The merits of "overpaying" for a home

The merits of "overpaying" for a home

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The merits of "overpaying" for a home

Posted on May 25 2012 at 01:16:49 AM in Finance & Investment

In the current real estate market in Las Vegas, investors are having difficulties finding homes to purchase, in large part because of the foreclosure legislation passed in Nevada late last year. The homes that are priced at or below market go into escrow very quickly after multiple bids, and this is a tough situation to be in as an investor.

The Las Vegas market, like all distressed markets, is composed largely of investors who are all-cash buyers. While this is disconcerting for investors, it does provide an opening for those who can attain a mortgage- this is the best way to counteract whales with large amounts of capital to dispose, especially in this tight credit market. From what we’ve been hearing, big foreign investors are not afraid to buy homes that they break even on; they are more than happy to wait out the market and profit solely from market appreciation.

So the question arises whether it is advisable to “overpay” for a home to outbid all-cash investors. To answer this question, let’s go through a pretty standard deal at a price range that is above the low-end ($20.000-$30,000), where there is much more competition for homes.

 

Home Price  $50,000.00

Down Payment  $10,000.00

Mortgage  $40,000.00    

Monthly Rent  $     800.00

Annual Rent  $  9,600.00

Gross Operating Inc.  $  9,120.00    

 

Operating Expenses  $  3,300.00

Net Operating Inc.  $  5,820.00    

 

Cap Rate 11.64%    

 

Mortgage Rate 4.50%

Monthly Mort. Payment $202.67

Annual Mort. Payment $2,432.09    

 

Cash in Pocket      $3,387.91

Return on Cash 33.88%

 

I assume you put 20% down on a home priced at $50,000 that rents for $800 a month. Nothing out of the ordinary here. I’m further assuming a vacancy rate of 5% and a mortgage of 4.5%- again, nothing out of the ordinary.

From these inputs, you return 33.88% annually after expenses. I think we can all agree this is a great return. Unfortunately, savvier investors know this and will outbid you more times than not, leaving you with a return that is substantial, but ultimately, theoretical.

Now let’s assume you increase your bid to account for these whales. We’ll raise our bid by 10% and see what happens.

 

Home Price  $55,000.00

Down Payment  $11,000.00

Mortgage  $44,000.00     Monthly Rent  $     800.00

Annual Rent  $  9,600.00

Gross Operating Inc.  $  9,120.00    

 

Operating Expenses  $  3,300.00

Net Operating Inc.  $  5,820.00    

 

Cap Rate 10.58%    

 

Mortgage Rate 4.50%

Monthly Mort. Payment $222.94

Annual Mort. Payment $2,675.30    

 

Cash in Pocket      $3,144.70

Return on Cash 28.59%

 

Your return obviously falls, but to a still respectable 28.59% annually. Your theoretical returns, which inpractice net you 0%, turn into robust 28.59% returns annually, assuming no appreciation in your property. But if you are a bull on real estate, which I suspect you are if you’re reading this, then you’re home merely needs to appreciate by 1% annually to “make up” for your 10% overbid. Here’s the simple math to demonstrate this.

(1% of $50,000=$500, $500/$10,000= 5%, 28.59% + 5%= 33.59%)

Your thought process about real estate should constantly be evolving according to market conditions. I hope I’ve shown you with this simple example that overbidding when you have access to a conventional mortgage is a very good strategy. If you believe a bull market in real estate is beginning, then you should be most concerned about accumulating as much inventory as possible, and less concerned about price.

 

  Article Information
Created: May 25 2012 at 01:16:49 AM
Updated: May 25 2012 at 01:19:10 AM
Language: English

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