Many aspiring property investors run into the same issue: limited budget.
That usually forces a choice between buying a larger home in a lower-quality location, or accepting a smaller dwelling, such as an apartment or villa unit, in a blue-chip suburb.
First-time buyers confront this trade-off more than anyone because their financial capacity tends to be tighter.
My view is that, in these situations, it is probably best to become a value-add property investor, rather than relying on a purely passive approach.
What is a value-add property investor?
A value-add investor allocates most of their budget to the land component and accepts that the dwelling may need work. In other words, they are willing to compromise on the dwelling’s condition so they can secure a better location.
The real power of property investment is the compounding effect of long-term capital growth. Hold a property for 30 years at 7.2% p.a. and it doubles roughly every decade. A $1 million property becomes $8 million after 30 years – three doublings – creating $7 million of equity. Crucially, almost 60% of that equity occurs in the final decade, while only about 15% accumulates in the first. This is a critical principle to grasp.
Over the long run, sustainable capital growth is driven largely by the land value, not the dwelling. So, we should not kid ourselves into thinking a value-add strategy outperforms a pure long-term growth strategy.
But the two can complement each other: value-add tactics can lift short-term returns without necessarily sacrificing long-term compounding.
How could this help?
I have written many times about property cycles. Broadly, markets tend to alternate between two phases: a flat cycle and a growth cycle. If you want to maximise returns in the early years, the objective is to buy just before a growth cycle. This matters because achieving above-average capital growth in the first 5 to 10 years gives you equity to leverage, allowing you to continue building your investment portfolio in property and/or shares.
Over very long, multi-decade periods, the priority is to own an investment-grade asset. Ideally, you achieve both aims: purchasing an investment-grade property at the beginning of a growth phase.
The advantage of adopting a value-add strategy is that you can create equity in addition to any market-driven appreciation – especially if your budget has forced you to invest in a location that is not considered pure blue chip.
That can give you more flexibility in the short term. For example, if you hold a property for only five years, but generate meaningful growth through improvements and market conditions, you may materially increase your borrowing capacity. Alternatively, it could be more economical for you to sell and use that equity to help fund a property upgrade.
In short, maximising equity growth in the early years can open financial options that may not exist otherwise.
What sort of improvements should a value-add investor make?
The objective of a value-add strategy is to generate the strongest possible return on your investment. In practice, this usually means undertaking improvements that increase the property’s value by more than the cost of the work itself, which is why cosmetic upgrades are often the focus. Of course, such improvements should also increase the property’s rental income.
The most effective cosmetic improvements typically include improving the kitchen and bathroom, updating flooring and window furnishings, painting, and adding efficient heating and cooling. In some cases, structural changes, such as adding a third bedroom to a two-bedroom home, can materially enhance value. However, investors should approach structural works carefully, as they usually involve higher costs and greater risk and complexity.
A common example is purchasing a property that is structurally sound and rentable, but clearly in need of upgrades to the kitchen, bathroom, flooring, paintwork, and window furnishings. In this scenario, investors can rent the property initially, even though the rental yield is likely to be relatively low, and then complete the improvements when their finances allow. This approach provides flexibility, whilst still unlocking the value-add potential.
Additional advantages of this approach
Improving a property after you purchase it delivers two important benefits beyond the primary goals of increasing its value and rental income.
Firstly, a recently renovated property is more appealing to prospective tenants, which reduces both the risk and duration of vacancy.
Secondly, when you eventually sell, there are fewer barriers for buyers. Every property has imperfections, and buyers will always find reasons to hesitate. The way to maximise your sale price is to minimise those objections as much as possible. Most buyers are not looking for a ‘renovation project’. Therefore, presenting a fully renovated property widens the pool of interested purchasers, increases the probability of achieving a stronger sale price, and shortens the time the property sits on the market.
What is the best way to implement this approach?
The most effective way to execute a value-add strategy is to work with a trusted buyers’ agent who has used this approach successfully for other clients. Experienced buyers’ agents support both new and seasoned investors and understand which cosmetic improvements deliver the greatest uplift. They also know which trades to engage to complete the work cost-effectively and efficiently.
Beyond helping you acquire a high-quality asset, the broader benefit is building a team of trusted professionals to support your investment strategy. In addition to their technical advice, you gain access to their network. Reputable professionals who have been in business for many years have invested heavily in cultivating relationships with like-minded experts and reliable service providers. Access to this network is immensely valuable.
As I have discussed previously, many investment decisions are ultimately “who” decisions rather than “what” decisions. Therefore, your task is to identify the right people to ask and trust, rather than trying to determine every step on your own. To achieve this effectively, you must surround yourself with high-calibre professionals. Doing so will likely have a profound impact on your long-term success as an investor.
How to fund improvements
Where possible, it is preferable to borrow the full cost of any improvements. This approach gives you maximum tax flexibility because it increases the portion of debt that is clearly attributable to the property. You can always use an offset account to reduce the interest expense.
However, you only get one chance to structure this loan correctly, and that is at the time you pay for the renovations. Even if you have the cash available, if your borrowing capacity permits, the most effective strategy is to borrow to fund the works and place your cash in a linked offset account. This gives you the ability to adjust the property’s gearing at any point in the future simply by changing the balance in the offset account. For instance, you may want to use this cash in the future for a personal purpose or contribute towards another investment.
What are the tax considerations?
Repairs and maintenance are generally tax-deductible in the year you incur them. In contrast, improvements are treated as capital in nature and must be depreciated over their effective life.
Capital improvements include:
- Replacing an entire structure or asset, such as rebuilding a fence or installing a new stove
- Upgrading an item beyond its original condition, including renovations, extensions, or alterations
- Undertaking initial repairs immediately after purchasing the property
The ATO sets out the effective lives for different assets – see Table 3 on page 72 of this ATO guide.
Structural improvements and fixed items usually fall under Capital Works and are typically depreciated at a flat 2.5% per annum.
If you renovate, it is almost always worthwhile obtaining a depreciation schedule to ensure you maximise all available tax deductions.
Cash flow impact
The outcome will always depend on the type and scale of the work undertaken. However, in many cases the increase in rental income, combined with the additional depreciation tax benefits, outweigh the extra interest incurred on the borrowings used to fund the improvements. As a result, it is not uncommon for an investor to be better off from a cash flow perspective on an after-tax basis. In that scenario, you have not only created additional equity in the property, but also improved its ongoing cash flow.
If your budget doesn’t allow you to buy a blue-chip asset
If your budget is not enough to buy a blue-chip property, then a value-add strategy, as outlined in this blog, is often the most effective alternative.
You can either allocate part of your budget to improvements and use the balance to secure the highest-quality parcel of land you can afford, or you can direct your entire budget towards purchasing a high-land-value property that is in a basic but still tenantable condition, with the intention of undertaking improvements when your financial position allows.
The advantage of this approach is that it gives you a direct way to create equity in addition to whatever uplift the market delivers over time.
