© 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 8:
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.
8. Conduct a scenario analysis.
This week we look at my ninth rule:
Golden Rule #9 – Only buy the property if you can still make the money in the worst case scenario.
Last time we looked at three different scenarios of a renovation project. (Click here to read the last article). In each case we spent approximately $400,000 to buy the property, made some repairs and improvements and then sold it.
In the most probable case scenario, assuming everything went to plan, the projected profit was $75,000.
In the best case scenario, where everything goes better than expected; the projected profit was $177,000.
In the worst case scenario, where nothing went right, there was a projected loss of $68,000.
There is a difference of almost $250,000 between the best and worst case scenarios. That makes a huge difference to your wealth!
If I was considering this renovation project and there was a realistic chance of losing money, I wouldn’t buy the property in the first place. If you research hard enough, there are plenty of projects out there where with some appropriate planning, you can maximise your profits and minimise (or hopefully eliminate) your losses.
So, which projects should you consider? Below I have outlined two projects so as to illustrate how a scenario analysis can be used to choose between two projects.
This is a period style home on a large corner allotment in an inner city suburb. This property is in need of renovation and you can also make some extra money as you can sub-divide and retain the existing house and create a new block.
This is a period style home on a corner allotment, across the road from Project A. This property is a period style home in similar condition to Project A and on the same sized block. However, this property could be rezoned to one of two categories.
If it is zoned “Historic Conservation”, there will be no sub-division allowed and strict conditions will be placed on any renovations. If it is zoned “Residential Medium Density”, this will allow the demolition of the house and construction of 4 new townhouses. However, there is also the possibility that the zoning remains the same.
If it is zoned “Historic Conservation”, the property will drop in value but if it is rezoned to “Residential Medium Density”, it will markedly increase in value.
Below I have outlined the potential profit (and loss) in the two projects using three different scenarios.
Worst Case Scenario
Project A $40,000
Project B -$100,000
Most Probable Case Scenario
Project A $70,000
Project B $70,000
Best Case Scenario
Project A $100,000
Project B $200,000
In each project, the most probable outcome is that you’ll make $70,000.
In Project B, you could lose $100,000 if it is rezoned to “Historic Conservation”, make $70,000 profit if it is not rezoned or make $200,000 profit if it is rezoned as a 4 unit site.
In Project B, the worst you’ll do is make $40,000 and the best you do is make is $100,000.
Which project would you choose, A or B?
I would choose Project A. It’s not the possibility of making $200,000 that attracts me to Project B but the real possibility of losing $100,000 that discourages me. In Project A, you still make money in the worst case scenario. It is pretty hard to go broke if the worst that can happen is you still make money!
You should be conducting a scenario analysis with any purchase you are considering. Be aware of the possible risks and returns of each project.
If the worst that you can do is make money, that sounds good to me!
Happy House Hunting!
Written by Peter Koulizos, university lecturer, author and buyers advocate.