Almost every property investor at some time or another has asked themselves whether or not they should sell an investment property they currently own.
There are so many variables to the equation that making a decision can end up feeling like guesswork.
I’ll outline a few key points in this article hopefully to make it easier for you to get back to sleep next time the question pops-up.
The general rule
The general rule in Australia touted by most property investment gurus is: “buy and never sell”.
The problem with general rules is just how frequently life throws curly circumstances at you making those general rules seem almost rare.
For example, what if you found out you have cancer and there is a leading new treatment available in the USA that may be your only chance of survival but taking this procedure would be expensive.
You simply don’t have the money to pay for it.
If you sold one or two of your properties you would have the money, but the experts say buy and never sell, so unfortunately you’re doomed.
What if your business was in a boom period and you had the opportunity to expand – but not the money, because it’s all tied up in real estate.
It may make more sense to sell and put the funds into your booming business.
What if you have a negatively geared portfolio with $5 million in equity?
Do you wait until your portfolio is cash-flow positive, and enough to retire on?
It might be better to ignore the advice of the experts and sell off some of your portfolio and retire now
You can “manufacture” equity by renovating, subdividing or developing.
Investors who manufacture more equity than they acquire through natural capital growth will find it more profitable to buy and sell frequently because each new purchase presents an opportunity to add value.
If most of your profit comes from adding value, then you shouldn’t let the “never sell” general rule bother you so much.
Of course, there’s nothing like getting rich from sitting on your hands and letting capital growth do its thing.
Another consideration for selling is mental health.
If you’re continually worrying about your property because it is in a flood-prone area or because it is a regional town whose economic fortunes are on a knife edge, then it may be better to sell just to alleviate the stress.
Stress is a hard aspect to figure out objectively.
But since profit and loss are measured in dollar terms, it may be easier to express your stress in the same units.
How much would a holiday every year worth $8,000 help alleviate the stress?
How much would it cost to get mental counselling of some sort?
Whatever your methods are, there may be a case where selling works out to be a viable option.
If you can understand the reasoning behind the general rule, you can check if it still applies to your specific case.
And the reason why experts recommend buy and never sell is the tremendous costs of “recycling equity” in this country.
Recycling equity is the term used for the process of selling a property you currently own and then using the sale proceeds to buy a different property.
The costs of buying, apart from the deposit, will include many of the following:
- This is usually free or at most a few hundred bucks.
- Loan establishment fee
- This is also usually free or at most a few hundred bucks.
- Lenders mortgage insurance (LMI)
- This is generally applicable if the Loan to Value Ratio (LVR) is greater than 80% and may cost thousands.
- Professional inspections
- These will usually cost around $500 in total and include:
- Building inspection
- Pest inspection
- Strata report
- These will usually cost around $500 in total and include:
- Stamp duty
- This is the biggy. It will cost you thousands.
Check out the office of state revenue for the state in which the property resides.
They may have an online calculator you can use to get a precise figure.
Although it can be waived in the case of first home buyers, investors will probably never be able to get away without paying stamp duty.
- This is the biggy. It will cost you thousands.
- Legal fees
These are easily over $1,000 for normal circumstance.
But they could be double or triple that if you’re establishing a new corporate entity and/or trust.
And then of course there is the cost of your own time to perform the research, arrange finance, negotiate a deal, do all the paperwork, liaise with everyone involved, etc.
There could be as much as a hundred hours in this.
If your time is worth $40/hour, then this would be a cost of $4,000.
I always draw up a detailed spreadsheet when I’m getting serious about potentially buying an investment property.
All up I usually find that 5% to 7% of the value of the property is lost in purchase costs.
The costs of selling include:
- Agents commission (say 2.5% of the sale price)
- More legal fees (another $1,000 minimum)
- Possible break costs for the mortgage, uh-oh if you had fixed interest
- Capital Gains Tax (CGT).
Speak to your accountant to get an approximate figure before making a decision.
This could be tens of thousands. But it could be worse, it could be nothing!
And then of course there is the cost of your own time again.
In the case of selling you need to figure out if it’s a good idea and you need to organise an agent, liaise with them over the sale and do all the paperwork again.
There is not nearly as much effort involved in selling as there is in buying so allow only $1,000 for your own time instead of $4,000.
Depending on the sale price of your property the total cost of selling could be around 3.5% of the value of the property without even including capital gains tax.
