A simultaneous fit of euphoria and vertigo weakens your knees as you gaze out the living room window of a brand new 22nd floor luxury penthouse. "This is the chance of a lifetime'' your real estate broker declares cogently. Your significant other turns to you and grins approvingly; "I love it, honey."
Amidst the flood of emotions and peer pressures, you manage to clear your head and ask yourself one sobering question -- is this a good long-term investment? Well, considering that homeowners usually depend on large capital gains to grow their nest-eggs, maybe not. In my educated opinion, this particular type of property -- a high-rise -- is less likely to produce these desired results. More specifically, a building with fewer stories may be a better choice if long-term appreciation is sought.
In order to proceed, certain elements of real estate appraisal must be explained. Fundamentally, there are two components of real estate property: land and the building erected thereon. Imbedded in basic real estate appraisal theory is the humble assumption that while land can either increase or decrease in value over time, buildings will invariably depreciate.
Lay people tend to have a difficult time grasping this abstraction, but think of it this way: buildings become dated, they require repairs and renovations, their layout becomes less compatible with modern life, and eventually you may have spent just as much keeping it up to date as it would cost to build a new property. The accretive effect of these deteriorations is expressed as an annual percentage of the original building value -- the depreciation rate. These principles of real estate appraisal imply that capital gains on real estate should be primarily the result of increases in land value.
My qualm with high-rise condominium projects is that only a small fraction of the sale price can be attributed to the value of the land. Consider a 100 unit, 20-storey new development erected on 10,000 square feet of land. Assuming that each unit has the same dimensions and layout, each unit would only "own" 100 square feet of land and 2,000 square feet of "building."
Realistically estimating the cost of a good quality residential construction at roughly $200 per square foot, we obtain a building value of $400,000 (Montreal estimate). Even if we estimate the land value to be $250 a square foot, the value of each owner's land would be $25,000, one sixteenth of the building value. If we assume straight-line depreciation of 2 per cent per annum on the building, the land would have to increase in value by $8,000 a year in order for the property to maintain the same value (assuming no change in construction costs). In order to sell the property at $425,000 in 50 years from now, the land would have to appreciate at an average annual compounded rate of about 6 per cent. This is not a hyperbole; I have seen many condominiums in my career with a land value of less than one sixteenth of the building value.
Now, consider another property with a land value of $150,000 and a building value of $275,000 -- a total value of $425,000. Increases in land value must now offset building depreciation of only $5,500 per annum to maintain its value (assuming the same depreciation rate). In order to sell the property at $425,000 in 50 years from now, the land would have to appreciate at an average annual compounded rate of about 2 per cent rather than 6 per cent.
To illustrate the significance of this difference in interest rates, note that if the land of the second property increased at 6 per cent compounded annually, it would be worth roughly $2,750,000 in 50 years from now. The perceptive readers will notice that although the second property would be worth $2,750,000 instead of $425,000 after 50 years, the owners of the first property will enjoy more living space during those years. There certainly are benefits to high-rises; it depends on each buyer's specific needs and desires.
You'll often hear the refrain; "Why rent when you can buy? It's just throwing your money away." Although this may have some merit, it is simplistic and naïve. Here's a shocker: as the fraction of land value to building value gets smaller, you're getting closer to purchasing an ordinary good! The decision to rent or buy a property with a land value of $0 is analogous to the decision to buy or lease a car, for example.
Assuming you paid cash for the property, you're indirectly paying for the depreciation on the building and the foregone interest you could have made on the amount you paid for the building. In addition, you're directly paying for taxes, electricity, heating, insurance, etc. In a free market, the rent would equal the said expenses in addition to a risk premium. In this way, it is similar to buying a car. Whether you lease it for four years or purchase it and sell it in four years, there shouldn't be a large difference in the total cost. However, differences in the general condition of both the property and the car can cause differences in price.
I concede that I have not yet tested the validity of my theory with the use of empirical evidence, but I am confident that my logic is sound and that the results of such a study would corroborate my claims. That being said, as with any academic theory, it has limitations. The theory does not take into account zoning regulations, views, and assumes an efficient market with fully informed buyers.
Also, it assumes that all buildings depreciate. Some buildings, particularly older buildings with architectural character, may actually appreciate with time -- the antique effect. Similarly, in reference to our car analogy, classic cars can appreciate. Ballooning construction costs (i.e rising wages of tradesmen) can positively shock building values as well. Finally, the term "high-rise" is subjective and dependent on the location. For example, units in a ten-storey condo building in Manhattan would likely have large land values, while units in the same building in some suburbs may have negligible land values.
This is not some kind of a diatribe against high-rise developments, but rather a theory based on real estate appraisal fundamentals, logical inference and experience. It is not to say that high-rise condos cannot be good investments, or that they are not better than other non-real estate investments. Buy them to enjoy living in them, or perhaps for rental income, but don't buy them with an expectation of tremendous capital gains -- you may be disappointed. Review your priorities, goals and your current life situation when considering any property. After all, there's a time in one's life to work hard and invest in one's future, and a time to sit back and enjoy the