Saturday, June 16, 2012

A Viable Investment – Part II

(click on the image to magnify)

The APOD’s screenshot above shows operating expenses total $5,647.98.  This includes, condofees which in turn include part of the utilities. The remainder of the utilities (e.g. phone or internet) I let the tenants pay. Then there is landlord insurance, maintenance, i.e. small repairs, and of course my time (management fees).

Subtracting these Operating Expenses from the Effective Rent gives us the Net Operating Income (NOI). One way to valuate rental real estate is to compare your Cap rate (NOI/Property Value) with that for similar properties in your investment area. In NW Calgary the Cap Rate is typically 3 to 3.5%.  Thus based on the example’s NOI of $12,571.20 minus $5.647.98 equals $6.923.22 and the property would be worth NOI/cap rate = $9323.22/0.035 = $197,806.17

We bought it for $200,000 so that sounds O.K. In other areas, however, the cap rate may be higher; say 5% and then the property would be worth only $138,464.  The reasons that the cap rate varies so widely can be numerous and it is up to the investor to decide what is important to him/her. In Calgary, annual appreciation is typically higher than elsewhere in the country so that may explain why an investor is prepared to miss out on some cash flow - he’ll make up in capital gains. At other times the cap rate is entirely based on market emotions and again it is up to investor to decide whether to buy, sell or walk.

But what is essential is whether the investor can hold on to a property until he/she chooses to sell rather than that it is a forced sale. When you’re forced to sell, especially at a market bottom then you are no longer in control and your investment is no longer viable. Hence you need an investment that not only has a positive net operating income but also is one that after financing costs throws of meaning full amounts of cash.

When an investor owns the property clear title, i.e. there is no mortgage then the entire net operating income goes to the investor. His return equals the cap rate which is NOI/Property Price (akin to the P/E ratio for stocks or better Earnings yield which is the inverse: Earnings/Investment price x 100%). In our example the capitalization rate equals $6,923.22/$200,000 = 3.5%. If a property appreciates by 5% annually, the investor’s total return is 8.5% per year - but in this post we focus on the cash flow returns.

Now, many real estate investors use leverage, i.e. a mortgage. If the cap rate exceeds the interest rate, the investor earns 3.5% on $200,000 but if $100,000 of that is borrowed using a mortgage at an interest rate of 3%, then the investor’s capital lay-out is only $100,000 and he makes 3.5% plus 3.5% minus the interest rate charged for the mortgage (3%) on the remaining $100,000. Instead of yielding $6,923.22 on $200,000 or 3.5%, the investment yields $6,923 minus $3,000 (interest on $100,000) = $3,923.22 on an investment of $100,000 or 3.92%!  Aahhh the power of leverage!

However, not only does the investor pay interest, he also has to pay back a bit of the mortgage principal every month. Typically in the first year of a 25 year mortgage the investor pays back about $2,734 of the initial $100,000 principal. Thus the total monthly mortgage payment is $473 which has to be paid out of the monthly cash flow of $6,923.22/12 = $576.93. Thus every month the investor puts $103.69 in his pocket. Not too bad plus he pays off 223.17 per month in principal. 

But what if the rental market tanks and he has to pay for rental incentives or collects only $700 per month in rent rather than $1050? Oops, his cash flow has gone negative, i.e. he has to PAY out of his own pocket $212.05 – part of which goes to paying down the mortgage, but still it is cash out of pocket. If there is no other income, the investor will be forced to sell the property! Subsidizing a property for $212.05 per month is often no big deal, but what if you had 10 such properties? You would need to come up with $2,120 each month! Ouch, you may need a job on the side to do so.

But if rents fall, guess what, the property value falls and new investors want a better cap rate; say the cap rate rises during high vacancy times from 3.5% to 5%?  Oh then the property, as you recall would be worth $186,464.32. Eh…. Noooo! That would be so if your NOI didn’t fall but with rents falling to $700 now the NOI has fallen to $5,534 and when valued at a cap rate of 5% the property would be worth to an investor only: $62,687 Oops!  There was that $100,000 mortgage and it did barely decline over the year but… your initial $100,000 equity has dropped now to barely $-37,312 that is NEGATIVE $37K!  Yep you lost $137,000!
Now if you had the opportunity to wait out this bad stretch in the market then you probably would recover most if not more than the initial $100,000 down payment but your 1 year mortgage term is over and the bank does not feel that you have enough equity in the place. They don’t want to renew and want their $100,000 back by the end of the month! Ouch, Oh…. Booh, booh!

Now, 50plus percentage drops in real estate value happen rarely, except in the U.S. J  Would it be likely for the rent to drop within the first year of your purchase from $1050 to $700? Not likely. But you better know whether you want to have that kind of leverage. Can you survive such a financial flue or would you be forced into an untimely sale. Do you have the financial strength to sit out such a blood bath?  In 1982, after the NEP and recession, Alberta real estate values in some condo complexes did indeed drop up to 50%! Many home owners were in trouble and handed the keys of their homes back to the bank. 

You have a viable investment, if your cash flow remains positive under those circumstances. Of course you can be more aggressive as an investor but the risk that you fail and end up with a forced sale or foreclosure will increase exponentially with your leverage.

The beauty of real estate is that you are the CEO of your own real estate company, you can determine at what level of leverage you feel safe; in other words, at what level your investment is still viable. When investing in stocks, you give that power away as happened to investors in Yellow Pages; in fact there even management lost control in the end and lenders determined where the cash flow went; Yellow Pages may never recover. In spite of its initial solid character and great dividends Yellow Pages was not a viable investment. Using leverage in real estate can also cause you to lose control; just ask a certain Peter Pocklington or the Reichmann family!

There is another profit center than cash flow that is greatly enhanced by leverage and that is the appreciation of your property. Something that is even more speculative. Thus, in real estate there is truly a risk-reward equation which can make you rich or put you in the poor house.

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