Recently a friend asked me to explain why a buyer should never pay more than appraised value on leveraged property. Since she had taken a few classes I began by explaining the opportunity costs associated with this strategy and I could see her eyes “glass-over” and I knew I had lost her. When I shifted gears and started showing her the economic costs in dollars and cents, she began to understand. Here are my examples.
Let’s say you offer to purchase a home at $250,000 and you plan to invest $50,000 and ask a lender for the additional $200,000 (80%). Now let’s assume you hold the house until you can sell it for $400,000. What is your return? The total gain on your $50,000 is $350,000 which is a 700% total gain.
Now let’s compare that to a situation where the appraised value of the property is $12,500 less than the offer price. The lender in this case will not lend on the difference and therefore the buyer must make up the difference. If the buyer puts the additional funds into the investment, they will not increase their return on the investment and in fact their return will decrease. Why? Simple, the opportunity cost. Every economics and finance student understands that if the $12,500 were invested in an alternative investment that produced the same return, the $12,500 would grow to $87,500.
Let me put it another way, if the buyer put in $62,500 as a deposit and the investment grew to $400,000 the total gain would be 540%. Compare this to the 700% gain and it becomes clear that buyers should never pay more than appraised value on leveraged property.
Let me provide you with one more illustration using the $50,000 deposit and the $12,500 which is the value of the difference between the offered and appraised values in Example 1 .
The buyer invests the $62,500. They borrow 80% from the bank and invest in an investment valued at $312,500. The buyer sells the investment years later for $500,000. The buyer invested $62,500 which produced $437,500 in gain. Now compare this to Example 1 in which the gain is $62,500 grew to $400,000 and the total gain is $337,500.
Why Should You Never Pay More Than Appraised Value on Leveraged Property?
Investors who use leverage to produce hefty returns lose out on potential gains when they fail to consider the opportunity costs associated with the additional funds required to cover the shortfall between the appraised and offered prices.