We recently did a very quick buy to sell deal, using an unusual strategy: Buying through an estate agent and selling back through an auction. This isn’t an obvious strategy that naturally occurs to most property traders.
The property was a 2-bed flat, in a tired state of repair and a short (49 year) lease. It was on the open market with an estate agent in Cherryleas Drive, Leicester. It was brought to our attention by a local estate agent partner, who consistently sources promising deals for us. With a strong local sales market, this property was perfect for a buy to sell, our preferred strategy at the moment. Figure 1 shows the property. After some strong negotiation, we were able to secure it for £62,500.00.
When buying a property with the intention of selling on, you should always consider multiple exit strategies in order to protect yourself. The ultimate fallback position is to rent the property out.
But given a number of exit strategies, how do you assess the best route to take?
Do you look for maximum absolute profit?
Do you look for maximum return on investment?
What about risks?
The answer isn’t immediately obvious…
However, there are analytical techniques that help you determine the best relative route to take, which takes into account returns and risk.
Most property investors are comfortable with the definition of a return. In essence, this is the profit (or loss) on an investment, usually expressed as a percentage over a given period that the capital was invested.
The average investor concentrates overwhelmingly on the return, whilst neglecting the risks. A risk can be defined as the chance (or probability) of a given investments return being different than expected.
A fundamental concept in investing is the relationship between risk and return. Generally speaking, the higher the return then the greater the risk, since investors demand to be compensated for taking on the higher risk that the investment won’t actually deliver the higher return.
How can you evaluate the various risk / return rewards for a given property investment strategy?
One of the best decision making tools is the Expected Value concept…
This is a fundamental concept in probability. The Expected Value is the anticipated value for a given investment. It is calculated by multiplying each of the possible outcomes by the probability that each outcome will occur and then summing all those values.
This is best illustrated by an example. Let us consider standard roulette with 38 numbered slots. A straight bet on any single number will payout 35 to 1. So if you had £1, would you take that bet? You are making a judgment on whether your investment of £1 will return £35.
The answer should be no. This is because the Expected Value of that bet is:
EV(£1) = -£1 x (37/38) + £35 x (1/38) = -£0.05
This means that an investment of £1 will expect to lose 5p on average. This is not an investment you would want to make and is exactly why the casino wins in the long run.
Have you ever met a poor casino owner?
If we can make an educated reasoning, using our knowledge of the macro-economic picture for the property markets in which we operate, of the probability of various investment outcomes, then we are in a position to compute the Expected Value of a given property investment that has a range of outcomes.
But property trading usually involves expenses. You can choose to do a basic refurbishment, a full refurbishment, or none at all. In our case, the flat not only needed a refurbishment but also had a short lease. Is it worth extending the lease, or leaving it as is? Further, there are often finance or holding costs to consider, which are larger the longer you retain the property on your books, as would be the case in a full refurbishment or lease extension.
How do we pull all this information together when working out the Expected Value?
We simply leverage another analytical tool called the Decision Tree…
A Decision Tree is a tool that allows you to analyse and choose between several courses of action and form a balanced view of the relative risks and rewards between them.
It is in this way that we decided the best expected outcome for the sale of the purchased Cherryleas flat was in fact through auction.
Let’s consider the options we had:
- Perform a very light refurbishment, leave the lease as-is and sell on through an auction.
- Perform a full refurbishment, extend the lease and sell on through an estate agent.
- Perform a full refurbishment, extend the lease and remortgage to a sensible LTV and retain to let.
From a point of view of return on investment, we utilised a Decision Tree and Expected Values.
Let us consider one branch of this tree: Option A.
By considering market values and talking to local auctioneers on the strength of the auction rooms at the moment, we determined that a reasonable reserve value would be £74,000. We reasoned that we were 60% confident that the reserve would be achieved. In addition, we were 20% confident that we might achieve more than the reserve, with a likely top value of £78,000. We also had to consider the chance of the property not reaching the reserve, which we assigned a 20% chance of that happening.
So in summary:
- 20% probability of achieving up to £78,000.
- 60% probability of achieving the reserve of £74,000.
- 20% probability of not making the reserve and failing to sell on the day.
Note the probabilities should sum to 100%.
