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Buying or Selling a Home
The Costs and Benefits of Purchasing a Second Home
By Robert Klosterman
President, White Oaks Wealth Advisors, Inc
A vacation home can provide a welcome escape for you and your family, but it’s wise to examine the financial viability of the investment before you buy
Many people reach a point in life where they
consider purchasing a second home. They
might be preparing to retire in another part of
the country, hoping that the property they
purchase today will become a good
investment in the years to come. Other
people buy a second home to enjoy right
now as a place to escape the weather, to
gather with friends and family, or to relax and
pursue leisure activities. And then there are
people who consider vacation properties to
be prime investments.
We purchase goods and acquire assets to
help further a lifestyle for ourselves and the
people who are close to us. This is what
motivates us to build and maintain an
investment portfolio over a period of time.
So the fact that there is a cost to a vacation
property should not dissuade anyone from
making such an investment if their main
objective is to enhance the time they spend
with friends and family. On the other hand, if
you are considering the purchase as a
financial investment, a number of factors
need to be identified and evaluated to
assess the potential effect on your overall
portfolio.
The purpose of this article is not to convince
you whether or not to buy a secondary
residence or vacation property, but to help
you clarify your own reasons for doing so
and to assess the potential financial viability
of the investment.
Examine all of the variables affecting cost
As it has been said many times before, there
are three considerations in real estate:
location, location, and location. Because of
this, the assumptions made about the value
of real estate can vary dramatically from
place to place, and from time to time. At
White Oaks Wealth Advisors, we have
identified a few basic issues and probabilities
that will affect the financial results achieved
by investing in real estate.
With that in mind, don’t rely on this article
alone as you consider purchasing property
for investment. It is important to look at a
wide range of factors, along with your own
personal objectives, as you evaluate such a
decision.
Some of the issues that should be
considered include the following:
Property values
It’s often the case that
people visit a particular area during a
vacation and decide to look at properties for
sale while they are there. Yes, I’ve done this
myself, and will probably continue to do so.
It’s very easy to get swept up into the
emotional aspects of a vacation property
when you’re enjoying time away in a new
place. The properties can seem very
attractive in that kind of environment. Be
sure to look at several different properties
and do your own investigation of relative
property values in the area, and how a
specific property stacks up relative to others.
Hidden costs
It’s also easy to oversimplify
the process of evaluating a property
investment by only focusing on how much
you paid at the initial purchase and how
much you expect to receive when you sell it.
You must take into account all of the costs
related to the transaction. These include the
net interest costs after taxes of carrying the
property for the period that you owned it.
You will have closing costs at the purchase
and sale of the property.
Also factor in any potential improvements
made to the property. In addition, people
usually spend a fair amount of money
redecorating a vacation property to fit their
tastes. The furniture purchased for the
vacation home will have very little value
upon sale, and so, consequently, it should
be considered in the overall cost of the
property. And, finally, real estate taxes are
anywhere and everywhere, and should be
considered on a net, after tax cost basis as
you consider the valuation of a property.
Maintenance costs
Of course you will pay
utilities to keep the property supplied with
water, electricity, heating and cooling. Also
many vacation properties are part of a
homeowners association, and the
association fee should also be considered as
a cost of maintaining this property.
