If You're Buying Real Estate, Don't Ignore the Frictional Costs
Over the past few years I have occasionally spent swaths of time examining potential investment real estate deals--apartment complexes, mobile home parks, office buildings, etc. More often than not, I have found that my walkaway price is somewhat away from (i.e., often about 10% below) what the highest bidder is willing to pay for the same property. The stock market analogy of this behavior would be entering good-till-cancelled buy orders at limit prices lower than current market, only to see the market run higher with the orders never executing.
While I do succeed in buying stocks, closing on real estate deals is a much rarer event for me. What's going on here? Is the gap between my bid and the market price in real estate deals just a difference in viewpoint on appreciation potential, or is another mechanism at work here? Having been through the lengthy due diligence process of buying real property a number of times, I am beginning to suspect that the answer lies in understanding so-called "frictional costs."
Generally, when I look at potential returns, I take into account frictional costs through what boils down to a very simple formula:
Net Return = Gross Return - Frictional Costs
To see how this works, let's compare a typical stock investment with a comparable real estate deal:
Stock Investment: $20 per share x 5,000 shares = $100k equity
* Trading commission: Discount broker commission is $10 per trade, or 2 b.p. round-trip on a $100k trade;
* Bid-offer spread: In a $20.00-$20.04 market, round-trip cost is 20 b.p.;
* Time: Company research (10 to 20 hrs.) and trade execution (1 hour) amount to about $1,600 (valuing my time at $100 per hour), or 1.6% on a $100k trade.
* Total Frictional Cost: About 2% of equity investment
Real Estate Deal: $1 mil. property - $500k loan at 50% loan-to-value = $500k equity
* Broker's commission: Seller pays 6%, giving round-trip cost equal to 12% of equity;
* Bid-offer spread: Not applicable in negotiated deal;
* Due diligence and closing costs: Inspection ($1,000), escrow ($1,500), transfer tax ($17,800), title insurance ($2,000), appraisal ($500), loan fees ($5,000), misc. ($200), giving a round-trip total of $28,000, or 5.6% of equity;
* Time: Market research (10 to 20 hrs.), property due diligence (10 to 20 hrs.), deal negotiation and closing (20 to 60 hrs.). Total: About 70 hrs. x $100/hr. = $7,000, or 1.4% of equity.
* Total Frictional Cost: About 20% of equity investment (or 10% of property price)
Assuming a five-year investment horizon (which is typical of the amount of time investors hold real property), the frictional cost of a stock investment is about 0.4% per annum, versus a hefty 4.0% per annum in real estate. If I desire a net return of 20% per annum, on a pro forma basis I need to "pencil out" 20.4% for a stock investment and a much higher 24.0% for a real estate deal on a gross basis prior to accounting for frictional costs.
(Tax advantages available through 1031 tax-deferred exchanges of real property help to offset the higher non-tax frictional costs of buying and selling real estate. However, even at a high capital gains tax rate of 20%, the savings approaches just 2% per annum (17% p.a. after-tax for 5-year taxable rolls vs. 19% p.a. for tax deferral over 25 to 30 years), when assuming 20% per annum pre-tax returns. At a lower capital gains tax rate of 15%, the savings is 1.5% per annum, again figured over a 25- to 30-year time horizon. In any event, the savings from deferral of capital gains tax is typically not large enough to make up for what is lost through higher non-tax frictional costs in real estate deals.)
My guess is that most real estate investors do not fully account for frictional costs, which I believe explains much of the discrepancy between my bid price and the (often higher) market price for real property. Particularly in the currently "hot" real estate market, investors are betting on continued appreciation in property values (10% to 15% per annum), significantly higher than historical levels (5% to 10% per annum). I am not here trying to predict when the current double-digit rate of real estate price appreciation will pause, but I do know that when the music does stop, there will be a lot of unhappy investors--especially those who have ignored frictional costs in figuring their pro forma investment returns.
While I do succeed in buying stocks, closing on real estate deals is a much rarer event for me. What's going on here? Is the gap between my bid and the market price in real estate deals just a difference in viewpoint on appreciation potential, or is another mechanism at work here? Having been through the lengthy due diligence process of buying real property a number of times, I am beginning to suspect that the answer lies in understanding so-called "frictional costs."
