This is another of those myth-busting episodes for you. This time we will take a look at the widely held investment principle that states ‘we make our money when we buy’. Whilst, it might sound rather obvious and a clear statement of the truth, is there more to it than that? Let's see what gets my vote in truth or myth this time...
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Today’s must do’s
Reflect on how you view your profitability with your property investments. Are you taking advantage of all of the possible methods to improve you overall returns? Take a look at this list and see if there is room to make improvements:
- Profit when you buy, add value & sell
- Profit through alternative rental income models
- Profit through capital growth & avoiding investment delay, the time value of money & compound growth
- Profit through cost, finance & other charges management
- Profiting through leverage
- Profit from available tax breaks
- Profit by changing our view of property to a vehicle to generate money rather than as a static object to own and rent out
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Transcription of the show
Hello and welcome to another episode of The Property Voice podcast. My name is Richard Brown and it’s a pleasure to have you join me on the show again today.
This is another of those myth-busting episodes for you. This time we will take a look at the widely held investment principle that states ‘we make our money when we buy’. Whilst, it might sound rather obvious and a clear statement of the truth, is there more to it than that?
Let’s dive right in to find out.
It’s understandable isn’t it…if a property is worth say £100,000 and we can bag it for £90,000, then we have just locked in £10,000 of profit straight away haven’t we?
Yes, that’s true BUT as we shall see, there are a number of issues, considerations and influencing factors that might mean that £10k in profit might not be all it’s cracked up to be! It might not be the only or best way for us to make money in property either…let’s consider some of the arguments now then.
- Buy, add value, sell
There are typically 3 ways to profit through a property’s value that we should consider: the purchase price, any return on added value works undertaken, and the selling price or revaluation.
Buying well usually means getting a discount.
The typical and long-term discount from asking price is around 4% to 5%. It varies depending on location and what stage we are in the property cycle, but this is the average we should expect over the long haul.
So, the first thing to consider is: if we get an offer accepted at 5% below the asking price, are we even getting a discount? The answer would be no on the basis that this is the average discount that all buyers are receiving from asking price, so we have not created any real value here at all. Granted, we don’t want to be paying above what a property is worth, so at least we would not have lost any money by securing such a discount, which is a decent start!
However, we investors usually look for bigger discounts and can realistically expect to achieve say 5% to 10% off the asking price of a property to beat the market. We usually achieve this by being more professional in our negotiation, showing a serious buyer status with finances in place, no chain to fall through and an always 'do what we say we will do' approach at every stage.
We may also be savvy at spotting issues that might give rise to a discount, like the property condition looking worse than it really is, it being stuck on the market for longer than average or a situation in the seller’s circumstances that might suggest a deal could be done.
Of course, it could also be an absolute lemon with loads of hidden issues that later catches us out…so a discount on a dog of a property could also end up costing us in some other way and so become a false economy too!
Finally, in certain hot markets, is getting any kind of discount even possible? Possibly not, unless we end up picking up one of those dog properties I just mentioned!
Next, there is a whole sub-sector of the property investment community fixated with buying ‘below market value’ or BMV. BMV usually means a distressed property and / or a motivated (or in some unfortunate cases) a distressed seller leading to a discounted selling price.
In the case of a distressed property – how much of the BMV discount is genuine equity realised and how much is in fact related to a provision for the costs of necessary remedial works?
I see lots of so-called BMV deals that show an apparent discount against properties in very good condition, but which require lots of work doing to them to compare favourably. Once the costs of improvement works are accounted for, this often takes a big bite out of that juicy BMV discount, making it not quite as compelling as we thought.
In addition to the costs involved in putting the property right, we might have to pay some fees to the introducer and it will also require time to complete the work as well. I will come back to the concept of the ‘time value of money' a little later, suffice to say that often BMV does not mean below the price of an equivalent condition property, so watch out for that little sales trick.
In the case of a motivated seller, or even a distressed seller, again time pressures create an opportunity for a discount. Rarely though would this lead to super large discounts, as competition from other investors would prop up the price to some extent. Sure, if somebody absolutely NEEDED to sell within a couple of days, then the one or two genuine cash buyers that could complete that fast without undertaking detailed searches and surveys might just bag a bargain.
All I am saying is, that there aren’t that many situations like this that’s all. Plus, do you have a pot of cash sat waiting for them and the stomach to forgo a detailed survey and searches? I suspect not. Even if you did…what is the opportunity cost of having that cash sat around waiting for the bargain of the year?
