We often hear our friends tell us about their real estate profits, where they bought a property several years ago, and then sold it for a tidy profit. Is it really such a big profit though?
Let’s work through an example. Let’s assume Bob bought a condominium unit 10 years ago, for $500,000. He just sold it for $750,000. That’s a nice $250,000 profit isn’t it? Unfortunately, that might be a simplistic over-exaggeration, and suffers from a fallacy. Here are the various factors that you need to consider:
Real estate is typically purchased with leverage, and with leverage comes interest. It’s not a bad thing, but these costs must be considered. Assuming Bob put down 25%, and has an interest rate of 2% per annum for a tenure of 35 years.
That works out to be a monthly interest (only interest, not principal) of around $625. Over 10 years, Bob will pay around $67,148.92 in interest.
2. Fees and Taxes and Insurance
Besides the interest, you’re looking at various fees that are typically ignored. Let’s assume that these figures:
Home insurance: average of $1,800 per year (total of $18,000 for 10 years)
Legal fees: $5,000 (buying and selling)
Taxes: $25,000 (buying and selling)
Broker commission: $15,000
Monthly maintenance costs: $250 ($30,000 for 10 years)
These miscellaneous costs add up to $98,000.
3. Renovation Costs
Assuming a very simple renovation cost – $10,000. This is usually MUCH more. We might see figures of $50,000 to $100,000, but in our example, let’s assume that Bob is a minimalist zen monk who believes that furniture are a unnecessary part of his life.
This brings the total costs up to $175,148.92. The seeming profit is not $250,000, but actually only $75,000. That’s a growth of $7,500 a year. Against his down payment of $125,000, Bob is looking at a annualised growth rate of around 6% per year.
What is the alternative?
If Bob doesn’t buy a place, then he has to be renting. You can typically rent at a lower price than your home, on average. In Bob’s example, his monthly mortgage is likely to be $1,242.24. Assuming he found a place to rent at exactly the same price of $1,242.24 per month, he will be able to get the same (or typically more) annual growth by putting his $125,000 in an index ETF which averages 6-8% per annum.
These are all assumptions, but it looks like Bob can do much better by renting instead of buying, and adjusting his lifestyle to maximise his savings and investments so that he gets much more in 10 years than the $300,000 “profit” he was supposedly earning.