Unlike a traditional home buyer who compares the price of a property to that of similar ones in the area (CMA or comparative market analysis), rental properties should be valued based on the NOI or net operating income they deliver month after month. It is akin to 'yield on a bond'.

Problem is that cap rates vary over time because of numerous factors. Suppose interest rates are close to zero; would you like to buy a building with a cap rate of 4%? You would probably answer that question with an enthusiastic: “Yes, you bet!”

Now suppose interest rates are 5%? Would you still be so
enthusiastic about that investment with a 4% cap rate? Do I notice hesitation? My answer would be “Heck yes! That is likely even
better!”

Wouldn’t I want the higher income from an interest
bearing investment? Well, if interest rates are
5%, the economy is probably doing a lot better than when it is 0% and under normal economic conditions real estate typically
appreciates 6% per year. Were interest rates at 0% chances are the economy is
poor and I will get little appreciation or worse... So, do I want to make 4% when interest rates are zero
and do I want to make 10% (4% NOI plus 6% appreciation) when interest rates are 5%? Yes to both. But… those
estimations are based on speculation aren’t they? The valuation of an investment is
circumstance driven; sometimes there may be some logic behind it while at other
times it is plain emotions that set the price and thus the cap rate.Now, speculating that under normal economic conditions I will get the 6% annual appreciation may be a low risk bet (based on similar past performance); but it still is a bet.

What if I could make even more money under those circumstances than
just 10%? Real estate prices are typically considered less volatile than
those of a stock market – I disagree with that assumption but let’s assume for
now that that is true. If 6% appreciation were the norm, the value of a $100,000
property would increase by $6,000 per year while it cash flowed at a cap rate
of 4% another $4000.

If interest rates are 1% and I took out a loan of $80,000
i.e. a loan to value ratio of 80%, I would pay $800 interest that year which
results in a net cash flow of $4000 minus $800 equals $3200. My investment is
$100,000 minus $80,000 or $20,000. So my return on cash invested is:
3200/20000= 16%. Without leverage, the
investor puts down the full $100,000 and makes only 4%. Next add the appreciation!
At a 5% interest rate and an LTV of 80% the investor pays $4000 interest per year and
his net cash flow is $4000 NOI minus $4000 interest = Null. BUT, the property likely
appreciated by $6000 and that translates in a return of 6000/20000 = 30%!

But markets are unpredictable, and instead of going up when
interest rates are 5%, the property value could have declined by 2% and at
year’s end, the investor did not make net cash flow but also lost $2000 in
value or 2000/20000 whch equals a loss of 10%! Ouch Leverage clearly increases risk; it
amplifies the upside but also amplifies the downside. The speculative
proportion of the investment has clearly increased dramatically. Not only does
the risk and speculative element go up with leverage. But you may also end up
with a money pit! When an investor borrows money for real estate it is usually done through a mortgage. The lender not only demands an interest payment, but he also demands repayment of part of the principal until the balance of the loan is zero at the end of the time of ‘amortization’ which typically ranges from 25 to 35 years. If your cash flow is positive after paying for interest, with the added demand of principal repayment the net cash flow may be zero or may even be negative. In other words, the investor has to make up for the negative cash flow out of pocket. The investor does now no longer control how the cash flow is to be used. Ooops!

When determining how much leverage you want, you should
first ask yourself how much cash flow you need.
Also you should ask yourself, if the market falls by 20% or more, will
the bank upon renewal of the mortgage want you to add money to your down
payment which at that time is zero or less in case of a LTV of 80%. Can you
handle that financially or would it be safer to go with an LTV of 70% or even
more conservatively an LTV of 60%. That way you may not get a cash call in a
falling market and still receive cash flow. You have then the financial
strength to wait out the down turn rather than being forced to sell the property at
or near the bottom of a market.

Although stocks in the stock market respond different price
wise than real estate and thus diversifies your portfolio, in many ways, similar
considerations are valid. We’ll discuss that in the next post.
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