Therefore, what we often find with so-called BMV deals is a combination of distressed property discount, combined with a motivated seller discount. I would usually expect the level of discount to be approximately evenly split between the two, if not more weighted towards the distressed property discount in truth.
So that magic 20% BMV deal you might be offered, could in fact only realistically be a maximum of 10% below its equivalent market value in genuine equity terms, of which you might have been able to secure at least half of anyway just by smart property searching and negotiation! You could find some of these more realistically priced properties knocking around quite easily, if you know where to look. I found a property a while back via estate agents, with a 15% discount against local comparables. Two previous sales had fallen through, leading to a motivated seller position and there was a modest amount of work required, along with a slightly adverse position on the street, leading to a modest level of distressed property discount too. I would estimate that in this case around 8% to 10% was due to the property and the rest to the seller’s position.
Adding value or forcing the appreciation.
So, aside from getting a discount when we buy, we can also profit on a property’s value in two other significant ways: when we add genuine value and when we come to sell or have the property revalued.
I have spoken at length on plenty of occasions about adding value to property. We can add value to a property by undertaking improvement or conversion works for example, which I will be discussing in the August issue of Your Property Network magazine, so look out for that.
Equally, we could improve a property’s value through more technical or legal changes, such as extending a lease, title splitting into several units, getting planning permission and so on. I like to use a term that I refer to as ‘return on works’ or ROW when assessing whether I can ‘force the appreciation’ and genuinely add value to a property for a profit.
In short, this looks at the upside equity or profit I might be able to achieve and compare this to the total costs of undertaking the works involved. Naturally, I am looking for a positive result, where my added value exceeds my costs by my minimum set profit margin. So, it might surprise you to know that I have bought properties for pretty much their full asking price or equivalent market value and still made a profit by applying some kind of added value improvement to them to make my profit!
So, adding value to a property is another potential way to make money through property, without necessarily relying on getting a big discount when we buy.
Dress to impress when it comes to selling a property.
Next, when we come to resell or get a property revalued in the case of keeping it and refinancing it.
If we can achieve a higher sale value than an equivalent local comparison, then we can profit there too. Some people are specialists in achieving this. For example, creating a designer look, a feeling or an experience can sometimes lead to people achieving sales values that ‘breaks the street ceiling price’ for the property.
You just have to look at how developers present their show homes to understand that by dressing a property well, it can achieve a better sales price. Or, look at how many agents undertake viewing days or sealed bidding processes now; that’s to create a buzz or buyer frenzy and so some natural psychological competitive spirit among would-be buyers.
Clever layout and design, dressing a property in a way that tells a story to your target buyer or introducing some clever competitive tactics can all lead to higher sales values than would normally be expected and so increase your profits here too.
- Rental income returns
You might have been saying to yourself, what about the income you generate from a property and wondering why I had not mentioned it already. Well, firstly, you’d be right to think of it and second, I wanted to keep the first point related to a property’s value to help simplify the discussion so far.
That said, rental income and, in particular, our net rental income after ALL costs adds to the mix.
So, which of these investments paying with cash, is the best one?
A flat valued at £100k bought for £90k with a net rental income after costs of £394 a month, or a flat valued at £100k bought for £95k with a net rental income after costs of £475 a month?
It’s a tough choice, isn’t it?
In theory, the first flat suggests that it has been negotiated better and so generated an extra £5k in profit to us. However, the net yield on this first flat is 5.25%, whereas the second flat has a net yield of 6.0% based off a slightly higher purchase price.
In cash terms, the second flat generates an extra £972 per year in rental income. If this were a real example, we would be looking at around 5 years before the second flat produced the same additional profit that the first flat produced up front, so we might still feel that the first flat is a better bet.
If the difference gets a bit bigger, or if our main goal is income, perhaps this might alter our views a little? I will add a bit of spice into the mix on this illustration in a minute for you though…so hold that thought.
Yes, I know we all want the higher rental value property at the lower property price, but that isn’t always possible and if it is, it often comes with strings attached like undertaking more in terms of refurbishment works. That’s why I made the choice imbalanced as that’s possibly more realistic on the streets.
The conclusion, however, is that we not only have to consider the returns in terms of property value, but in income too. In fact, more so with a rental property, where we might not be able to access the locked in equity for many years to come. This is a concept known as the 'total returns from our property investing', which takes us beyond price alone.
