Time value of money
By Rich Harvey, CEO and Founder www.propertybuyer.com.au
In my previous articles I have raised the theme of property cycles and trends and the paradox of why so many investors leave their run too late and only buy when the market is high. Smart investors know how to make money at any stage of the property cycle. While buying the right type of property in the right areas is essential, the role of timing in your purchase can also make a big difference to your bottom line.
During a property slump, there are generally less investors competing with you. At the same time there may be fewer properties available to buy on the market which can tend to help hold up prices. In the Sydney and Melbourne residential property markets, home buyers have been the dominant source of sales in the last 2 years, although investors are now starting to re-appear as they are encouraged by the low vacancy rates which is pushing up rents.
Let’s consider for the moment the concept of “Opportunity Cost”. The definition of opportunity cost is the value of the next best alternative forgone. What does this mean I hear you say? Well it simply means that if you do not make a decision to take a particular course of action, then you will suffer the loss of opportunity.
While some believe that opportunity only knocks once, I personally believe that you have to get out there and create your own opportunities! Knock on lots of doors and the opportunities will come flooding in! Don’t expect the dream deal, dream job or dream person to land in your lap without doing anything. There are specific steps you need to take to make it happen. Employing a buyers’ agent to leverage your time, money and negotiating ability is an excellent first step. When purchasing property, you will need to get your finance pre-approved, target your research areas, develop a shortlist...in fact there are 14 key steps you must take to succeed in optimising the outcome of your property purchase (for a home or investment property). A buyers’ agent can make this process simpler and clearer for you.
Buying an investment property now (particularly during a downturn) can make excellent financial sense as shown in the following example. Let’s take the following example of two investors Adam and Ben and track the progress of an investment property over a typical 10 year cycle. We will make some basic assumptions below, but these are all conservative estimates. Adam will buy the property now at the beginning of 2006 while Ben procrastinates and doesn’t end up doing anything until 3 years later at the beginning of 2009.
Purchase price: $450,000
Rental yield: 4.5%
Interest rate: 7.5%
Here are the results of the price growth after each year.
Growth pa End year value Rent pa Interest pa Cashflow
Investor A - Adam Buys 2006
2006 13,500 463,500 20,858 27,000 -6,142.50
2007 13,905 477,405 21,483 27,000 -5,516.78
2008 14,322 491,727 22,128 27,000 -4,872.28
Investor B - Ben Buys 2009
2009 34,421 526,148 23,677 27,000 -3,323.34
2010 36,830 562,978 25,334 27,000 -1,665.97
2011 39,408 602,387 27,107 27,000 107.41
2012 42,167 644,554 29,005 27,000 2,004.93
2013 64,455 709,009 31,905 27,000 4,905.42
2014 70,901 779,910 35,096 27,000 8,095.96
2015 77,991 857,901 38,606 27,000 11,605.56
2016 85,790 943,691 42,466 27,000 15,466.12
At the end of the first three years, Adam has made a respectable (but small) capital gain of $41,717 (sum of first 3 years of growth). But what is the opportunity cost to Ben if he now decides to buy in the beginning of 2009? In summary, Ben’s costs include:
- Lost opportunity for growth of $41,171
- Lack of savings/ investment discipline - doing this now helps
- build wealth consistently
- Paying higher price to enter the market,
- Paying higher deposit to purchase
- Indecision - lack of confidence
- Inability to move forward and leverage from initial investment.
The capital growth rates used in the example are fairly conservative, but could mirror what has happened over the last 2 years with low growth rates in Sydney and Melbourne. However, if the capital growth rates for the first few years started to rise due to significant shortages in construction starts or extremely low vacancy rates (as is the case now), then the opportunity cost would be much higher. For example if the capital growth rate of just 5% pa were used (instead of 3%) in the above example then Ben’s opportunity cost would rise to $70,931. Or what if Adam had purchased in other areas of Australia that had much higher short term capital growth of say 10% pa for the next 3 years? The opportunity cost would be then over $148,950.
While the actual figures are very important, developing the mindset of a successful investor is also crucial. The regular practice of buying investments (rather than consumer goods like the latest plasma TV) helps keep Adam on track to achieve his financial goals. Please note that we are just looking the big picture here - the figures do not include all the holding costs or calculate what Adam could achieve if he had invested his money in other alternatives.
The key point of this example is to demonstrate that is better to take action today and buy a well positioned property than wait for the perfect time in the cycle. Adam has taken a long term view of the residential property market and knows from his research and speaking with other successful property investors that despite the doomsayers, prices do increase over time and double in value every 10 years. The opportunity cost if you wait is too high. Consider refinancing and releasing the “dead equity” you may have in your existing home or investment properties to safely leverage and get your money working harder for you.