Wednesday, May 04, 2005

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.

20 Comments:

Anonymous Anonymous said...

Hey, you have a great blog here! I'm definitely going to bookmark you!

I have a wisconsin real estate site/blog. It pretty much covers ##KEYWORD## related stuff.



Come and check it out if you get time :-)

wisconsin real estate wisconsin real estate

7:40 PM, October 19, 2005  
Blogger Johnny said...

Hello, just visited your blog, it's geat. I also have a consolidation loan related blog with some useful articles about the topic. Hope that it is helpful to you.

11:20 AM, October 20, 2005  
Anonymous Anonymous said...

Hey, you have a great blog here! I'm definitely going to bookmark you!

I have a Loan site/blog. It pretty much covers Loans related information. We provide online applications, business, residential, we do all loans.

Come and check it out if you get time :-)

1:20 AM, October 22, 2005  
Anonymous Anonymous said...

Nice site. Check mine out if you can. investing in gold

6:12 PM, October 23, 2005  
Anonymous Anonymous said...

Nice post. Check out my site if you can. bad credit home equity loan

6:54 PM, October 23, 2005  
Anonymous Anonymous said...

Hi, I ran across your blog and really like your content. I run a small website about make money in real estate. You'll find that we offer a free course on make money in real estate

9:37 PM, October 26, 2005  
Anonymous Anonymous said...

I just came across your blog, and wanted to drop you a note telling you how impressed I was with the information you have posted here. I also have a free stock trading blog, so I know what I'm talking about when I say your site is top-notch! Keep up the great work, you are providing a great resource on the Internet here!

9:50 PM, October 26, 2005  
Blogger . said...

I just came across your blog, and wanted to drop you a note telling you how impressed I was with the information you have posted here. I also have a stock trading blog, so I know what I'm talking about when I say your site is top-notch! Keep up the great work, you are providing a great resource on the Internet here!

3:43 PM, October 27, 2005  
Blogger websoftware said...

Hi:

Interesting Blog.

I just set up a new site just for San Diego downtown real estate.San Diego downtown real estate. I show all **San Diego MLS listings** on the site.

I f you have a chance, please visit.

Bob

2:56 PM, October 28, 2005  
Anonymous Anonymous said...

If you are looking to change the look of your emails from plain white with black text to a colorful, eye-catching, attention grabbing email, OnLetterhead is the product for you. Go from "White" to "Wow" with one click!

With "OnLetterhead's "Ease of Send & Setup" (EOSS) technology, all the work is done before you type your message! Just click and send and see the results a branded difference can make.
** Real Estate Marketing**

6:51 PM, October 29, 2005  
Anonymous Anonymous said...

Hello,
Great blog with some useful info on colorado home equity loan. I have a colorado home equity loan themed site you and your visitors might find interesting. I'd love for you to check it out.

2:44 AM, October 31, 2005  
Anonymous Anonymous said...

If you are looking to change the look of your emails from plain white with black text to a colorful, eye-catching, attention grabbing email, OnLetterhead is the product for you. Go from "White" to "Wow" with one click!

With "OnLetterhead's "Ease of Send & Setup" (EOSS) technology, all the work is done before you type your message! Just click and send and see the results a branded difference can make.
**Marketing Strategies for the Future**

1:38 PM, October 31, 2005  
Blogger Texas Seo Expert said...

very informative blog.. I have a site featuring some of the finest Texas Real Estate available. Hope you enjoy.

3:14 AM, November 01, 2005  
Blogger aajkal19 said...

It is very quick and easy to list your FSBOHomes For Sale By Owner . In as little as 10 minutes you could be selling your home For Sale By Owner on-line. You can also upload up to 7 color photos to your real estate listing. You pay absolutely no commissions and can change your listing information on-line at any time.

11:39 AM, November 02, 2005  
Blogger Goodman441 said...

Hello, this is a great blog on unsecured personal loan, Please visit my site when you get a chance at http://www.loanofficial.com

4:10 AM, November 03, 2005  
Anonymous Anonymous said...

Nice Site. We have Free Houses on my site. Please take a look century 21 real estate listing

8:41 PM, November 03, 2005  
Blogger Evelyn said...

f you are thinking about investing in real estate, Costa Rica is the best option. The tourist boom in this country has been impressive, obviously supported by the beauty of its people and its territory. Just take a look at these tourist havens offers. I already purchased a property in this country and I recommend that you do.

Great investment opportunity in Costa Rica: costa rica
condominiums
, condos for sale,
costa rica homes.
Visit us for more info at:
title="http://www.costa-ricarealestate.com/">http://www.costa-ricarealestate.com/

3:06 PM, November 07, 2007  
Blogger Omar Cruz said...

I like this blog is fantastic, is really good written. Congratulation. Do you want to see something more? Read it...:Great investment opportunity in Costa Rica: costa rica retirement property, costa rica retirement information, costa rica hoteles. Visit us for more info at: http://www.costarica4retirement.com

2:59 PM, December 06, 2007  
Anonymous Penny stock investment advise said...

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.
.

11:00 AM, October 24, 2011  
Anonymous solaris one said...

I like this web blog very much so much superb info .

4:14 AM, August 23, 2017  

Post a Comment

<< Home