When a property sells for $1 million and later resells for $1.5 million, many people jump to the conclusion that the owners made about $500,000 profit. You often see this type of commentary in the property pages of newspapers about the real estate transactions of sports stars, celebrities and socialites. We know that there are some expenses in there, but it’s still a good earn; right? Well yes, but it’s maybe not as good an ‘earn’ as we might originally have been led to believe.
Before passing judgement on whether a transaction was as profitable as it seems, doing some back of the envelope arithmetic can be insightful. In real estate, the difference between gross and net profit is usually significant. Transaction costs, for example, are one of those significant costs often overlooked when buying.
There are many factors to consider when working out gross vs. net profit. By being aware of all the factors that can dilute profit, you can more easily set your sights on a realistic net profit, rather than a gross profit. Also, because there may be variances in the types of costs which apply to different properties, using a set formula such as ‘transactions costs are 8%’ does not quite paint an accurate picture. Some of the main costs to consider are listed below.
Stamp duty is a large unavoidable cost when buying real estate. The percentage payable increases as the property becomes more expensive. Given the average house price in the Inner West is over $1 million, most people are at least 4% behind on the day they settle their purchase. Land tax may also apply in some cases, so do your due diligence before you buy.
Renovation and improvement costs is an area that is not captured by the data in any way. If you overspend on a renovation, your net profit will quickly be diluted, even if the transaction looks good on paper. With the construction boom still occurring across Sydney, building costs continue to remain at record high levels. Disciplined spending and good project planning is crucial to ensuring that your renovation will create a true profit, rather than merely pumping up the price for a zero net profit.
Negative gearing is a fancy phrase for making a loss. Even though you share some of the loss with the government through your tax return, a loss is a loss. Therefore, before getting too excited about the house you paid $1 million for and sold for $1.5 million, you should consider the amount of money you spent propping up the investment over the years you owned it. Negative gearing means that the accumulated amount spent on the shortfall between rental income and costs, has to be added to the base price as a holding cost, before you calculate your profit. Many people who achieve a good paper trade would be frightened to know what their true net position really was, if they subtracted all the ‘prop up costs’ from their gross profit.
Rates can come in a multitude of disguises. Strata rates, water rates, council rates and special levies on strata buildings all need to be taken into account.
Vacancy rates and agent’s fees are applicable costs for investors to consider. One of the realities of owning an investment property is that the bank still wants their mortgage payment, even when the investment property is vacant. You should allow for at least two vacant weeks each year.
Selling fees are the amount that you pay the agent for selling your property, along with conveyancing costs. Let’s remember that you also paid the conveyancer on the purchase too! These costs are avoidable by going the DIY route. You just need to decide if you want yourself as a client!
Property can be profitable. But it’s crucial that property is not seen as an easy ticket to financial freedom. In recent years, the boom has seen many investors turn a handsome profit. But this boom was unprecedented and came on the back of record low interest rates.
Investors should take note that net profit needs to be your ‘true north’ when investing. Too many people make tax deductions their ‘true north’ when buying an investment property. If you make tax deductions a priority over profit, that’s exactly what you will get.