You should consult a tax expert to at least get a rough gauge of the cost of CGT.
Let’s assume you have owned a property for about 7 years and in that time you’ve seen its value grow by 60%.
Because you’ve held the property for more than 12 months the 50% CGT discount applies.
So you’ll only end up paying tax on 30% of that capital gain and there may be other deductions you can claim such as some of those “entry” costs.
Let’s say because of your tax rate, it ends up being one third of the total gain, or in this case 10% of the value of the property in total.
So all up what are you looking at for the total cost of recycling equity?
There is 5% spent on entry costs, 3.5% spent on exit costs and 10% due to CGT. 18.5% in total for this example.
This is a very rough estimate.
A comprehensive spread-sheet would be worthwhile.
Assuming 7% per annum growth in the new property, it would take almost 3 years for it to recoup these losses.
So you can see why many recommend you buy and never sell.
Let’s say you’ve done all your research and you can’t decide between 2 possible investment opportunities.
One is in suburb “Xyz Heights” and another is in “Abcville”.
You can only afford to buy one, not both and you eventually decide to buy in Abcville.
After 5 years you check to see how your next best alternative has gone and are disappointed to see that the property you were going to buy in Xyz Heights has just sold for double its original value.
Your investment in Abcville has grown, but only by 60% over the same time-frame.
Because you could have made a better investment, you have an opportunity cost.
Don’t worry, this isn’t some weird kind of tax you have to pay, it is just a way in which you can reflect on your performance as a property investor.
Five years ago you had 2 clear choices and you chose one.
If the option you didn’t choose outperformed the one you did choose, then the difference is the opportunity cost.
The cost of investing in Abcville versus in Xyz Heights is 40% over those 5 years.
One investment achieved a 100% improvement in value, the other only 60%.
The difference is 40%.
This is assuming everything else was equal, that is, the rent, insurance, repairs, depreciation, management fees, land tax, etc. were all the same.
When multiplied by the value of the property, you can see that opportunity cost is a lot more expensive than stamp duty.
If the property’s value was $200,000 your opportunity cost would be a whopping $80,000! Lucky it isn’t a payable tax.
This highlights how important it is to get each new purchase right.
But that opportunity cost example is not as tragic as if you had been paralysed and not made any investment at all.
Your deposit would’ve earned interest in the bank at a measly rate which you would’ve paid tax on anyway.
And the value of those dollars would’ve been eroded with inflation.
Let’s assume having that money in the bank at 4% interest earned you a net profit of 2% after inflation and tax.
If the original purchase price was $200k, then the entry costs would’ve been around $50,000.
So let’s assume you had $50k in savings to invest in the bank or property. 2% of $50,000 would be $1,000.
Compounded over 5 years you’re looking at $5,204 or about 2% return on investment for leaving the money in the bank.
Putting money in the bank may have been less risky, but the opportunity cost would have been even more extreme.
The Abcville investment grew by 60%. If you had sold it and lost about 14% on the sale due to CGT and other exit costs, the net proceeds from the sale would be roughly $125,000.
The opportunity cost of leaving your money in the bank versus your 2nd best property investment would be almost $120,000 over 5 years.
There are 2 key lessons to learn here: put a lot of effort into the decision to invest to reduce opportunity cost, but also make sure you do actually invest rather than sit on the sidelines.
There’s another way of looking at opportunity cost I need to cover before we can complete our consideration of whether to sell or hold.
What if you have an existing property with no equity to draw on in order to buy another property or perhaps not enough serviceability to buy another?
You may think opportunity cost doesn’t apply to you since you can’t buy, but it does apply since you can sell.
If you already owned the Abcville property and sold it in order to buy the Xyz Heights property, would you be better off?
Sell or hold?
You’ve probably already figured it out, but just in case you haven’t, the reason why an investor should sell is if the cost of recycling equity is less than the opportunity cost of an alternative investment.
Sounds pretty simple, you just add up the recycling costs and the opportunity costs and see which one is bigger.
But there are 2 tricky parts to these calculations:
- Estimating future capital growth and
- Deciding on the time-frame
The recycling cost is calculated more or less instantly.
That is, you can sell a property and buy another in a few months.
But the opportunity cost of capital growth will be measured in years not in months.
So the comparison of recycling equity costs to opportunity costs needs a time-frame.
This isn’t hard but it is up to you to decide.
