Is selling on investment property to buy another a good idea?

Sunday, 15th Aug 2010
Categories: Finance, Newsletter

 Investment Property At one time or another, almost every investor will find themselves wondering whether they should keep their current investment property or sell up to secure a better performing one. Is the grass really greener on the other side, or should they stick with what they’ve got?

This scenario is a common one and often comes about because the investor feels they haven’t received a sufficient return on their current investment or because they want to buy in another “hotspot” area and can’t afford to hold both investments. They’re looking for property that perhaps has better money-making potential at a faster rate of growth. So, which of the two courses of action – to sell or to hold – is going to deliver the best outcome? At first glance you may think the answer is obvious. But is it?

As many of our regular readers would be aware, I believe the buy-and-hold strategy is the surest way to wealth creation through property (not to say that there isn’t a time and place for other methods). However to successfully implement this strategy, you must resist the temptation to sell. With the above scenario, my general advice in nine out of ten cases is to actually hold the existing property.When you add up the transaction costs in selling and then buying, and the price you can afford to pay for the replacement property, the figures usually don’t stack up. At least not for a long time anyway.

Let me give you a fairly simplified example of why you should rarely sell (please note figures are estimations only as various transaction costs alter from state to state).

Assume that you own an investment property worth $400,000 that you purchased for $200,000 (inclusive of all buying costs such as stamp duty etc) 10 years ago. Let’s say it’s expected to generate 6% per annum capital growth. In 10 years time this property will be worth approximately $716,000.

You may think you will be able to generate a better capital growth rate of about 8% per annum if you purchase in another area, so you consider selling this property. If you sell the property for $400,000, you will attract standard expenses of real estate agent fees, advertising costs, and legal/conveyancing fees. Depending on where you live, these could equate to around $15,000 all up. This leaves you with $385,000. You will also have to pay capital gains tax on the gain of $185,000 ($385,000 – $200,000), which let’s say is about $41,000 at the discounted capital gains rate of 22.5% (50% discount applied to the top marginal income tax rate). This will now leave you with $344,000. Now to purchase a new property, you need to allow for standard expenses including stamp duty, legal/conveyancing, and inspection costs. Let’s average these at a total of $15,000, again these will vary depending on where you live. With what’s left you will probably be able to purchase a property for around $329,000.

Let’s assume you find a property for $329,000 which does generate 8% per annum on that new property purchase. In ten years time, this new property will be valued at around $710,000, LESS than the value of the original property if you had kept it. So even after ten years, you would have still been better off with your original property. It will actually take 11 years for the new property to grow in value more than the value of the property you sold to make the whole situation worth the effort.

And this whole process, in terms of transaction costs for buying and selling, cost an average of $70,000! You’d probably be better off holding your existing asset and if you could afford to, leveraging the equity in the property to fund your next investment property when you’re ready. Instead of blowing that $70,000 on expenses which leave you with nothing to show, use it to invest further.

Generally speaking, I think there are really only three situations in which you should sell property assuming you have a choice. The first is if the neighbourhood is declining. Increased crime and other unsavoury activities which decay an area, may indicate your investment will no longer be a good investment in years to come. Secondly, selling is okay if you are ready for retirement and selling part of your portfolio is your strategy to derive an income. And lastly, if you truly believe that you can generate significantly superior returns elsewhere. As you can see in the previous example, even a few percent per annum might take ten years or more to generate enough return just to break even. You need to be talking about more than just a few percent per annum to consider selling.

Of course, if selling an existing property wasn’t part of the equation, then I would certainly advocate buying property that is likely to deliver the best rate of growth compared to another. Using the previous example of a $400,000 investment at 6% per annum versus the same investment at 9% per annum, over 20 years that relatively small 3% difference equates to almost $1 million in extra value than the 6% growth alternative.

Yes, it can certainly be tempting to sell, especially if you feel your current investment isn’t performing as well as it should. But as you can see, the grass isn’t always greener on the other side.