- Capital growth & investment delay, the time value of money & compound growth
This is an interesting one that some people can overlook. So, let’s break it down a little.
House prices do tend to trend upwards over the long-term. Sure, there are periods when they flat-line or even go down, but over extended periods of time the trend or regression line is usually upwards. So, it stands to reason then, that the longer we hold a property the more likely we are to see some capital growth.
It should also follow that the longer we delay buying a property that we will end up forgoing some of this capital growth. I grant you that if we time our entry into the market incorrectly, say at the top of the market, that this argument can then be watered down. However, when you also consider that we can achieve rental income whilst we own the property, this also needs to be factored in.
History has shown us that we have averaged around 7% house price growth per year over the past 55 years or so. Just look at the Nationwide House Price Index to prove that point. Equally, in the example above, we saw that our net income from our two flats investment alternatives was around the 5% to 6% mark and that assumes no mortgage is used, which if it were would lead to a higher net rental yield most likely.
But sticking with our 7% average capital growth and say 5% average net yield, that’s obviously a combined 12% per year return on our investment. Now, consider the opportunity cost to us of waiting a year to find this gem of a property project. It would have actually cost us 12% in lost the combined capital growth and net rental income by sitting out this long to find that perfect property!
Not only that, but if we wait long enough to locate that £90k discounted property, it could now cost us over £96k if we had to wait a year to buy it, due to the same average house price inflation. Yes, I know it’s not that simple but you get the idea.
This is a good way of illustrating the time value of money too. Put our £95k to work now and realise a combined growth of around £11,400 over a year, or sit and wait for that £90k apparent gem with nothing to show for it in the meantime, or worse, it turns out that it might then cost us £96k instead!
I was going to show the impact of this ‘good enough’ property versus waiting for the so-called ‘perfect property’ but it might just make your head hurt in an audio podcast, so you’ll just have to trust me on this…the gap gets wider the longer out you compound the growth!
I hope these numbers didn’t fry your brain too much whilst driving, dog walking, gym training, lying in bed or whatever else you might have been doing at the same time as listening!
The long and short take away from this point is: delaying our investment costs us money due to the time value of money!
- Cost, finance & other charges management
A few weeks back, we had Amit Ramnani as a guest on the podcast. He was talking to me off air about how asset managers and wealth advisers are now focusing less on new business and more so on portfolio management. In particular, he looks at the costs involved in managing an investment portfolio and how this can erode the net returns we achieve.
This same principle also applies to our property investments.
Imagine the difference to our net investment returns that could be made if we are able to keep our costs down. Yes, we do need to look at quality, not cutting corners and so creating false economies. But, if we can genuinely secure equivalent services but for less money, we will naturally improve our returns significantly in some cases. I usually assume that a standard BTL has annual running costs in the region of 25% of the annual rent, excluding a mortgage and taxation. However, if we can drive this down to say 20% a year, then this additional 5% drops straight into our back pocket as additional profit.
Here are some examples to illustrate. When undertaking works, I have seen fixed price quotes for a recent works project range from £65k to £85k, and as a member of LNPG I have seen the cost of kitchens and bathrooms achieve something like 70% or more discount on refurb projects.
I see some letting agents, especially online ones, who charge as little as 7% letting fees, although I personally still pay a little more than this to ensure quality and a personal local presence.
With financing, I have seen some lender fees be totally removed on a remortgage by renewing directly with the same lender. Equally, by renewing onto longer term fixed rates, I have seen my ‘total cost of finance’ reduce due to avoiding broker and lender fees repeating every couple of years as well.
Perhaps this is an extension of the make money when you buy principle rather than a completely new point – I just mention it to sow the seed that we can improve our returns by adopting a professional or business-like approach to our ‘total cost of ownership’ with our properties.
Leverage is another topic that I have covered at length.
You might remember my two flats examples from earlier, where there was perhaps a leaning toward the first lower priced flat.
Let’s revisit those examples, although this time using a mortgage. If we take out a 75% LTV mortgage in each case, we can see the following return on investment or ROI.
Flat one that would cost us £90k with a £22,500 deposit and a revised net rental income after the mortgage of just about £2oo a month. That’s a simple ROI on the deposit of 10.7%, which compares to our ROI using cash of 5.25%.
Flat two that would cost us £95k with a £23,750 deposit and a revised net rental income after the mortgage of around £267 a month. That’s a simple ROI on the deposit of 13.5%, which compares to our ROI using cash of 6%.
