Friday, January 4, 2013

Should I sell or should I hold?

The thing most people forget about property investment is that it isn't really a liquid asset.  Yes, you can sell it, but it doesn't necessarily get snapped up, unless buyers can smell that you are desperate to get rid of it, and you accept a ridiculously cheap price to get it off your hands.  Classic case of smart buyer, desperate seller.

When people are thinking of selling a property, the reasons are usually these:
I need the money for something else (I can't afford it)
I'm going to invest the money in something else (this investment is doing badly and I can't afford it)
And the more direct people say:
This investment is doing badly (I can't afford it)
I can't afford the maintenance on it - it always needs something done to it (I can't afford it).

I'm usually a bit surprised by this, but then, I like to buy property with my worst case scenario in mind.  What if interest rates rise?  What if rents drop?  What if insurance costs skyrocket?  What if the rates go up?  What if it has long vacancies?  What if it is vandalised? What if it is damaged by tenants?  What if a meteor falls on it?

I'm yet to have the last one happen, though it would be pretty cool, hey? Particularly if it was empty and vandalised and damaged and rents dropped and interest rose, but my insurance paid out.  Can there be an Act of God if you are an atheist? I'm sure I could sell the story to Woman's Day or some such mag if insurance did let me down.

I've noticed though, that many people have a limited idea of what is 'can't afford it'.  For some it is "I'm not sure how I'm going to feed the family or fill the car this week" and that is hard to argue with, they are really making fundamental choices on priorities.  For others it is 'I had to put in $20 once to stop the mortgage bouncing, when we did the entire repaint and rewire and re-roof that year".  Really?  Doing OK then.

What if we looked at affordability in a new light.
If property values double in general every 7-10 years, then we could take this as a measure of whether or not the property was performing.  Simply ask these questions:
1. What is the current value of my property?
2. What is that divided by 10 to get my 10 year doubling*?
3. How much have I spent on the property this year in rates, insurance and repairs?
4. Is the answer to question 3 more or less than the answer to question 2?
Regardless of the answer, question five is:
5. Can I live with that?

If I was to plug in the numbers using a realistic rental property, it would go like this.
1. Current value = $200,000.00
2. Ten percent of that is $20,000
3. It cost $3,000 in rates, insurance and repairs each year.
4. $3000 is way less than $20,000 for sure.
5.  You mean I really made $17,000 in unrealised and untaxed capital gains?  Wow, this property investment thing rocks!

Wait, you forgot to ask, 'how much rent did you make?'  That question is important.  This property made $14,000 (or $270 per week).  But there was also interest on the mortgage of approximately $10,000 (5% of $200,000), so that was only a pre-tax profit of $4000.  Or $75 per week. In other words, profit.

If I add in the $325 of capital gains each week ($17,000 divided by 52 weeks), and I'm feeling pretty prosperous all of a sudden.  Hmm, I can afford that!

Now some years this story isn't going to be as rosy.  We've done a gross assumption that capital gain is linear for a start, but also If I repaint the exterior as I need to every 10 years I will have zero real or 'imagined' capital return that year.  Is winning nine times out of ten worth playing for?  I think so.  I'd need to re-roof every fifty years, which will also wipe out a years worth of return or gain, and reclad just as often.  So really, every fifty years, I make a profit for 43 years, and break even or slightly lose in seven.  Sounds pretty good to me.  If I knew I could never sell it, I still think I'd be happy.  What do you think?

I welcome your comments on this blog post.  It is just my opinion and certainly you'd be a fool to rely on it as any sort of financial advice.  Certainly it contains assumptions about capital gains, interest rates and costs and so on.  But I do hope it gets you thinking.

* Hopefully you know 'The Rule of 72'.  I've used 10% here just to simplify the math for me and others who can't be bothered with complex calculations, but I really should have said 7.2% in order to double the property value every 10 years with compound interest.  I'll explore the rule of 72 in a future post.  Promise.

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