Friday Morning: A Reader Asks for Help -- Does This Condo Purchase Make Sense?

Note: This came in as a comment, but we thought it would generate more feedback if we turned it into a full post:

Hi all,

I need some help crunching some numbers.  I was looking at buying a condo for $400K and wanted to see if it was really as profitable as some have said.  I am engaged at the moment and plan to start a family five years from now, so this home purchase is for building up equity for the next home, where I plan to stay for a long time.  So keep in mind that this first purchase is purely for profit. 
Heres a list of additional costs for me (Yearly):
Mortgage Payment ($2,200) - Rent ($1,600) = $600 / month = $7,200
Property Tax (1.5%??) = $6,000
HOA ($200 / month) = $2,400
Maintenance = ??
Insurance = $1,200

Here is a list of the benefits: (The amounts are taken from the Mortgage Payment calculator on Yahoo's finance page for a $400K loan with $50K down)
Income Tax Savings ( 1/3 of Loan Interest ) $21,000 / 3 = $7,000
Paying Down Principal: (~$300 a month) = $4,800

After three years, this house would probably be sold for $449K assumming 4% YOY.  The realtor's cut (6%) would be $27K.  That leaves $22K.  If I take into account the extra costs and the savings above, which adds up to -$5,000 a year, the profit is fairly low... about $7K.  $7K in three years??? Are my calculations incorrect?

Any assistance anyone can offer would be very much appreciated.  Please let me know if any of my estimates are inaccurate.

Comments

[Jorge S]

Based on your numbers it is not a good investment. You will be better off just investing the $50K down payment and every year's cash flow buying a mutual fund tied to the DJ. On the other hand, life and an investment like the Condo cannot be predicted with the surgical precision you use. As an investment, the Condo should be played along with the market. I like the DJ better because it gives instant liquidity and very low transaction cost ($300 vs $27,000) and you don't have to find a willing and able buyer (there are a lot of willing buyers but not that many able buyers for RE).

[Greg]

The math is fine, it's the underlying reality that raises problems.

You're taking a big risk for not very much money. Suppose the market tanks?

This market is different from anything we've seen before. On the plus side, the economy in SoCal so far is holding steady so far.

On the minus side, there's a huge amount of property that people may be trying to sell cheap or walk away from. This is because it's held through mortgage loans on terms, like ARMs and teaser rates, that make it hard for people to keep up with payments. It's also easy for them to walk away because of California's rules on mortgages. The situation in the real estate market in southern California is like the stock market before the big crash in 1929--lots of assets held on very small margin.

Some people think things are going to be okay. Some don't. I think the real answer is that no one really knows.

It's a ton more risk than I would take, especially if you're a small investor trying to build credit and assets for a real home. I say that as a small-scale real estate investor myself, albeit in Seattle.

[Joseph]

Your planning horizon is too short for real estate. Generally, real estate will double every 10-15 years, so 5 years is not realistic. Also, you did not take into account the potential tax loses which cannot be calculated without more information but may be substantial.

[Pat]

Your numbers seem to be a bit off.

Your rent won't rise? I bet it might. Figure about $6500/yr payment beyond rent a year, not $7200.

Property tax: I'd figure more like $4500/yr, not $6000. But, let's say $5000 to be conservative.

I'll take your word on the HOA.

Insurance: $1200/yr is way high for a condo. You can get decent coverage for $300/yr for a condo, maybe even less. The biggest part of your HOA should be going to structural insurance.

Maintenance: I bought a conversion and maintenance has been pretty close to zero.
However the biggest difference lies in your guess as to sales cost.
6% is dead.
Once again, I'll be conservative and say 4% (though in a few years I think 3% will be pretty easy to get).

So you're looking at about $22K gain in 3 years, not $7K.

Of course, if prices go down, then that's an entirely different equation.

This is all a guess.
Rents may go up a lot more than 9% in 3 years.
Prices may not go up at all or go down.

Welcome to the parimutuel betting window called Capitalism.

I would not disagree strongly with any previous postings. Here are some additional thoughts to ponder.
1. Condos as compared to detached homes, are not generally where the big gains in appreciation occur.
2. Since you are trying to think in terms of investment (and your primary residence is not _really_ an investment) the golden rule for real estate investment is "you make your profit when you buy, not when you sell."
3. You gotta live someplace.

[john]

Dont forget about the opportunity cost of investing that 50k in other investments. On a conservative basis, you could assume a 4.5% return on 50k in CDs/money market funds. This will lower you realized return.

[Cal]

I posted this last night under the original question:

J,

A few things I would point out, you would need to calculate the "opportunity cost" of the 50k down payment and the ~300 a month (3600 a year not 4800) if you rented and put that money in a savings account. You can get a bit over 5% right now, The 50k would earn 7881 after 3 years before tax, the ~300 a month entered into a 5% paying account (before taxes) would have a balance of 11674 after 36 months.