Table I
| Purchase Price |
$ 250,000 |
$ 250,000 |
$ 250,000 |
$ 250,000 |
| Annual Appreciation |
4% |
6% |
8% |
10% |
| Sales Costs |
10% |
10% |
10% |
10% |
| Closing Costs |
$5,000 |
$5,000 |
$5,000 |
$5,000 |
| Holding Period |
5 |
5 |
5 |
5 |
| Taxes |
$ 2,000 |
$ 2,000 |
$ 2,000 |
$ 2,000 |
| Maintenance |
$ 4,400 |
$ 4,400 |
$ 4,400 |
$ 4,400 |
| Mortgage Net |
$ 1,199 |
$ 1,199 |
$ 1,199 |
$ 1,199 |
| Mortgage Rate |
6% |
6% |
6% |
6% |
| Down Payment |
$ 50,000 |
$ 50,000 |
$ 50,000 |
$ 50,000 |
| Inflation |
3% |
| Gross Sales |
$ 305,249 |
$ 337,212 |
$ 372,461 |
$ 411,327 |
| Net Sales Proceeds |
$ 274,724 |
$ 303,491 |
$ 335,215 |
$ 370,194 |
| Interest Costs |
$ (58,322) |
$ (58,322) |
$ (58,322) |
$ (58,322) |
| Closing Costs |
$ (5,000) |
$ (5,000) |
$ (5,000) |
$ (5,000) |
| Improvements/Furnishings |
$ (21,665) |
$ (21,665) |
$ (21,665) |
$ (21,665) |
| Utilities |
$ (12,742) |
$ (12,742) |
$ (12,742) |
$ (12,742) |
| Taxes |
$ (10,618) |
$ (10,618) |
$ (10,618) |
$ (10,618) |
| Net Proceeds |
$ 166,377 |
$ 411,838 |
$ 443,562 |
$ 478,541 |
| Tax Savings |
$ 27,576 |
$ 27,576 |
$ 27,576 |
$ 27,576 |
| Net After Tax Proceeds |
$ 193,953 |
$ 439,414 |
$ 471,138 |
$ 506,117 |
| Mortgage Payoff |
$ (186,376) |
$ (186,376) |
$ (186,376) |
$ (186,376) |
| Net Cash Out/Benefit |
$380,329 |
$625,790 |
$657,514 |
$692,493 |
| Return on 50K |
0% |
0% |
6.19% |
14.55% |
Estimate your break-even point based on rates of appreciation
In Table I, we have identified four
possible scenarios that could occur in
the valuation of a vacation property.
These scenarios assume that we will
not rent out the property. About half of
the clients who consult with us about
purchasing a second home do not
consider renting their property out to
someone else. They worry that the
property will not be kept up well, or
they don’t want other people living in
property they are ultimately purchasing
for their own use.
Columns one through four show the
differences in annual appreciation that
might be experienced from the real
estate investment. General home
appreciation in Minnesota for the last
year was about 10.2 percent, and
averaged about 10.6 percent over the
last three years. This is an abnormally
high rate. The 10-year average is
about 6.3 percent, and the five-year
average is about 8.4 percent. This
compares favorably with the national
rate of appreciation—4.3 percent over
10 years. As with all investment
assets, real estate is cyclical in nature.
Recently, we have had some greater
price appreciation and it is uncertain
how long that will continue.
As an example, in Daytona Beach,
Florida—another popular vacation
spot—the average appreciation over
the last year was 10.2 percent,
however for the last 10 years it has
averaged 3.2 percent. Last year the
Phoenix-Mesa area appreciated at 7.1
percent, and in the last 10 years has
averaged 5.4 percent. Myrtle Beach,
South Carolina, has similar numbers
with 7.3 percent for the last year and
4.5 percent appreciation over the last
10 years. With Baby Boomers buying
vacation properties at a higher level
than previous generations, these
numbers are surprising low, relative to
what we might have believed
anecdotally about real estate prices.
That being said, you can place your
own assumptions because we’ve
looked at an annual appreciation at 4
percent, close to the national average,
6 percent, 8 percent, and 10 percent.
Table II
| Rental |
4% |
6% |
8% |
10% |
| Gross Sales |
$305,249 |
$337,212 |
$372,461 |
$411,327 |
| Net Sales Proceeds |
$274,724 |
$303,491 |
$335,215 |
$370,194 |
| Interest Costs |
$58,322 |
$58,322 |
$58,322 |
$58,322 |
| Closing Costs |
$5,000 |
$5,000 |
$5,000 |
$5,000 |
| Improvements/Furnishings |
$21,665 |
$21,665 |
$21,665 |
$21,665 |
| Utilities |
$12,742 |
$12,742 |
$12,742 |
$12,742 |
| Taxes |
$10,618 |
$10,618 |
$10,618 |
$10,618 |
| Net Proceeds |
$166,377 |
$195,144 |
$226,868 |
$261,847 |
| Tax Savings |
$27,576 |
$27,576 |
$27,576 |
$27,576 |
| Net After Tax Proceeds |
$193,953 |
$222,720 |
$254,444 |
$289,423 |
| Mortgage Payoff |
$186,376 |
$186,376 |
$186,376 |
$186,376 |
| Net Cash Out |
$7,577 |
$36,344 |
$68,068 |
$103,047 |
| Rent Received |
$43,330 |
$43,330 |
$43,330 |
$43,330 |
| Total Benefit |
$50,907 |
$79,674 |
$111,398 |
$146,377 |
| Return on 50K |
1.81% |
9.40% |
16.13% |
21.68% |
These scenarios further assume the
purchase of a $250,000 property. This
can vary by location and by personal
preference, but provides a good
number for a starting place. As you
can see, five years later, the gross
sales price has appreciated
considerably. Even at 4 percent, our
$250,000 house will appreciate to
$305,249. Now if we had actually
gotten 10 percent appreciation, there
would be over $100,000 more,
appreciating to a value of $411,327.
