5 – APPRECIATION

Capital appreciation can be amassed by one of three ways:

1. identifying properties without foresight
2. identifying properties with foresight
3. identifying properties with potential 

1.IDENTIFYING PROPERTIES WITHOUT FORESIGHT

Capital appreciation has to be real.  Remember the equation:

Pactual = Preal  + Pbubble

Pactual  - Current Market Value of the property

Preal   - The real price of a property based on fundamental principles

Pbubble - The surplus or deficit of the actual price over the real price

Real capital appreciation has to be based on the real price then and now.  Anything else is just a bubble!  Okay, one should sell when a bubble exists as you maximise your exit price but that is dealt with in chapter 7.  Hopefully you will see through several bubbles during your time in property investment before you exit.  However you should only ever be interested in real capital appreciation during your ownership period.  Why? – Because its real!  You know that the real price is the bottom price that you can expect for your property.  Bubbles are temporary inflations or deflations to prices which burst back to the real price.  Bubbles only distort things and are washed out in the long run, anyhow.

The way to guarantee real capital growth is to buy when there is a negative bubble.  I always invest in negative bubble areas.  That is to say when the bubble bursts then – BINGO!  Instead of a bubble bursting and prices fall dramatically it happens the other way round – when the bubble bursts prices rise dramatically.

Look at this example based which are based on real life examples that have happened to me only recently:

I was buying properties in Hull, East Yorkshire.  A property I bought was advertised at £29,995 and rental value £295.  Working out the figures:

Pactual  = £29,995 x 95% = £28,495

Preal  = the higher of:

What an investor would pay for it: annual rental/(long term average rate+2% loading) = (£295x12)/(5.62% + 2.00%) = £46,457

What a first time buyer would pay for it: (salary of someone willing to live in property x 4)/0.95 = (£14,000 x 4)/0.95 = £58,947

So the Preal is the higher of £46,457 and £58,947 hence £58,947.

So:

Pactual - Preal = Pbubble

£28,495 - £58,947 = -£30,452

So I bought a property for £28,495 that is actually worth £58,947.  That’s £30,452 locked in capital growth because its REAL!  So what is it actually worth now?  Well its worth about £36,000 which is far from £58,947, its real value.  The negative bubble of £30,452 is however exploding.  The growth that I have experienced of around £7,500 has occurred in the last 3 months.  The rest will occur over the next year.  But I know with certainty that the £30,452 will blow up in my face far quicker than the average growth rates for the UK ever will do.

Remember that this certain capital growth is independent of both the following principles holding:

1. We are not in a recession so there are an abundance of first time buyers
2. The buy to let market exists so there are an abundance of buy to let investors

As long as one market exists then you are certain of capital growth.

So why does negative bubbles exist

There is really only one answer to this:

We live in an imperfect market!

There are a limited supply of funds offered to us from the lenders so they have to make a choice – do they lend to:

1. An investor that is unaware of superior markets such as Hull in this example and lend to him to buy a lower yielding property in a more conventional and favoured area OR
2. To a private individual who wishes to buy a property in an area that is not considered ‘low value’ OR
3. To an investor or private individual that wishes to buy in a low value area

Usually lenders opt for either 1 or 2 and forget out about 3.  This is because they think their money is safe within a property that is valued more than a ‘low value’ property, typically £60,000.  This is very short-sighted and to be honest a plain stupid view of property lending.  But this is where people like me succeed.  There are some lenders, although be it a handful, lend on properties of ‘low value’.  If you buy low down enough then the only way is up!

Speak to your broker about low value lenders.  If your broker isn’t fluent in these type of lenders then speak to my broker, Liz Syms at Connect IFA on 01708 443334.  If you mention my name then you will receive a 50% discount on her fees.

Using Lenders To Our Advantage

Okay so I’ve told you how lenders favour higher value properties.  Its time to look at the flipside of the equation.  Lets forget low value areas and look at high value areas.  Consider a flat in Kensignton, London.  Lets assume you’ve done the research and you’ve found the average salary for the first time buyer in this area is £75,000.  A 1-bed property comes up for sale for £250,000, rental value £1,000pcm.

Pactual  = £250,000 x 95% = £237,500

Preal  = the higher of:

What an investor would pay for it: annual rental/(long term average rate+2% loading) = (£1,000x12)/(5.62% + 2.00%) = £157,480

What a first time buyer would pay for it: (salary of someone willing to live in property x 4)/0.95 = (£75,000 x 4)/0.95 = £315,789

So the Preal is the higher of £157,480 and £315,789 hence £315,789.

