an opportunity like that. But my ability to invest is constrained by the property’s expected negative cash flow.  

Investing $70,000 per year in an investment that delivers a 10% IRR will generate more wealth over time than investing $30,000 per year in an asset with a 15% IRR. This is because the total amount of capital invested plays a major role in wealth accumulation. However, most investors cannot invest in numerous multiple small-scale developments (to, for example, invest $70,000 per year in a 15% IRR investment) due to borrowing capacity constraints. 

The purpose of a financial plan is to answer one key question: how do you convert your cash flow throughout your working life into the largest possible pool of wealth by retirement?  

The key is to allocate your borrowing capacity to investments that will fully utilise your investable cash flow while also delivering the highest possible IRR. Your borrowing capacity is your most limited resource, so it’s critical to put it to work in the most effective way.  

Considering investing in a property development?  

If a small-scale property development can achieve a 15% IRR, it might be a good option for investors who cannot afford the cash flow required for a traditional (high growth, low yield) buy-and-hold strategy. However, it’s important to be realistic about what kind of IRR is achievable over the long term. 

There are two key challenges with property development today. First, construction costs have risen significantly in relative terms, which has squeezed development margins. Second, land prices, especially in blue-chip locations, are much higher than in the past. To make a development financially viable, you will need to buy in a more affordable location, but the trade-off is typically a lower capital growth rate. 

I believe a well-selected, investment-grade buy-and-hold property can realistically deliver an after-tax IRR of 10% to 11%. If a development project is not expected to generate a meaningfully higher return than that, then pursuing a development strategy may not be worth the additional risk and complexity. 

Other interesting observations  

I wanted to share a few other interesting insights that came up during this financial analysis. 

One key observation is that property expenses, excluding interest, have risen significantly over the past two decades. Back then, they accounted for around 22% of gross rental income, whereas today, they have climbed to 30%. I have written about this trend in more detail here. 

Another notable point is that there were years when this client did not fully maximise the benefits of negative gearing because they were too highly geared relative to their income. In several years, their taxable income was either very low or completely wiped out after accounting for rental losses. The real power of negative gearing comes when property losses offset income above $135,000, as this delivers a tax saving of at least 39%. Typically, it’s best to avoid gearing so aggressively that taxable income falls below $45,000, as the tax benefit then drops sharply to less than 17%. Maximising negative gearing benefits can significantly improve the IRR.