I read the following article in the Sydney Morning Herald about a two brothers that bought a terrace on Cleveland Street in Chippendale (suburb next to Redfern on the edge of the Sydney CBD). They completely renovated the property and recently sold it for $940,000, which was $5,000 below the record for that suburb. They had paid $675,000 for that property in late 2010.

http://smh.domain.com.au/real-estate-news/cleaning-up-in-cleveland-street-20120518-1yu3x.html

However, my concern is that this just propagates the idea that property is a great investment and in particular that one can make money by buying old/rundown properties, renovate them and sell at a profit. I believe the headline figures and the general discussion of the article reflect this.

For example, your first impression might be wow! $940,000, looks like they made a lot?

Purchase price | 675,000 |

Sale price | 940,000 |

Face-value profit | 265,000 |

‘Growth’ | 39% |

But then you read that they spent $215,000 on renovating it:

Purchase price | 675,000 |

Renovations | 215,450 |

At cost | 890,450 |

Sale price | 940,000 |

Face-value profit | 49,550 |

‘Growth’ | 7% |

Now, 7% might not be huge but it may still seem like a good return to you. And note, that this is all the information that the article gives you.

But, then i began to think about all the other costs associates with a property:

- what about stamp duty and other fees associates with the transfer of property?
- how did they finance the purchase, did they take out a mortgage?
- what about general price inflation?

So i began to investigate these and tried to estimate each. Now I’ve had to make a few assumptions, in particular about financing, but I believe these are fairly standard.

*Stamp duty*

Stamp duty | 25,865 |

Mortgage registration | 100 |

Land transfer | 200 |

Stamp duty and fees | 26,165 |

Estimate sourced from: http://www.stampdutycalculator.com.au/stamp-duty-nsw

*Financing*

Assumptions: They got an investment loan with a LVR of 80% (i.e. a 20% deposit). They bought it in late 2010 and sold it in May 2012, so lets say 18 months duration. The average discounted variable interest rate over this period was 6.94% (source: RBA).

Mortgage amount | 540,000 |

Interest cost | 60,750 |

Establishment fee | 600 |

Mortgage interest & fees | 61,350 |

In addition, I’ll assume that the brothers have financed the renovations with their own money (i.e. equity funded). Whilst this is a big assumption, it means that my estimates are conservative

*Inflation*

Generally speaking, prices rise year on year and this is illustrated by the general inflation rate reported by the RBA. Simply put, if I buy a property for $100 today, in 10 years, even if there was no real growth in house prices (driven by supply/demand forces), the price of the property will be higher because of general inflation in the economy, how much higher? well depends on what the general inflation rate is.

I used the RBA’s inflation calculator to provide a general estimate (www.rba.gov.au/calculator/annualDecimal.html). (Calculated quarterly from Sep-2010 to the Mar-2012 quarter)

Purchase price | 675,000 |

Price after inflation | 699,150 |

General inflation value | 24,150 |

**Overall picture**

Including these costs in the initial calculation, the total costs incurred by the two Brothers is about:

Purchase price | 675,000 |

Renovations | 215,450 |

Stamp duty and fees | 26,165 |

Mortgage interest & fees | 61,350 |

General inflation value | 24,149 |

Total | 1,002,115 |

So the estimated profit is? NIL.

After including stamp duty, financing costs and accounting for general price inflation, the real loss is $62,000.

Purchase price | 675,000 |

Actual total cost | 1,002,000 |

Sale price | 940,000 |

Loss | -62,000 |

Return on investment | -9% |

**What was the return on investment?
**

In this example, I assumed the Brothers put down a 20% deposit when they purchased the property, i.e. $135,000. I also assumed the renovations were funded by their own money, i.e. another $215,450. So the two Brother’s effectively invested $350,450 of their own money.

Ignoring the general inflation value above (which is a non-cash amount), the cash loss at sale was -$37,850.

Which gives a return on investment of -11%.

Anyone can tell you that you should not investment your money in anything that gives you a NEGATIVE return on investment, which means you’re going to loose money!

Also, there are others costs involved in this entire process which are material, but have not been considered. E.g.

- Financing cost of money needed for renovations
- Capital Gains Tax
- Cost of DA process (lawyers etc)
- Cost of project manager (during the 6 month construction period)
- Sale costs, e.g. advertising, agent’s commission
- Other costs unknown to this amateur property observer like me

So the real cost loss would have been greater than shown above.

**A simple alternative**

The Brothers could have taken the $350,450 they invested in the property, put it into a term deposit or a high-interest e-Saver, and over the 18 months they could have earned around 5.5% interest (with interest compounded monthly)

After paying personal tax, in general, the Brothers could have earned about $21,000 after tax for a return on investment of about 6.0%.

Cash ‘savings’ | 350,450 |

Interest rate | 5.50% |

Interest income | 30,067 |

Tax rate (assume) | 30% |

Net interest income | 21,047 |

Return on investment | 6.0% |

**How would you choose to invest your money**?