Set a time-frame over which both the property you currently hold and the one you’re thinking of replacing it with, will be examined.
Ask yourself this question, “How long will I give each investment to prove itself”?
Your answer may be 3 years or 1 year or 5 years or 2 years.
It doesn’t matter that much but months would be a poor comparison timeframe as would 10 years.
What matters is that you choose a time-frame that suits you and then base all your estimates, like capital growth, on that time-frame.
Estimating future capital growth
We all know it’s not really possible to accurately predict capital growth.
Investment comes with some risk after all. But we can get a pretty good idea, especially for short terms like 2 years or less and for longer terms like 20 years or more.
Long term predictions are pretty easy.
The long term average growth rate for any 1st world nation over the last few hundred years would be a decent benchmark to start with.
Short term capital growth predictions are easier than mid-term ones because you can get a lot of information about a property market currently.
Property markets aren’t that volatile and so not a lot can change in 2 or 3 years. If something radical is about to take place, you can usually uncover that through some fundamental research.
Price growth will happen when demand exceeds supply.
You need to determine the level by which demand exceeds supply to have any hope of estimating future capital growth.
A market’s current demand and supply situation can easily be determined by looking at the demand to supply ratio (DSR) which is available from DSRdata.com.au.
However, converting a demand to supply ratio into a capital growth prediction is very difficult.
This is why at DSR Data we don’t publish such a figure.
There are other enterprises that will stick their neck out and offer predictions of capital growth. But they usually do so for very large markets like Sydney, South-East Queensland, Tasmania or even all of Australia.
You can’t assume that your property will experience the same growth rate as the suburb in which it resides let alone its post code, local government area, region or city. So city growth predictions won’t be of help to you.
The following figure shows a chart of the 2 years average growth rates from December 2012 to 2014 for each Demand to Supply Ratio score from 29 to 77.
The average growth rate of a market with a score of 34 was only 5% over 2 years, that’s only 2.5% pa.
The average growth rate for a suburb with a score of 70 was nearly 20%.
The chart quite clearly shows that the higher the demand to supply, the higher the potential is for capital growth. No surprises there.
We all know about the law of supply and demand.
The smooth line that cuts through the middle of most of the squiggles is a 4th order polynomial line of best fit.
This “smarty-pants” line shows a clear relationship between DSR and capital growth.
But the volatility of the squiggly lines shows that it’s not 100% perfect.
You can use the freely available DSR score for any suburb in Australia to try and gauge the potential for capital growth that a suburb has.
Translate this to a guestimate of capital growth to help finalise your calculations. Just be aware that this is a rough estimate.
Regional versus City
Regional markets are usually more volatile and risky than city markets.
This is because city markets have tremendous economic diversity.
If the entity you work for in the city goes belly up, you may still find work elsewhere in the same city and you may not need to move.
In a regional market, the options are not as great and people may be forced to move in search of work.
The reason I bring this up is that if you see a dipping DSR in a regional market, your incentive to sell should be greater than in a city market.
A regional market can be depressed for decades whereas city markets should experience some growth within a 10 year span.
So the general rule of buy and never sell should not be adhered to so strictly in regional markets.
It makes more sense though in city markets.
Some other considerations
If you already have some equity in a property and your serviceability is good, you may not need to sell in order to buy another property.
If you can borrow against the equity in an investment to buy another, then perhaps the opportunity cost will not be so great because you can actually buy the best investment rather than watch it pass you by.
Then the opportunity cost for not selling is measured against the second best alternative, not the best.
If you have a truly long-term outlook, like a couple of decades for regional areas or 7-10 years in city markets, then it may not be such a big deal to hang onto a property.
Young investors should be encouraged to hang onto property more so than older investors since the young have more time on their side.
If you own property that is cash-flow neutral or cash-flow positive, then holding costs are less of a concern.
This means your opportunity cost won’t be as bad as for a negatively geared property.
If the positive cash flow is significant and the future capital growth is hard to predict, then it may be worth your while to just hang on.
In order to answer the question of whether to sell or not, you need to calculate the cost of recycling your equity and the opportunity cost of not doing so.
If your strategy involves the manufacture of a significant amount of equity, don’t be afraid to sell.
If you prefer the buy and hold strategy, you’ll need to keep an eye on your market and regularly recalculate opportunity costs.
Your estimate for capital growth becomes a key factor for either approach.
The DSR can assist in this estimate.
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