Property tax is also tax deductible, but I would caution you to check your mortgage interest tax deductibility, check what you paid in FEDERAL taxes last year (I bet you are including all taxes plus social security, medicare, California disability which wouldnt change with the deduction) and divide that amount by the amount of your taxable income to get a more accurate ballpark percentage. To pay 33% in federal taxes on taxable income, that income would be north of 400k a year. Your down payment is less than 80% of the home price so you also have PMI considerations and possibly a hit to the rate for the increased risk.

I would also check with the HOA if there were any assessments levied or planning to be levied. Maintenance is usually assumed at 1% a year but if all major appliances and systems are in good working order over 3 years it could be much less.

The final issue would be one of risk. Equity is merely the difference of what you owe versus what the property is worth, in a downturn Condos traditionally perform poorer than homes. So you could pay down your debt but not build equity if the housing market does poorly. I think an assumption of 4% appreciation is aggressive considering the current enviroment and lending contraction. In a 3 year span the fees (realtor, mortgage fees, various closing costs) really would eat you up and I think your scenario is more of a break even one at best assuming that 4% appreciation is correct.

(rental increase was pointed out as a contributor as well, I missed that in the above post)

[Kim]

Yep, everyone is right on. Unless your quality of life is going to substantially improve by buying, your down payment would be better invested in something else. Even if it earned just 10%, you'd have a bigger chunk of change in 5 years. That, coupled with the condo resale market, slipping prices, etc. etc. make this a no brainer.

[Mary Ellen]

You also have not accounted for any increases in the HOMEOWNERS ASSOCIATION which are pretty much unregulated so that means those costs can dramatically increase depending on the association. And those fees are NOT tax deductible.

[Linda Slocum]

I agree with Pat - you've got some bad assumptions going on here.

Insurance should be about the same as renters insurance, since the building insurance will be covered by you HOA (or at least it should be).

Property tax is usually in the 1.25% range, and is tax deductible just as mortgage interest is. Make sure you include Federal and State taxes in your calcs, not just the Federal rate.

Maintenance for condos is covered by the HOA for the most part, and the sellers should provide you with a 1-year home warranty that you can renew, allowing you to pay about $45/call for service calls if your dishwasher or a/c go bad. Check with the HOA to find out what they do/don't cover.

If you don't plan on rent increases in your calculations, then you're not using apples to apples numbers.

Also, you say that you calculated a $400k loan with $50k down on a $400k purchase. Did you calculate based on a $400k loan or a $350k loan? And why $4800 in principal portion when you show approx $300/month in principal included in each monthly payment?

Return on Investment (ROI) is calculated on the money you spend, not the cost of the home since the bulk of it is leveraged. So your investment is your costs plus your down payment, less what you would have paid in rent in your case.

I'm not going to get into a commission debate, since it's anybody's guess what the real estate market will be like in 5 years, but do plan on paying for escrow, title and transfer fees when you sell.

[pc]

Agree on most of the points stated.
1) According to your calculations, you are risking $50k over 3 years, in order to gain $7k. A pretty poor return, wouldn't you say? That assumes that housing will appreicate 4% YOY, and none of us really has THE crystal ball.
2) Also keep in mind that gains will *not* be tax free. Gains on housing are tax free if you are using the property as your primary residence. Why aren't you living in the condo, instead of renting it out.
3) Since you don't have teh required 20% down payment, you will be subject to PMI,
4) An investment property has slightly different tax consequences that a normally, owner-occupied place has. I think you're allowed to deduct the shortage of rent minus expenses, but am unsure about the mortgage interest. Be certain that 100% of the mortgage interest is tax deductible before taking the plunge.
5) Honestly, wouldn't you rather put $50k towards something a little safer? good luck

[Frank]

Leaving aside all your other numbers ... there is no way you can reasonably expect five years of appreciation on your condo when prices are already churning negative YOY and look set to accelerate from here. Prices only need to fall 1/6 for you to be trapped underwater, and condos generally bear the brunt of a bust.

[Travelingman]

Most of the assumptions seem fine with excpetions of property tax and possible HOA increases.

However, your assumption of YOY growth is not aligning with current facts on ground.

Prices are flat to declining today in most zips.

You read it here and other blogs, inventory is growing; foreclosures are increasing and stricter lending is resulting in less buyers, thus creating downward pressure on prices.

the 5 year run up on prices has been unprecedented and it's not about quality of RE getting better - it's been about credit and creative yet toxic loan products given to many who should not have been approrved coupled with speculation and fraud. That credit boom is now drying up

Homeowners with about $515 billion on adjustable-rate home loans will pay more this year, and another $680 billion worth of mortgages will reset next year - the number of foreclosures is forecasted to unprecedented.

I'd venture to say, that RE will be stagnant to decline in most zips.

your ROI isn't going to be great. In 10+ years, it may be fine but within your timeline, it may not be such a great investment.

[eprobert]

We run the same calculations on a monthly basis and it just does not make sense to buy a "starter condo" at the present time.

Maybe a starter house, but even then, we're renting a nice houae for $1700 with a garage and the monthly payment difference between buying is simply MASSIVE.

Not much reason to buy right now, unless you're thinking of making a huge down payment and staying for 20+ years and it's the perfect place.