Principles of Diminishing Returns in Real Estate: Over or under improvement
Be aware of Over Improvement and Under Improvement in Real Estate
REAL ESTATE PRINCIPLE: THE PRINCIPLE OF DIMINISHING RETURNS IN REAL ESTATE
In your quest for choosing the best property for your budget, it is advisable that you arm yourself with am important principle in real estate: THE PRINCIPLE OF DIMINISHING RETURNS.
Let me explain this in common parplance: OVER IMPROVEMENT and UNDER IMPROVEMENT in real estaste which should be avoided as much as possible.
Over Improvement – An improvement which is not suitable to the site on which it is placed because of excessive size or cost
Under Improvement – An improvement which is not suitable to the site in which it is placed because of deficient size or cost.
Based on years of experience, and with the knowledge of numerous successful developments in real estate, the rule of thumb is 30% value of the lot and 70% value of the house, more or less. So for example, if you you have a 50 sqm lot intended for low cost housing valued at about P300,000 and you put up a house worth 700,000 that would be fine. Supposing you want to further improve the house making it 1 million in value, still fine but just be aware that there is a principle in real estate which is THE PRINCIPLE OF DIMINISHING RETURNS. Which means improvement that can lead to profit will be only up to a certain level, beyond that level, it will become a loss. Supposing further that you want to add a third storey of your 2-storey home with the same value of lot and perhaps the total value of the house would become 3 million pesos, this could be over improvement as the ratio of the value of lot and house is now distorted. The owner who over improves may not realize it while he is still lving in the house, but when the time comes he has to sell the property for good due to changing situations in the family, he could not sell it for a profit.
For example, a house owner from Dalaguete Cebu asked me to sell his house with a lot area of 2,000 square meters for 15 million. And the reason for selling is he got separated with his wife and wants 50% share of the property. He said that the lot would come out free because P15 million alone is the cost of the house. It is such a big beautiful house and indeed when you build a house like that today, 15 million pesos would not be enough. But for a rural area like Dalaguete Cebu, the lot is very cheap and he put up a house as big as worth 15 million. After years of offering the property, nobody bought it even for 10 million offer. He spent so much for such a big house thinking only of how he would be happy with his home, and when conditions in his life changed, and he no longer needs the house, he then realized that it cannot be sold for a profit. This is an example of OVER IMPROVEMENT in real estate. He lost several millions due to OVER IMPROVEMENT.
Even some subdivision developers fall into the trap of OVER IMPROVEMENT. For example, developers developed low cost subdivisions or higher level approaching middle end classification, by putting up a nice swimming pool and a clubhouse. Eventually, the homeowners could not maintain the swimming pool and it became a pond. During raining days, you can see frogs swimming on the pool. The subdivision is located in the interior part of Mactan Cebu. Homeowners of this development cannot sell their property for a good profit due to lack of maintenance of the subdivision plus the fact that the cost of buying the house is high due to the cost of over improvement by the developer. Another example is a developer who developed a residential subdivision in Talamban Cebu City consisting of about 50 townhouses with prices ranging from 5.5 million to 6.5 million. Indeed, the quality of materials used and the design are very good. However, they missed to consider that the barangay road that connects the subdivision to the main road was too narrow and nothing can be done about it. It’s still a 2-way street but it’s narrow something less than 4 meters in width. They missed to consider that prospect residents of the place who have that budget of 5.5 million to 6.5 million won’t feel comfortable passing that very narrow road to an interior place no matter how good the house might be. It’s over improvement for such an inferior place caused by a narrow road. Result? Out of 50 ready for occupancy houses, only about 5 were sold. All the rest are still waiting for buyers although houses are already built.
On the other hand, a buyer or homeowner should also be aware that there is such thing also as UNDER IM[PROVEMENT, an improvement which is not suitable to the site in which it is placed because of deficient size or cost. This can also cause losses in real estate investment.
For example, a house owner called me to sell his property in Cordova with a lot area of 1,300 square meters. He built a 150sqm bungalow at the back end of the lot leaving over 1,000 square meters of lot as frontage of his house. The husband is a foreigner married to Filipina but after years of living together they qaurreled and decided to separate and sell their property for a 50/50 share. The wife wants to sell the house and lot for 7.5 Million pesos because it’s the real market value of the property. I agree with the wife’s contention that the house and lot is indeed valued at 7.5 million but the property has been in the market for 3 years now and no takers. Why? It’s because of UNDER IMPROVEMENT. Prospect buyers like the house, but the lot area at 1,300 square meters is too much for them that makes the property beyond their budget. They could have added townhouses on the 1,000 square meter lot frontage for a profit but given their situation, they cannot undertake such a plan due to their conflicts. All they want is a fast sale and share the proceeds rigfht away. Unfortunately, it’s still waiting time for them as they could not even agree with the final price. The husband wants to sacrifice by selling it for 5 million but the wife insists on 7.5 Million. As to how they go about this conflict, it will be a legal case. But that’s another story to tell.
Engr. & Broker Manuel Jr. Arengo
Real Estate Broker License No. 0007808
16 years experience in Real Estate