If you’re new to real estate terminology, you may be wondering what overcapitalization is. Basically, over-capitalization refers to overspending on construction or renovation costs, meaning that the actual cost of a property’s construction/renovation is higher than its actual market value. Overcapitalization is also considered asset inflation. Confused? Let’s keep it simple. For example, Mr. A plans to renovate his house by remodeling the bathrooms, basement, and kitchen; upgrade living room and bedrooms; add a porch and pool; install vinyl siding, fence the front entrance, and expand the yard. Mr. A decides to use high-quality, expensive materials in the renovation. While he was doing it, he forgot to consider the actual market value and quality of the houses in this area, which was less than the value of his improved house. This is overcapitalization.
Now the next question is what should be done to avoid overcapitalization? Easy! When home builders and renovators plan home improvements, they need to consider a few factors that have a greater impact on the overall value of the property. For example, assessing the neighbor’s housing style, neighborhood demographics, streetscape, design trends of neighboring property, and recent resale prices of homes in the area.
Although improvements and renovations generally add value to a property, it would be wrong to say that they will ALWAYS increase its value. The reason is that if renovations and improvements are exaggerated, without taking into account the real value of the area where your property is located, you may be overcapitalizing your property. This means that the cost of your property will not equal its market value.
Therefore, it is rational for a home builder or renovator to be aware of overcapitalization and increase the value of the property only as much as they can afford. Remember, you must be very careful about overcapitalization when upgrading or renovating your property.
Overcapitalization often occurs when people are not rational and business-minded in their approach. Typically, homeowners will spend more on fixtures and fittings in order to live in the property.
Some cultures often prefer to live in larger houses as a status symbol and will choose to spend more on improvements than is the local norm.
However, if you are an investor or a builder, it is important to get the mix right as this will result in higher profit margins. Getting it wrong can often mean longer sales periods and reduced prices. Do your due diligence to avoid disappointment.