Silly Math for Speculators

If I had a nickel for every time I had to endure some property investor telling me about how much money they made, I’d have enough to buy a condo in Phoenix. But just for fun I decided to run some numbers on a stereotypical flipper and what conditions s/he would require to make a “profit” on a flip. Before beginning, remember the mindset: opportunity cost stays in the textbook — what is being measured is whether or not the flipper has more money in a year than when he bought. So we can calculate the approximate profit of a flipper, assuming he bought a year ago and sold today. The profit reaped is therefore:

Profit = Sales Price – Purchase Price – Interest – Expenses + Rent – Sales Fees

Sales Price – Purchase Price = Pi*(1+a),  (where Pi is purchase price and a is annual appreciation)

Rent-Expenses = Pi*CR, (where CR is the cap rate (generously about 5%))

Sales fees = Pi*f, (where f is the sales fees from a sale (say about 3%))

Interest = Pi*LTV*i, (where LTV is the loan-to-value ratio and i is the mortgage rate)

It is approximated, for simplicity, the loan is interest-only (which is reasonable with a 35 year am). We sub:

Profit = Pi*(a + CR – f – LTV*i)

To achieve a positive return, a+CR-f-i*LTV > 0; solving for a,

a> LTV*i – CR + f

So we have a required capital appreciation to ensure the flipper makes money on paper, a huge psychological barrier needed to elicit a sale. We can plot appreciation versus LTV for various interest rates, assuming 5% cap rate and 3% closing costs:

So what do the numbers mean? Well at current interest rates of 4%, a flipper requires capital appreciation of 1.3% to ensure he doesn’t lose money. I ran the numbers with a 3% cap rate (typical of some detached dwellings and some condos):

And assuming the flipper keeps the unit vacant:

If the unit is at 3% cap, the 20-1 leveraged flipper requires a 3.8% annual appreciation; when the unit is held vacant, this increases to 7%.

This cursory exercise shows how leverage with low earnings requires continued capital appreciation to stave off a paper loss, a case made clear when analyzing the simple case of a flipper with a 1 year tenure under various scenarios. When interest rates go up, the required capital appreciation increases at a time when we expect increasing costs of capital to weigh heavily on upward price movement. With high leverage, interestingly, it is an absolute necessity to have prices increase, even for those with variable rate mortgages at around 2%.

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Alum

first

patient renter
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patient renter

Only a matter of time until this is the headline in the Globe and Mail:

http://money.cnn.com/2011/02/09/real_estate/under

Flip Flop
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Flip Flop

Re 26% over ask:

I would think an increase in over ask closes indicates that more buyers are cashing in (the ones with significant equity from the runup), and are deciding there's no need to piss around over a few grand.

Set it low, let the market drive it up close to market value and bank your profits. This tends to be what happens at the top of a run-up. No need to be greedy when you've alread doubled your money.

Assuming that number isn't BS anyway.

Don Lapre
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Don Lapre

Why on the first graph is the Y-intercept <-2%? If cap rate is 5% and closing costs are 3%, at a 0% LTV should it not be -2%?

space889
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space889

Well, Vancouver Sun just shut down the I'm ahead with renting and investing difference into stocks bear arguments for the bears. Vancouver housing has done better than TSX and with leverage means even bigger return.

http://www.vancouversun.com/business/Gains+Metro+

space889
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space889

actually I think the analysis is far too complicated. Most people don't bother thinking about the selling cost or severely under-estimate it when they buy for a flip so that needs to come down. As well unless it's a pre-sale flip most flippers will either sell right away after completion or rent out for a year and then sell. In the latter case they consider the interest, strata, etc to be paid by the rent and any shortfall is basically principle repayment which is as we all know "forced savings". So really the entire equation/formula for determining gains for a flip for most people is really just:

sell price – purchase price.

Devore
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Devore

@space889: It has only outperformed if you're able to sell and capture the gains. Otherwise, all you have is a more expensive house, and possibly more debt through the modern wonder of the HELOC and refinancing.

Devore
Member
Devore

@Devore: Oops, premature posting.

