The Golden Rules for House Hunting – part 8

© Property Professor articles — www.thepropertyprofessor.net.au.
Reproduced with permission.

In this series of articles, I am outlining my “Golden Rules for House Hunting”. So far, we have looked at Rules 1 to 7:

1. Buy the worst house in the best street.
2. Look for streets with redeeming features.
3. Look for improving areas with easy access to the city/beach/facilities.
4. Capital growth is dependent on Location, Land and Looks.
5. Avoid buying near adverse locations.
6. Consider if you could resell the property in the ‘bad’ times.
7. Check out the local knowledge before you buy.

This week we look at my eighth rule:

Golden Rule #8 – Conduct a scenario analysis.

Unfortunately many people buy property without doing their sums, let alone a scenario analysis.

A scenario analysis allows you to calculate figures based on three different situations; best case, worst case and most probable case scenario. This allows you to assess all the factors and the risks involved in any project. Calculating figures based on three different scenarios allows you to work out the best, worst and most probable outcomes. In the best case scenario, we assume that the variable factors work in our favour. In the worst case scenario, we assume that anything that could go wrong does go wrong. The most probable case scenario is based on everything going to plan.

Let’s imagine that you have bought a small period style property in need of renovation for $400,000.

SCENARIO ANALYSIS (Most Probable)
Purchase price $400,000
Purchase costs (approx 6% of purchase price) $25,000
Renovating costs $40,000
Holding costs (6.5% interest for 5 months) $15,000
Selling costs (approx 3.5% of selling price) $20,000
Profit $75,000
Final sale price $575,000

The above is based on everything going to plan. You are sensible with your purchase price, you renovate to a budget and you sell the property within a reasonable time and in a similar market to the one in which you originally purchased the property.

But suppose it all doesn’t all go to plan! In the following scenario, I have assumed:
• You got caught up in the auction hype and paid an extra $20,000 for the property.
• Purchase costs stay the same (these are mainly fixed bank and statutory charges).
• Your renovating costs have doubled. Unforeseen electrical, plumbing and roof repairs.
• A slightly higher interest rate.
• It is a very soft market and selling time increases dramatically.
• Salesperson has negotiated a higher commission and advertising costs increase as your property is on the market for a long period of time.
• In this very soft market you sell for about 10% less than originally planned.

SCENARIO ANALYSIS (Worst Case)
Purchase price $420,000
Purchase costs (approx 6% of purchase price) $25,000
Renovating costs (extra $40,000) $80,000
Holding costs (7.5% interest for 12 months) $40,000
Selling costs (approx 4.5% of selling price) $23,000
Loss -$68,000
Final sale price $520,000

Now let’s suppose that it all goes exceptionally well. In the scenario below, I have assumed:
• You’re an excellent negotiator and you bought the property at a $20,000 discount.
• Purchase costs stay the same (these are mainly fixed bank and statutory charges).
• You saved $10,000 on the renovation as you have sourced second hand materials.
• Found a lender with a lower interest rate.
• Your salesperson is a genius and sells it very quickly.
• Your negotiating skills come into play again and your sales person agrees to a lower commission.
• The market is on the way up and someone falls in love with the property. This results in the property selling for approximately 10% more.

SCENARIO ANALYSIS (Best Case)
Purchase price $380,000
Purchase costs (approx 6% of purchase price) $25,000
Renovating costs $30,000
Holding costs (6.0% interest for 3 months) $7,000
Selling costs (approx 2.5% of selling price) $16,000
Profit/Loss $177,000
Final sale price $635,000

If everything was to go according to plan, there was $75,000 profit in this renovation project. However, by considering a couple of different scenarios, you could end up losing $68,000 or making up to $177,000. That’s a difference of almost $250,000!

It is vital that you do your own sums rather than just listen to what the selling agent (or anyone else with a vested interest) tells you.

Happy House Hunting!

Written by Peter Koulizos, university lecturer, author and buyers advocate.

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