Generally, when I look at potential returns, I take into account frictional costs through what boils down to a very simple formula:
Net Return = Gross Return - Frictional Costs
To see how this works, let's compare a typical stock investment with a comparable real estate deal:
Stock Investment: $20 per share x 5,000 shares = $100k equity
* Trading commission: Discount broker commission is $10 per trade, or 2 b.p. round-trip on a $100k trade;
* Bid-offer spread: In a $20.00-$20.04 market, round-trip cost is 20 b.p.;
* Time: Company research (10 to 20 hrs.) and trade execution (1 hour) amount to about $1,600 (valuing my time at $100 per hour), or 1.6% on a $100k trade.
* Total Frictional Cost: About 2% of equity investment
Real Estate Deal: $1 mil. property - $500k loan at 50% loan-to-value = $500k equity
* Broker's commission: Seller pays 6%, giving round-trip cost equal to 12% of equity;
* Bid-offer spread: Not applicable in negotiated deal;
* Due diligence and closing costs: Inspection ($1,000), escrow ($1,500), transfer tax ($17,800), title insurance ($2,000), appraisal ($500), loan fees ($5,000), misc. ($200), giving a round-trip total of $28,000, or 5.6% of equity;
* Time: Market research (10 to 20 hrs.), property due diligence (10 to 20 hrs.), deal negotiation and closing (20 to 60 hrs.). Total: About 70 hrs. x $100/hr. = $7,000, or 1.4% of equity.
* Total Frictional Cost: About 20% of equity investment (or 10% of property price)
Assuming a five-year investment horizon (which is typical of the amount of time investors hold real property), the frictional cost of a stock investment is about 0.4% per annum, versus a hefty 4.0% per annum in real estate. If I desire a net return of 20% per annum, on a pro forma basis I need to "pencil out" 20.4% for a stock investment and a much higher 24.0% for a real estate deal on a gross basis prior to accounting for frictional costs.
(Tax advantages available through 1031 tax-deferred exchanges of real property help to offset the higher non-tax frictional costs of buying and selling real estate. However, even at a high capital gains tax rate of 20%, the savings approaches just 2% per annum (17% p.a. after-tax for 5-year taxable rolls vs. 19% p.a. for tax deferral over 25 to 30 years), when assuming 20% per annum pre-tax returns. At a lower capital gains tax rate of 15%, the savings is 1.5% per annum, again figured over a 25- to 30-year time horizon. In any event, the savings from deferral of capital gains tax is typically not large enough to make up for what is lost through higher non-tax frictional costs in real estate deals.)
My guess is that most real estate investors do not fully account for frictional costs, which I believe explains much of the discrepancy between my bid price and the (often higher) market price for real property. Particularly in the currently "hot" real estate market, investors are betting on continued appreciation in property values (10% to 15% per annum), significantly higher than historical levels (5% to 10% per annum). I am not here trying to predict when the current double-digit rate of real estate price appreciation will pause, but I do know that when the music does stop, there will be a lot of unhappy investors--especially those who have ignored frictional costs in figuring their pro forma investment returns.
posted by Lloyd Sakazaki at 10:07 AM
3 Comments:
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I have a web site where I research stocks under five dollars. I have many years of experience with these type of stocks. I find that the best measurement of how undervalued a stock is is the price to sales ratio of a companies stock. The price to sales ratio is the market cap of a companies stock compared to the amount of sales the company does on an annual bases. A good example of a company with a low price to sales ratio is carrols restaurant group the company has a market cap of just 160 million dollars but does over 800 million dollars in annual sales the company is solidly profitable. In other words the price that the market is valuing the company at is 160 million dollars this is only one fifth of what the company does in annual sales 800+ million dollars. the stock currently trades at around 7.25 cents a share under the symbol {TAST} I think the stock could get to 50.00 dollars a share over the next five years. I base this on the current net profit margin of around 1.75% or 14 million dollars on sales of 800 hundred million dollars. if the companies sales were to increase by 50% or 400 million dollars to 1.2 billion dollars over the next five years. and if the companies net profit margin were to expand from 1.75% to 5% or 60 million dollars over the next five years. than if the companies stock increased in price to where it was trading at a price earnings ratio of 20 this would put the stock at 40 dollars a share. this may seem to be a somewhat optimistic scenario but not really that much. there are many stocks that trade at much higher price earnings ratios when they become popular than 20 times earnings. I find that companies like carrols restaurant group are very rare. I also find that companies that have low price to sales ratios that are profitable or of decent quality tend to become takeover targets or get taken private by private equity firms or the management of the company. or other companies in the same business.
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