Is this CBD Apartment a great investment opportunity?

Is this CBD Apartment a great investment opportunity?

Check this out! Would you take this opportunity to make $200,000 off a $400,000 investment, or a 50% return?

I was recently shown a potential investment opportunity. It is a "leaky building" in Auckland and this happens because back in the day, the building rules were too lax. So the entire building now needs to be renovated to modern standards, which is a huge cost, and banks will not fund a purchase of these apartments, that's why they are going for "cheap". The angle to this investment is that they sued the council and won, so a huge part of the remediation cost will be paid by the council. And because you need to pay in cash, the pool of buyers is smaller, therefore potential to snag a bargain.  And because I love looking for trouble, it was worth checking out. 

These are the facts and numbers:

  • This is on a great street in the Auckland CBD, short walk to an upcoming train station, 2 bedrooms with carpark.
  • Buy the apartment for $380,000, spend another $40k on remedial works, and the balance will be paid via compensation from the council
  • Carparks in the CBD are selling for about $100-120k
  • No rent for 2 years whilst renovating. 
  • After remediation will be worth about $600k

Does this sound like a great deal? You can pocket about $200k gain just like that. Well, let's dig deeper. (And I hope you get to learn something from this case study)

  • The above assumes EVERYTHING goes according to plan. That costs of remediation do not escalate. That the TIME taken does not stretch. These 2 happen with more regularity than you think.
  • But let's give this project the benefit of the doubt, that everything will go according to plan.
  • There will be no rent for 2 years because of remediation (although 3 years is just as likely but let's ignore that for now.) Rates will still need to be paid, body corp fees etc. That adds another $14-21k to the cost. So your cost is now about $435k.
  • Add in the potential rental after tax of $15k per year (assuming it will immediately find a tenant for 3 years after remediation, which may or may not be the case). If you sell the property after 5 years, you will get $600k + $15k for 3 years, total  $645k. 
  • Potential profit of $200k

Lesson #1: The key is this. Investing $450k now (I'm simplifying the timing of all the cash flows),and getting $645k after 5 years is only a 8.25% compound return per year. This is very important. Don't be tempted by the surface "nominal" return. Learn how to think in compound annual returns. 

The next question will be, is 8.25% good enough for you? For some people it might, but don't forget this assumes everything goes to plan and there is no risk.

Lesson #2: This might sound good for many people but my hurdle rate for real estate is 12%. This is because anything lower does not justify the risks, and more importantly, I can find opportunities that return more than that. So as a rational investor, why would I accept something that is lower? This applies to my stock market investments as well, except that my hurdle rate increases to 15% at least. 

So the next time you find something that APPEARS cheap, dig deeper. Consider what the compound returns actually will be, and whether that meets your hurdle rate.

Joshua Fong, CFA

Article by Joshua Fong, CFA

Published 17 Aug 2020