What is the Expected Value of the auction sale?
This is calculated as:
EV(Auction Sale) = (0.2 x £78,000) + (0.6 x £74,000) + (0.2 x £0) = £60,000
Therefore, on average, we expect to return £60,000 on this property from an auction sale. Notice this isn’t an achievable value – if we don’t hit the reserve of £74,000 we won’t achieve any sale. It is an Expected Value of the investment, given the stated risks (probabilities) and returns (sales values).
Now we have expenses to consider. A very light refurbishment would be in order, consisting of redecorating and new carpets to freshen it up, but no work to the kitchen or bathroom. There are also auction fees, capital holding costs and so on. In total we would expect to spend £5,000.
Figure 2 shows an example room in the flat before refurb, Figure 3 shows the same room after redecoration and new carpets.
Taking expenses into account, this means we can say that the benefit of selling at auction would realise £60,000 – £5,000, or £55,000.
Again, this is not an absolute realisable figure. It is the relative benefit of option A and can be compared with the other relative benefits of option B and C to determine the best option to take.
If we continue this analysis for all options, we get the following decision tree, shown in Figure 4.
Note that the larger refurbishments needed in option B and C incur larger costs, reducing the expected net benefit of taking that option.
It is clear from this analysis that option A of selling through auction gives the largest relative expected benefit, so this is the option we chose.
And what of the outcome?
Well, the property went to auction and achieved a sales price of £77,500, right near the top of our market assessment, validating our decision.
You can see the result here
How we made such a good return
This property was part funded by a private investor, who wanted a good return on his money. This enabled us to buy with speed, a prerequisite in the current strong sellers market.
The headline figures are:
Revenues | |
Sale | £77,500.00 |
Cost | £62,500.00 |
Gross Profit | £15,000.00 |
Expenses | |
Search fees | £200.00 |
Insurance | £134.50 |
Refurbishment | £689.68 |
Legal Fees | £1,570.20 |
Auction Fees | £1,500.00 |
Investor Return | £1,200.00 |
Net Profit | £9,705.62 |
Because we have leveraged private investment capital, the returns on our own employed funds over the period of investment will be a very healthy 68.45%
How smart thinking helps avoid a catastrophic loss
Note that tools such as Decision Trees and Expected Returns need accurate market knowledge to provide sensible input values. We need strong local knowledge of market values, refurbishment costs and local demand in order to make informed decisions about expected end sale values. The Expected Value and Net Benefit is sensitive to the input values and assigned probabilities and so sufficient thought must be given to make these as accurate as possible.
The more astute of you will notice that if an auction sale returns a net benefit of £55,000, then with a purchase price of £62,500 we will, on average, lose £7,500, not unlike the casino roulette example mentioned above.
This would be correct if the £62,500 spent on the property was a true sunk cost. The beauty of property as an investment is that it retains an intrinsic value. Note that in this example, all options actually remain available. Should this flat not have met the reserve at auction, then we still own it and options B and C were still viable. We would have gone with the next best expected net benefit, option B. If we couldn’t achieve an expected asking price of £90,000, then option C was available to us.
Remember Expected Values are not necessarily realisable returns. In Option A, we would either return £74,000 or more (the property met or exceeded the reserve value), or we would have lost £5,000 (our sunk costs should the property not have met the reserve).
If, instead of property, the £62,500 was (e.g.) earmarked for investment into the development and marketing costs of a mobile phone app, with an expected net benefit of £60,000, then that is not an investment you would want to make. This is because the £62,500 invested is a sunk cost, lost forever should the mobile app not make the returns you expect.
This is a good example of limiting the downside and avoiding catastrophic financial disasters which wipe you out.
What decision making tools do you use when evaluating such deals? We would love to hear your thoughts in the comments below.
If you want to be considered for membership of the Tycoon Investment Club so that you can join like-minded private investors and earn enhanced returns on your money whilst also learning about how we structure deals like the Cherryleas flat, then send an email to support@tycoonsystem.com and we will be in touch.
Kudos to Mark : this is one of the most pragmatic and lucid application of decision theory that I’ve come across! Many thanks Parmdeep for posting it.
Many thanks Andy, I hope you found it useful.
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