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BUSINESS GUARDIAN guardian.co.tt JUNE 29 • 2017
Determine the true
value of real estate
David, 38, and his family live
in a three-bedroom house
on 7,000 square feet of land.
A few years ago David con-
verted his garage into a small
flower shop that his wife
Candy operates a stone's throw from a pri-
vate medical clinic, church and funeral home.
Candy uses the profits to cover the food bill
of $2,000 and half of the monthly mortgage
payment of $5,200.
Some time ago, a young intern working at
the clinic approached David to rent a room in
his house but Candy was not comfortable with
sharing their space. David decided to convert
a shed at the edge of the property into a small,
He has since extended the shed to create a
second apartment which generates a total of
$4,500 per month. The community has seen
steady growth in recent times and the demand
for rooms now outstrip supply.
Eager to exploit this opportunity but having
used up all of their savings ($150,000) for first
two apartments, David approached the bank
to refinance his mortgage from $600,000 to
$900,000 to modify the main house and create
more space for rent that would generate an
additional $8,000 per month.
Whilst the bank was willing to lend him
based on his salary, the business' profits
and the rents (existing and potential), they
declined the facility because they found out
the structures violated the Town and Country
The bank advised they would entertain the
facility if the illegal structure was demolished
and any further improvements would have to
be done according to the building code.
David felt that in spite of their long-standing
relationship, the bank dealt quite harshly with
him in requiring demolition. Out of frustration,
he decided to put his property up for sale and
start all over again.
After listing his home, the agent advised
David that even though the property was of-
ficially valued at $1.3 million, no one would be
willing to pay more than $995,000 because of
the violations. The couple decided to delist
the house and focus on saving to purchase a
second property in which to live, while allowing
them to rent out their first house for around
$5,000 per month.
The real value
We have been given two values from the
agent: what prospective buyers are willing to
pay: $995,000 and what the official valuation
stated: $1.3 million; a difference of $305,000.
We have no idea what David paid for his prop-
erty except that he spent $150,000 to build the
As with all our discussions, we need to make
some reasonable assumptions in order to offer
In this case, we will assume real estate gener-
ates a cash flow return on investment of five per
cent per annum, which would help us calculate
the capital value of the property based on the
existing and potential cash flows in the form
of rents and business profits.
Knowing this, we could gauge the true op-
portunity cost if he decided to sell in favour of
a fresh property. We also assume the incomes
quoted above are after all property and busi-
ness-related expenses have been deducted.
If they sold off and moved, Candy would
need to find a location that is also ideal for the
flower business. Failing to do so would mean a
loss in income of $4,600 per month earmarked
for groceries and part of the mortgage.
Adding up all the existing and potential in-
come streams (business profits, rent from the
apartments and the rental value from the main
house) they will be giving up $169,200 per year.
When we capitalise this cash flow using a
5 per cent rate of return the true value of the
property should be $3,384,000 ($169,200 /
If someone bought the property---inclusive
of the business---for $995,000, they would be
earning a cash flow return on investment of 17
per cent per annum ($169,200 / $995,000).
If we excluded the business profits then the
value would then be $2,280,000, which is still
significantly more than $995,000; the cash
flow return on investment would then be 11.5
per cent (both estimates excludes the capital
appreciation on property values).
The second property
It might be a good idea for David to keep the
existing property. Of course, his plan to in-
crease his rental income by purchasing a second
property is an option albeit an expensive one.
Unfortunately, we were not given informa-
tion regarding his current employment income
and family expenses so it is difficult to gauge
how much he can save and how much he can
qualify to borrow.
Based on what obtains in the real estate
market today---and considering the current
valuation of David's existing house---it is rea-
sonable to be prepared for a price tag of over
$1,000,000 for the new property, which is
significantly more than the $300,000 that
the bank was willing to lend him.
Apart from having to save up to 17 per cent
for downpayment and closing costs ($170,000
assuming property price of $1 million) David
must qualify for a $900,000 (90%) mortgage.
Using a term of 22 years (age 38 to age 60)
and an interest rate of, say, six per cent per
annum, the payments would be $6,148. When
we add this figure to the current mortgage of
$5,200, David would need a total qualifying
income of $28,370 per month.
If he does not have this income then he
would be forced to borrow less, which means
he must have more money saved up. Depending
on his ability to save, this would determine
how much time it would take to accumulate
If it takes too long then the variables may
change to his disadvantage: interest rates would
go up, property prices may increase and as he
gets older the loan term would shorten.
The practical option
Which is easier: look for something new or
work with what you have?
If David looks for a new place it would cost
more because a second property requires land
and building whereas the current property only
requires modification to an existing building.
He can choose to do this out of pocket with
savings over time or in combination with
He can keep the illegal apartments and in-
crease his rental income. The downside to this
is the cost of funds borrowed might be higher
depending on the type of loan and if the project
takes several years the cost of materials and
labour will inevitably increase.
If he wanted to do things legitimately Da-
vid could demolish the apartments and se-
cure adequate financing to expand the main
house, thereby increasing his rental income
from $4,500 to $8,000.
The opportunity cost would be the loss of
his investment of $150,000 and of rents whist
construction is underway. However, what he
stands to gain is an almost doubling of rental
income, increase in the property value and
improvement in its saleability because of
Choosing this option would also mean ser-
vicing a new loan but the new $8,000 rent
should be able to cover it and even recover
the $300,000 in less than four years.
If he chooses to defer this latter option until
he recoups his original investment it would
take him about three years ($150,000 / $4,500
rent = 33 months), but this time could have
consequences as mentioned above and he
will obviously be postponing the extra rent
of $3,500 ($8,000 - $4,500).
Nicholas Dean (CertFa) is a certified
independent financial adviser and is the
managing director of The Financial Coaching
Centre Ltd. If you have any questions or
need advice on today's subject please email:
email@example.com or visit website: www.
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