Cleaning up in Cleveland Street – looking below the surface

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:

  1. what about stamp duty and other fees associates with the transfer of property?
  2. how did they finance the purchase, did they take out a mortgage?
  3. 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?

 

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