Nov222016

How to sell a house for $100,000 profit and still lose money

Most homeowners ignore the carrying costs during their ownership period when they calculate the gain or loss on a sale.

renting_is_betterIf someone claims they bought a house for $900,000 and sold it for $1,000,000, how much money did they make? $100,000? No, not even close.

People tend to forget about the transaction fees and carrying costs when they compute the gains and returns on their real estate purchases. In the example above, when the buyer paid $900,000, the actual costs paid at closing were probably $5,000 to $15,000 higher due to closing costs, appraisals, lender fees, insurance, and other miscellaneous closing costs.

The homeowner lost another large chunk when they sold. Most people still pay a 5% to 6% commission to a real estate agent when they sell their house, so the $1,000,000 sale cost them $50,000 to $60,000. Further, if sellers make repairs prior to listing, which they commonly do, those costs further increase their basis. Between the initial costs, subsequent repairs, and closing costs, it’s easy to see how someone can sell a house for a $100,000 profit and end up making nothing at all.

Carrying costs

Many homeowners in California ignore the excessive carrying costs they paid during their ownership tenure. The monthly costs should not be entirely added to carrying costs because a component of those costs is unavoidable consumption. However, any amount paid on a monthly basis in excess of a comparable rental exceeds the consumptive value, and these costs must be added to the basis to compute the actual profit and loss during the ownership period.rent_not_for_losers

For example, after adjusting for tax savings, amortization, and opportunity costs, many homeowners in California pay monthly ownership costs in excess of a comparable rental. Rather than buying a house, the homeowner could rent a similar house in the neighborhood, and after adjustments, this savings might be $1,000 or more in some communities.

The owner paid $1,000 per month to be on title rather than on lease, and this extra payment is an additional carrying cost of the investment. Over a five-year holding period, this could amount to $40,000 to $60,000 in additional costs depending on how much rent escalated during that period.

Perhaps 2007 wasn’t a good time to buy

Let’s consider the case of a 2007 homebuyer in Irvine who paid $900,000 in 2007. Back near the peak of the housing bubble, this $900,000 purchase price translated to a monthly cost of ownership at least $2,000 per month in excess of a comparable rental even after the tax savings and other adjustments.i_rented_housing_bubble

By 2016, this homeowner has probably refinanced to lower their payments, and rents escalated during that time, but at best, the costs today are at rental parity. Over the 9 years that owner held title, they paid approximately $100,000 in extra carrying costs as compared to a rental.

So let’s say they sell today. Last year, Irvine exceeded the bubble-era peak, so today that owner could probably sell for $1,000,000, a paper profit of $100,000. Since their loan amortized, and since they likely put money down, they will obtain a check at closing. It won’t feel like a loss to them, and they will forget about the excess mortgage interest and other costs they incurred while they owned it. Their closing costs will include a $60,000 commission.

So how does it all add up? They actually paid about $910,000. They paid $100,000 in extra carrying costs. Their actual cost basis is $1,010,000, and their closing net was $930,000 after commissions and closing costs, so on the sale for a $100,000 profit, they actually lost $80,000.

And that was after spending eight years trapped in their home, underwater on their mortgage.

Rental parity is key

rental_parityThe opposite scenario also played out over the last five years. People who bought in 2011 made a fortune. Even in California, most markets in 2011 traded at or below rental parity, with the inflated beach communities a notable exception. Instead of paying an extra $1,000 or more a month to own, those buyers saved hundreds or even thousands of dollars a month compared to a rental, savings that should properly be subtracted from their cost basis.

A buyer of a $700,000 house in 2011 may have saved an extra $100,000 over renting, particularly since rents rose so strongly over the last few years. In addition, that $700,000 is probably worth $1,000,000 or more today, so their math looks a bit different.

They actually paid $710,000, but they saved $100,000 in carrying costs, bringing their basis down to $610,000. They netted $930,000 after commissions and closing, but on the sale for $300,000 in profit, they actually made $320,000.

Timing the housing market properly saves buyers big money.

Don’t underestimate the importance of rental parity analysis when calculating the actual profit and loss on a real estate purchase, especially on a family home.