It’s surprising how many people don’t know the difference between “enterprise value,” which is the sales price of a home (debt plus equity), and “equity value,” which is what is left at the end of the day when you sell your home and pay off the mortgage. When you are determining whether a property was a good investment for you, it is only the latter calculation that matters.
Fooling The Logic
Most people simply look at how much the value of their home has appreciated since they bought it, and compare it to what they paid. Let’s say someone bought a home for $500,000 a year earlier and their neighbor’s identical home just sold for $550,000. Simple math would suggest a potential 10% return in one year (a $50,000 profit on a $500,000 purchase). This, while straightforward, is not an accurate calculation for several reasons.
It is critical to factor in transaction costs on the sale of your home and deduct them from the gross sales price to see how much of the sales price you have left. This will include what it might cost you to prepare the house for sale (painting, landscaping, staging in some cases, etc) as well as real estate commissions and other transaction-related costs.
Let’s say in our hypothetical example, our seller would invest $10,000 in sprucing the place up for sale, and the real estate commission plus other closing costs on the $550,000 sale might be another $33,000 (say 6% of the sales price). Thus that $550,000 sales price results in only $507,000 after these transaction-related costs, implying a mere 1.4% return ($7,000 profit on a $500,000 purchase price), right? Wrong again. Fooled you twice with what seems like sound logic.
Proper Return Calculations
To calculate your investment return, you need to compare your profit (or loss) to the equity you have invested, not the entire home price. Let’s say you put 5% down to buy the home in the example above, which equated to $25,000. Your $7,000 profit in this case actually represents a very attractive 28% return on your investment in only one year. One way smart homeowners can increase their returns is to appreciate how much the return on their invested equity can be enhanced by saving say 1% in the agent’s listing commission. In the example above, a 5% sales commission vs. 6% would have increased our hypothetical seller’s return on their $25,000 of equity investment from the 28% we just calculated to an astonishing 50% ($12,500 profit on the $25,000 investment).
A couple of basic takeaways from this:
- Make sure to factor in all costs of a transaction.
- Understand the difference between the aggregate home value and the equity you have invested in the home, which is what impacts your true economic return.
- Appreciate the impact sales-related costs can have on your return.
When you begin to factor in the possible costs, you can get an accurate estimation of what you can expect back from your investment. Looking at everything that can affect your return is a good measure of whether or not the investment is “good.” When you are looking to get into real estate it isn’t a quick easy search, it’s a process that requires thought and education. If done correctly, you can reap the rewards of real estate investing.