Only capital gains count, because (in Vancouver anyways) rents have been largely flat for years, so you're just getting terrible yield if you've invested for income.

patriotz
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Active Member

@Devore:

It has only outperformed if you’re able to sell and capture the gains.

That's true of any asset if you're comparing total returns.

The real point is that if asset X has outperformed other assets on a total return basis that means it's time to sell it, not time to buy.

Duh.

space889
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space889

@Devore: I don't think most people care about that. They just compare the estimated market price versus their purchase price and any gains is as good as cash in the bank. After all, the banks have been drilling into our head that home equity = cash.

It's true that no gains are really gains until it's cash in your hand but that's really just a very minor detail in most people's mind. For the average people, you have to keep it very simple because critical thinking is hard and far too much work!

space889
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space889

@jesse: The question is how much do they estimate it to be? I know people knows about selling commissions and such, however I believe that most people severely under estimate the actual dollar amount until they actually see the amount on the cheque they write to the realtor. I could be wrong but most people I know have really bad estimation skills.

Best place on meth
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Best place on meth

Math is hard, way too hard for flippers.

Flippers just wanna' flip.

Manna from heaven
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Manna from heaven
BC's debt to income ratio stands at 160% http://communities.canada.com/vancouversun/blogs/… How will I ever be able to afford that tear down crack shack on the West Side when I'm competing against overleveraged idiots. Now, before some cheerleader chimes in and says that I should lower my sights, I'd like to add that I'm an accredited investor (more than $1 million in liquid assets) and routinely make in excess of $200,000 a year. Please don’t think that I’ve shared that information for the purposes of bragging. My financial situation and my inability to purchase a dump clearly illustrates the absolute absurdity of this market and anyone who wishes to defend it. Tempted to buy some waterfront on the coast and say the hell with it! I could fish, harvest clams, mussels and oysters, and forage for berries. Doesn't sound too bad.
Not much of a name..
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Not much of a name..

@jesse: I agree with space. Most people just look at the "profit" in their RE as sale price – purchase price. That's 100% pure profit. All you have to do is follow RET to know that. All other expenses are immaterial to these people. If people truly looked at the numbers, why would they be buying RE in Vancouver right now?

registered
Member
registered

Hot off the press, another view on Canadian returns:

http://www.financialpost.com/news/Canada+random+s

SD92129
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SD92129

Shouldnt:

Sales Price – Purchase Price = Pi*(1+a)

Actually be:

Sales Price – Purchase Price = Pi*(a)

As you later stated in:

Profit = Pi*(a + CR – f – LTV*i)

I completely agree with you that most dont see the bigger picture which includes the (CR – f – LTV*i). Those who say "you are throwing your money away on rent" never see the LTV*i and lots of landlords have a hard time keeping CR > 0 regardless if they factor their own time in or not.

Best place on meth
Member
Best place on meth

@SD92129:

It actually goes like this:

Phase #1 – collect condos

Phase #2 – ???

Phase #3 – PROFIT!!!

SD92129
Guest
SD92129

@Best place on meth:

I think it goes one step further. Most can't get their heads wrapped around the "???", so they just think it is:

Phase #1 – collect condos

Phase #3 – PROFIT!!!

They figure that nothing needs to happen between 1 and 3 and that 3 is pretty much the inevitable outcome of 1. A lot of people are going to learn that they are playing with real money.

Best place on meth
Member
Best place on meth

@Manna from heaven:

What really stands out from that TD report (other than the obvious insanity of BC'ers having a 160% debt-income ratio and -4.2% savings rate) was that the debt servicing ratio has held fairly steady over the last 10 years.

The thing is that interest rates have dropped by half over that time.

What happens as interest rates rise, and god forbid even go back to where they were in 2001?

Anonymous
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Anonymous

OK – Here's some context for my post yesterday. The database is not too friendly so I only did it for detached houses.

% Solds at or above asking – February

2001 7%

2002 17%

2003 16%

2004 23%

2005 16%

2006 27%

2007 21%

2008 22%

2009 7%

2010 29%

Now I hesitate to publish this next number beacause of the grief I got yesterday but here goes:

2011 32% (February Month-to-Date)

The 26% from yesterday was for all property types. And people – it took me over an hour to do this so please don't shoot the messenger.

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