So:

Pactual - Preal = Pbubble

£237,500 - £315,789 = -£78,289

The negative bubble is £78,289.  Remember what I said earlier that this certain capital growth is dependent of both of the following principles holding:

1.We are not in a recession so there are an abundance of first time buyers

2.The buy to let market exists so there are an abundance of buy to let investors

Well, actually only certain capital growth will occur if the following holds:

1.We are not in a recession so there are an abundance of first time buyers

This is because the buy to let investor is not interested.  Your only market is the owner-occupier.  The price willing to be paid is £315,789 and will only be paid by an owner-occupier.  This is what I call the speculative market.  You are basically aiming to sell to the owner-occupier which can be a fickle market.  However, if you get it right then you can make massive gains.  Property programmes such as the Property Ladder have fuelled this type of investment of selling to the private individual.  But please, please, please understand this is not the basis of property investment.  This is only as of a result of rocketing prices (or negative bubbles bursting – depends on your view point!) that has made these type of property programmes credible.

Look at the disparity of the numbers:

What an investor would pay                                  £157,480

What an owner-occupier would pay                    £315,789

Difference                                                     £158,309

So when or if the owner occupier market collapses, if it does, you’re left with a property that you thought you could sell for £315,789 but is actually worth, in real terms, £157,480.  That is why trying to sell to the owner-occupier market is high risk.

2.IDENTIFYING PROPERTIES WITH FORESIGHT

Okay, so you want to be clever!  If you don’t want to make money the easy way by identifying properties available that will lock in certain growth then lets play the speculative market.  Property prices will rise, in real terms, due to:

An increased demand for:

• Unique properties that are scarce such as riverside apartments, 3 bed properties where there’s a glut of 2 bed properties, or houses in central districts as opposed to flats
• Properties that are considered ‘safe’ and more profitable investments to overseas investors compared to the what’s available back home
• An increase in a desirability of an area due to major employers locating in the area, improved transport links such as an a addition of a train station, tube or carriageway or improved services to an area such as a good school, leisure facilities or shopping centre.
• Properties being next to an area that is booming so as to make the area in question highly desirable as its cheaper than the booming area even after travel and time costs
• Properties being brand new and a qualitative effect being experienced due to new properties being most sought after
• An area undergoing a regeneration programme thus resulting in a general uplift in an area

This type of speculative investment is less certain.  This is because you are either:

1. not in full information, or
2. asking the prospective purchaser of your property (even if you’re not selling it will ultimately determine the real value) – what are all these extras worth?

The reason why it is difficult to quantify these extras is because they are qualitative as well as quantitative.  What is the true worth of a property next to a train station compared to a property 10 mins away from the station?  Is it £5,000 or is it £50,000?  It is this that determines the average selling price.

Take for example a riverside apartment on the north side of the river in London.  How many properties are there for sale – say 10 properties.  Out of those, how many need to sell? Very few.   How many people are actively looking for a north side riverside apartment? Loads!  So for scarce, highly desired properties – it’s a seller’s market.  This means you simply have to wait for the buyer to come along unless you are forced to sell.  The only reason for you to be forced to sell is if you need the proceeds to buy your next place or interest rates are on the up to the point you cant afford the mortgage payments.

If you have a desired property then you can wait for the buyer to come to you AND your price as long as you can hold out for a buyer.

Having a desired property like listed above will incorporate a qualitative factor within the price.  Current thinkings say that there is no way to quantify these qualitative factors hence you can receive ridiculous amounts for seemingly basic extras such as being next door to a tube station, offering a brand new property or being next to a booming area as it is highly desired.

One thing I am noticing in the market these days is the increased value of time.  There is a real perceived value in a property that is located in an area that saves you time on the commute.  A property located 1 minute closer in travel time can have a disproportionate increase in value if measured to the worker’s hourly rate.  This is because the worker’s leisure time is worth more than what they earn.  Its worth looking at the properties that are or potentially able to save the buyer/tenant over 15 mins in commuting time.

3.IDENTIFYING PROPERTIES WITH POTENTIAL

okay, this section is for people who like to make money the hard way!   You can add value immediately to a property if you are willing to enhance it.  You can enhance a property in a number of ways:

1. Refurbish it
2. Extend the property
3. Convert the loft

1. Refurbish It

There is real synergy to be created if you get this right.  Synergy means the sum is greater than its parts, or some people like to say 2+2=5.  Let me explain.

Joe buys a house for £100,000.  Spends £5,000 refurbishing it and sells immediately for £125,000.  So he makes £125,000 – (£100,000 +£5,000) = £20,000.  So in this example:

£100k + £5k = £125k.

£20k has miraculously appeared from nowhere!  The reason for this £20k appearing is due to:

1. Joe saving time for the buyer – if a buyer saw the property for £100,000 still requiring a refurbishment then the buyer would not be interested in it as he neither has the time to do the refurbishment nor the time to supervise someone to refurbish it.
2. Joe having £5,000 to refurbish it and the buyer not – Joe is a businessman.  He has £5,000 to refurbish the property and the buying power to buy the property.  Whereas its likely the buyer will only have enough for his deposit on the property only.  So on a 5% deposit of £100,000 a private buyer would need £5,000 to buy the property and £5,000 to refurbishment totalling £10,000.  If the buyer buys the property after Joe has refurbished the buyer will only need 5% x £125,000 = £6,250.  So the buyer needs less money to buy the property after refurbishment.
3. Joe is an expert – Joe will probably have the contacts, know-how and expertise to get the refurbishment done cheaper than a private individual as he is in the trade.  So if Joe views the property alongside an amateur investor Joe will cost the job at £5,000 and the amateur investor may cost the job at £8,000.  With Joes ability to price the job lower than the amateur Joe can go in with a higher offer than the amateur – well in theory anyway!  Due to programmes like Property Ladder, House Doctor, Selling Houses etc everyone thinks they are a property developer!  So amateur investors are under budgeting for the refurbishment and over estimating the eventual selling price thus pushing the professional investor out.