Many people would further assume
that with a $50,000 down payment, 4
percent appreciation allowed them to
double their money in a period of five
years. However, there were a number
of related costs during this period.
First, there would be the costs of
selling the property. The property can
be sold on its own, but generally a sale
would require appraisal fees and the
cost of a realtor. We’ve assumed
these to be roughly 10 percent. Also,
there is the cost of carrying the interest
6 percent interest rate. It’s likely that
money was spent on property
improvements, furnishings and utilities.
We’ve estimated $21,665 in
furnishings and improvements, and
$12,742 in utilities. With $10,618 in
property taxes, we end up with a net
number of $166,377.
Of course, we could save some taxes
over that period of time. We calculated
that with the maximum tax bracket at 35
percent, plus state taxes, we would
have saved an estimated $27,576 over
that period of time. This gives us a total
proceeds of $193,953. Our net
mortgage pay-off is $186,376, giving us
a total cash out of $7,576. At this level
our $50,000 is not there. We have lost
around $43,000 on the property.
On the other hand, we can look at this
as the investment paid for the use of
this property and the fun that we’ve
had staying there. We wouldn’t have
paid rent on other properties during
this time, and so that should be
calculated into this equation as well.
However from a pure investment
standpoint, absent any rentals, the
return on the $50,000 is negative.
Moving over to the next column at 6
percent appreciation, we have a
similar experience, except that we
have a higher gross sales price, but
we still don’t have our $50,000 back.
At 8 percent appreciation, finally,
we’ve actually gotten a return on our
investment of about 6.19 percent over
that five-year period of time. That’s
not an unattractive rate of return.
If we had rented a property instead of
purchasing, we could assume a onemonth
stay at a value of $3,000 per
month—again that number can vary
widely—and over the five-year period
of time, we would have invested
$15,000. In other words, in order to
come out ahead in purchasing the
property, we would have required a
minimum of 8 percent appreciation to
make things come out well for us on a
financial basis.
At 10 percent, we assume that the
appreciation rates that we’ve had for
the last few years are going to
continue for the next five years. While
that is possible, we wouldn’t put a lot
of faith in this scenario for the long
term. However, if it were possible, our
actual net rate of return would be
14.55 percent, a very attractive
investment over a period of time.
Consider the financial benefits of renting out a vacation property
Of course the possibility exists that we
could purchase the property and rent it
out to others. This dynamic can
change the financial outcome
considerably, as you can see in
Table II.
Let’s assume we purchase the same
property, but we rent it out for $2,800
per month for three months. While a
more sophisticated method of
calculation for rental properties could be
used, we feel this approach tells the
story adequately. I’ve used this
assumption primarily because most
properties of a vacation type are used
on seasonal basis, and the busy season
typically averages three months.
This would also allow us personal use
of the property for two or three weeks
each year. The total rent received in
this scenario would be $43,330,
increasing our total benefit
considerably. It would not, however,
give us enough overall benefit to justify
only a 4 percent appreciation. Over
that period of five years, we would
have merely gotten our money back
over that period of time.
At 6 percent of appreciation, however,
we actually do come out with a positive
rate of return of 9.4 percent. Eight
percent appreciation would result in a
16 percent rate of return. And, finally,
at 10 percent appreciation, we ring the
bell with a rate of return of 21.68
percent.
Clearly, renting gives the investor the
edge in having a real estate
investment pay off for them. It is not
without risk however. Projecting that
you’ll receive rent for three months
each year is different than actually
receiving it. Rental seasons can vary,
and we can have situations such as
the period after the September 11
attacks when people don’t want to
travel and vacancies may be higher
than normal. On the other hand, we
might be able to rent the property out
for a longer period of time. It is
possible to rent properties in the offseason
to permanent residents and
generate income that way as well.
Real estate tends to be a hands-on
investment. Unexpected expenses for
maintenance and repairs are often
necessary, and these possibilities
have not been factored into our costs.
In summary, the purchase of a
vacation property is often a very
personal decision. We have attempted
to identify some of the costs and some
of the issues that you may face in
making this decision. But regardless
of cost, this can be a good investment
in personal lifestyle and enhance the
quality of the time you spend with
friends and family. And, clearly, that is
what we expect the accumulation of
financial resources to do for us.
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