Saturday, May 19, 2007

New Property Purchase (3) - Refurbishment

I have had a preliminary meeting with the contractor. Looking at the rough cost estimates for the basic redecoration and the full fit out and the comparable rental yields, the full fit out option should be the better financial option when looking at this project in isolation. The factors for and against the full fit out were as follows:

1. Yield: the yield on total cost will be higher;

2. Cash Flow: I will have a positive cash flow on a 20 year P+I mortgage (which I will not get with the basic fit out);

3. Pay Back Period: the pay back on the additional expense is 3.9 years on the preliminary figures. I have identified a few areas where some costs can be saved without having an adverse impact on the rental income. I hope to get the pay back period down to around 3.6 years with the final numbers. This is an important point, because the fit out will depreciate so it has to pay for itself and provide an acceptable return before it needs to be replaced;

4. IRR: the projected IRR obviously depends on what numbers I input for (i) the basic fit out (ii) the full fit out (iii) the additional rental and (iv) how long I expect the additional fit out to last. The latter is the most important factor. Some items could last 10 years. Others will need reworking/replacing every 3-4 years. If I assume an average of 4 years, my IRR is a low 5.2%. If I assume 5 years, the IRR jumps to 12.9%. The former does not justify the expense. The latter is acceptable to me as it is comfortably above the return I need to earn on my investments in order to retire on schedule (but would not get a property developer excited);

5. Time to next project: this actually favours the basic fit out. The additional money that I will spend on the full fit out (compared to the basic) is money that is not available to contribute to the next purchase;

6. Time to lease: the full fit out will take about 10 weeks. The basic fit out will take 4-5 weeks. This effectively costs me about a month in income.

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