The new biggest challenge for investors
Until recently, I always believed the toughest part of investing in real estate was finding the “right” income property (eg. good geographic metrics, under market rents, purpose built, good shape, good location, etc.). In the past, my ability to find “diamonds in the rough” is what made me an effective and successful investor. However, my opinion has now changed.
Looking back over my past few deals I realize that in today’s environment, putting the right financing in place for an investment property is now more difficult than finding a good investment property and dictates your ultimate success or failure.
Most novice investors just assume that the bank is going to use the purchase price when determining Loan-to-value. They look at how much money they have available and work backwards. If they have $300,000, they can use $250,000 for the down payment and $50,000 for closing costs. This means they can buy a property for $1 million and the bank will give them a mortgage of $750,000 based on a 75% LTV. However this couldn’t be further from the truth today.
How did this situation come about?
Historically low interest rates in Canada have been the catalyst leading to:
- Cheap cost of funds
- Market cap compression
- Increased demand for real estate as alternative investments (Bonds, T-Bills, GIC’s) offer poor returns
- Limited supply
As an investor looking to acquire an income property, you welcome low interest rates but cheap cost of funds is a double edged sword. On the one hand you want as low an interest rate as possible to minimize expenses. However, there is a direct correlation between cost of funds and market caps. Both move in sync which means as interest rates go down, market caps follow suit (which means the price goes up).
Why does this matter?
Market cap compression directly affects cash flow. For instance, most income properties on the market in Toronto, and in surrounding areas, are being listed with cap rates of 4% to 4.5% (and in prime Toronto locations sub-3% market caps). The problem is that there is a big disconnect between actual valuations dictated by the market and the criteria that banks use to value an income properties for financing purposes.
Just this week I approached two majors banks regarding an income property in a prime Toronto location and was told they use a cap rate of 6% to determine value. A 6% cap rate on a good income property in Toronto is like a unicorn — they just don’t exist.
Most people, like myself, like to see the real math and numbers to truly understand a concept. So here it is.
Assume a property nets $40,000. Based on a 4% cap, a seller would list that property for $1,000,000. Bring that same property to the bank for financing and based on a 6% cap, that same property would be valued at $667,000. The bank will typically offer 75% LTV which would translate into a mortgage of $500,000. The purchaser would have to come up with the balance, or $500,000 in cash, to complete the transaction. One of the great benefits of investing in real estate historically has been the ability to leverage and borrow from the bank.
As if that wasn’t a big enough obstacle…
To make things even tougher, most banks have their own internal guidelines when determining a property’s cash flow and they differ significantly from what you see on the property’s fact sheet when it is for sale.
For example, most real estate agents will assign $400-$500 in annual repairs and maintenance per unit under expenses on the income statement. Banks and CMHC tend to use $800-$900 per unit. If you plan to manage the property yourself, it doesn’t matter, they will assign a 4% (of gross) management expense.
Capital expenditures warrant another 1.5% to 2% of gross. What does this mean? It means that if you apply these guidelines the cash flow gets even weaker making it tougher to get the financing you need.
Unless you are a REIT or have deep pockets, the erosion of leverage makes it almost impossible for the average investor to enter this market.
That will be my next entry. Stay tuned…
Author: Paul Kondakos, BA, LL.B, MBA – Professional Real Estate Investor