Now, we can perhaps see the benefit of flat two more clearly. We only actually need to put in an extra £1,250 of our own cash to buy it, whilst we can achieve a 26% improvement in ROI by doing so!
As Paul Daniels, the magician, used to say…now that’s magic and indeed leverage is like a magic trick in property too! Need I say any more about the benefits of leverage here then?
- Tax breaks
I am reluctant to go too deeply into the subject of taxation, quite simply because everyone’s situation is different and unique to them. However, there are some clear potential tax breaks that may work well in certain situations that might also be worth looking at. It could be argued that their potential benefit and impact onto the bottom line could perhaps even surpass that of a modest purchase price discount alone. Here are some examples:
- Lettings & PPR relief when converting what was our home to a rental property, which could be worth £40,000 plus 18 months of tax-free capital gain, when the property is rented out after moving out.
- Tax-free rental income on lodger rental income, which could be worth £7,500 a year
- Capital gains tax annual exemptions when we sell a rental property, which could save us £11k per person in capital gains and not to mention that capital gains tax is at a lower rate to income tax in the first place.
- Mortgage interest relief on holiday lets and similar, which allows 100% relief at your highest tax rate, compared to what will be an after profit relief capped at the basic rate, which might also push us into a higher tax bracket too!
- Capital allowances on commercial properties…not going into too much detail on this, but where it applies it can offset a year or two’s rental profits typically.
- Stamp duty savings by buying a company’s shares that owns a property rather than the property itself and / or buying 6 or more properties in a single transaction. The former reduces stamp duty from the prevailing rate plus the 3% premium to just 0.5% when buying shares instead.
- Paying corporation tax on flip profits instead of personal income tax could save 20% in the tax take for higher rate taxpayers, which if reinvested could also compound up nicely over time as well.
- Tax-free cash input into a pension to reduce our effective tax take by 20%, 40% or even more…and in some cases, we could even utilise this tax-free cash to help fund our investing activities.
- Reduced or even avoided inheritance tax by some careful tax planning…could be worth a small fortune in reality!
As I mention, I don’t wish to go too deeply into these points but there are genuine tax savings to be had that can dramatically improve our property investment returns. Just ping me a note if you want a few pointers on who you could speak to about some of these points.
- Property as a vehicle to generate alternative income streams
Again, I don’t wish to go too far here, suffice to say that with a little lateral thinking, we could realise additional profits from properties we encounter, just by changing the nature of the transaction. Here are some examples:
- Increased rental income from a change of use, such as from a single let to an HMO or holiday rental.
- Earning fees for work related to a property that we don’t own, but can control or influence, such as sourcing fees, project and lettings management fees, assisted sale profit share or planning gain JVs and such like.
- Securing additional rental income by breaking the rent down into different sections or offering added value services, such as a pet premium, renting the out garage separately, offering additional cleaning & gardening services, providing high speed broadband and satellite TV in a premium HMO, furnished properties rent premiums and so on.
Right, I had better stop there and draw a line under this discussion!
The principle we are examining is that we make our money when we buy.
I believe that whilst that is partly truth, it is definitely not the whole truth. In actual fact, we can and indeed do make money from property in a variety of different ways and through alternatives methods too.
This could be:
- By undertaking improvement works or dressing the property to sell.
- By looking at our total returns, including capital and rental returns.
- By starting to invest sooner rather than later to capitalise on the time value of money and compound growth.
- By adopting a cost management approach to all of our fees, charges & expenditure.
- By maximising our returns and minimising our cash outlay through leverage.
- By taking all the available tax breaks.
- By looking at property as a vehicle to generate income in many different ways, rather than just an asset to own and derive rent from.
So, for me at least – making money when you buy is a myth.
We don’t only make money when we buy and in some cases, we don’t make any money at all when we buy either!
We can make money from property in plenty of different ways and so we must learn to be agile, flexible and creative if we are to both spot and capitalise on ALL of the possibilities that are open to us as a result. That’s our role as professional property investors.
As you can probably tell, I aim to stimulate both thought and action with some of these topics. So, please do drop me a line if you want to have a chat, you can email me at firstname.lastname@example.org if you want to talk about anything from today’s show or more generally in property investing. The show notes will be over at the website www.thepropertyvoice.net
But for now, all I want to say is thank you very much for listening once again this week and until next time on The Property Voice Podcast…it’s ciao-ciao.