Now I’ll be honest with you.  I know absolutely nothing about the construction of property or refurbishment or building works!  I have done refurbishments before only because the properties were so cheap and I couldn’t resist them.   I bought a 7 bed property, yes 7 bed, for £42,000 in Corby.  I never saw it but I heard it was completely vandalised inside as it was an old crack house.  I knew that it could let out at £500 pcm after refurbishment so I thought it must be worth £50,000 at least.  If the refurbishment would cost less than £8,000 then it makes sense.  So I got a quote - £5,000 they said.  So I said okay.  That was my involvement in the refurb!

Now there are loads of books on how to add value to a property by making it look pretty and this ain’t one of them!  If you want to play this game you have to look at the numbers carefully.  You need to check there is a safe profit margin in it for you.  So what is safe?  You should always be prudent.  That is you should always over estimate your costs and under estimate your proceeds.  Look at this example:

There’s a property for sale for £100,000 that would be worth £150,000 if it was refurbished under current market conditions.  The cost of the refurbishment is estimated at £10,000 and will take 2 months.  I would adopt this forecasted profit & loss:

Selling price - 90% of anticipated selling price = 90% x £150,000               £135,000

Estate Agents fees 1% +VAT                                                                    (£1,586)

Net proceeds                                                                                                £133,413

Costs:

Purchase Price                                                        £100,000

Refurbishment 150% x estimated costs              £15,000

Loan repayments 6 months interest                    £2,500

Total costs                                                                                         (£117,500)

ANTICIPATED PROFIT                                                                              £15,913

So prudently it will take you 6 months to make £15,913.  Annualised its £31,826.  Now is this worth your time?  Are you worth more than £31,826 p.a.  For me it isn’t but for you maybe.  You’ll be surprised how people don’t do this simple profit & loss account to really see if a project is really worth their time.  And remember its anticipated.  It could be more OR it could be less!

Extend The Property

It is NOT a blanket rule that if you extend a property it increases the value of the property more than what you spend on the extension.  It all depends heavily on where your property is located.  I have created a rule of thumb measure of how much your property will increase by if you splash out on an extension.

Its all to do with the ratio of land to buildings cost.  If you build on desired land then you win, if not you lose!  So how do we find out if we own a property sitting on desired land.  Well its all to do with the rebuild cost of your house.  This you can find this from your buildings insurance policy which should have the rebuild cost stated.  It would have been determined when you last had the property surveyed.

Now to decide if the land is desired you simply calculate the following ratio:

Current Market Value

Rebuild cost

If the ratio is greater than 1 then its desired.  If its less than 1 then its not desired.

So if Jack has a property that is currently worth £100,000 and the rebuild cost is £60,000 then the Current Market Value Rebuild Ratio is:

£100,000/£60,000 = 1.667  which is greater than 1 hence Jack should extend.

If Jill also has a property worth £100,000 and it has a rebuild cost of £120,000 then the ratio is:

£100,000/£120,000 = 0,833 which is less than 1 hence Jill should not extend.

You should use this ratio as a multiplier to determine how much value will be added to the property.  So in the above examples if they both decided to spend £30,000 on a downstairs extension then their properties, as a rule of thumb, increase by:

• x £30,000 = £50,000 for Jack

0.833 x £30,000 = £25,000 for Jill

So Jack makes £50,000 - £30,000 = £20,000 profit as a result of the extension

Jill makes £25,000 - £30,000 = £5,000 loss as a result of the extension

Now this is only an approximation.  It all depends on how you extend, the choice of materials and whether you add a bedroom or a dining room.  There are many books written on what adds value more than others and you should read them if you intend to extend.  This multiplier should help you decide whether you should extend or not.  If the multiplier is greater than 2 and you are willing to take on such a project then the decision to extend is a no-brainer i.e. yes you should!

Convert The Loft

Its difficult not to justify such an improvement to a property.  They are cheap to do and add one of the most powerful increases to a property price – an extra bedroom!  To calculate whether you should or you should then use the multiplier above but multiply it by 3.  Let me show you using the same example above:

Jack’s multiplier 1.667  x 3 = 5.00

Jill’s multiplier    .833    x 3 = 2.5

These are both Jack and Jill’s loft multipliers.  So if Jack and Jill both spend £5,000 on a loft conversion then they can expect an uplift in the values of their homes by:

Jack: 5.00 x £5,000 = £25,000

Jill: 2.5 x £5,000 = £12,500

So Jack and Jill can expect to profit from their loft conversion to the tune of £20,000 and £7,500 respectively.

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