Let’s look more closely at Mr. Jones, assuming favourable, and then unfavourable market conditions.
The Effects on Mr. Jones of Favourable Market Conditions
Let’s assume that, for the first five years, there are no adverse changes in Mr. Jones’s condominium complex – in other words, no special assessments are levied against his unit – and his maintenance fees, mortgage interest rates, and realty taxes remain steady and unchanged. Let’s also assume favourable market conditions during those years – that property values appreciate according to traditional trends.
After the first five years, by making regular mortgage payments, Mr. Jones’s principal on the mortgage is reduced by $20,250. The principal amount remaining on his mortgage after five years therefore drops to $167,250. His original down payment of $62,500 and the paid-off principal of $20,250 now represent the paid equity that he has in his condominium unit, namely, $82,750.
We could add to that a traditional 2 per cent increase in real estate appreciation per year, which in five years amounts to 10 per cent, or $25,000, so the value of Mr. Jones’s condominium unit after five years increases to $275,000, in which he owns a total apparent equity of $107,750, or close to 39 per cent.
Under these favourable market conditions, the difference in Mr. Jones’s overall financial exposure ($13,920), in comparison with Mr. Smith, has been fully recouped. So is his closing cost of $4,500 to buy the unit.
If he sells his unit after five years, Mr. Jones will make a profit of $25,000, representing the difference between the original price of $250,000 and the unit’s increased value of $275,000, putting him way ahead of Mr. Smith, who, as we will see, is barely able to cover his total five-year accommodation from his investment.
In fact, at the end of the first five-year period, Mr. Jones’s equity might have appreciated even more if he had taken the mortgage at the lower, variable interest rate, or the market value of his unit had appreciated at a higher rate due to exceptionally high demand.
During the following five-year period, projections look even better for Mr. Jones because the original down payment and closing costs are not “repeat expenditures.” His overall financial exposure will be lowered to $97,920, representing the carrying cost of looking after mortgage payments, maintenance fees, and real estate taxes.
If market conditions remain favourable, he’ll accumulate greater equity due to the accelerated progression of the payments on the principal of the mortgage and the traditional market appreciation of his unit.
The Effects on Mr. Jones of Unfavourable Market Conditions
However, in the event of adverse market conditions, the value of Mr. Jones’s condominium unit may depreciate.
Real estate is a volatile industry. Market corrections, such as occasional booms and busts, can be expected, though it is hard to predict when they will occur and how long they will last.
Instead of the traditional market appreciation during the first five years of Mr. Jones’s condominium ownership, the market might experience a slowdown and subsequent correction.
In cases like this, properties lose value, sometimes quite rapidly. The loss of value may be quite severe, as witnessed in many urban areas of the U.S. from 2006 onward, when property value, especially of condominiums, decreased as much as 50 per cent.
If Mr. Jones finds himself in such an adverse situation, he may lose the amount of his down payment. Furthermore, he will not gain from the traditional market equity buildup. In fact, his incurred losses may run into thousands of dollars.
It is fair to state that Mr. Jones’s financial well being in preserving and maintaining the value of his condominium unit depends on quite a few variables: the state of the economy, market trends, mortgage interest rates, his job security, and the quality of the management and governance of his condominium complex together with the timing and duration of his ownership in relation to market trends.
If the market depreciates 15 per cent in the five years after Mr. Jones buys his condominium unit, the unit will be worth $37,500 less, due to depreciation, or $212,500. Therefore his apparent equity cannot possibly be more than $212,500 less the outstanding mortgage principal of 167,250, or $42,250. And this despite the fact that he made a $67,000 down payment and paid off a further $20,250 of the mortgage principal.