Real Estate

# Investment Properties - Theoretical Maximum Price

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• Feb 13th, 2020 10:00 pm
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[OP]
Member
Oct 31, 2019
435 posts

## Investment Properties - Theoretical Maximum Price

I'm starting to see some trends that are defying my understand of real estate as an investment vehicle - wondering if anyone here can add some insight.

I always figured that the theoretical max. price of an investment property (most applicable to downtown condos in cities) would be the price at which the cap rate equals the mortgage rate.

Why? Because if the cap rate is lower than the mortgage rate then the return on taking a mortgage to buy a property is negative. If the cap rate is above the mortgage rate then there are benefits to taking on leverage.

For example: let's say that the cap rate is 2% and you pay 3% on your mortgage. This means that for every \$100,000 you borrow, you are LOSING \$1,000 annually (would expect downward pressure on price in this case). If the cap rate was 4% with 3% mortgages then you are GAINING \$1,000/year for every \$100,000 that you borrow (would expect upward pressure on price in this case).

To clarify: Cap Rate = NOI / Price.
NOI = rental income - costs to run operate (maintenance, property tax, insurance, etc). Note: NOI does NOT include interest expense; it is capital-structure neutral.

Real word example:
https://www.bungol.ca/listing/318-richm ... 2-4006786/
Sold price: \$680,000 (three months ago; note prices are WAY up from then)
Closing costs: \$22,000 (Land transfer tax + legal fees, etc.)
Total purchase price = \$680,000 + \$22,000 = \$702,000
Rent: \$2,400 as of this week
Condo Fees: \$438/month
Property Tax: \$223/month
Insurance: \$30/month
Annual NOI = 12*(2,400 - 438 - 223 - 30) = \$20,508
Cap Rate = \$20,508 / \$680,000 = 2.92%

But that's a generous cap rate. If we assume one quarter of one month's rent per year to account for vacancy, leasing costs, etc. then the cap rate drops to 2.84%. This assumes that nothing ever goes wrong with appliances and that there are never any special assessments, which is a very generous assumption (I can't think of an easy way to estimate those). With cap rates roughly equal to mortgage rates, this means that the ONLY source of return on borrowed money is appreciation.

A lot of the cap rates on recent sales looked like they were below 3% at the end of 2019, yet prices are going silly at the moment while rent is not. I've never been a firm bear before because the cap rate in Toronto was ALWAYS well above mortgage rates, however these numbers are becoming a bit of a head scratcher.

Am I missing something?
12 replies
Deal Guru
Jun 26, 2005
10096 posts
Toronto
Ever since about 9 yrs ago, doing calculations like this will never lead you to buy any condos in Toronto in a high quality location. Yet if you bought some 8 yrs ago, you're rolling on the floor laughing.

Because of price appreciation, rent will no longer cover all your expenses in Toronto condos. At least in good locations. And one should NEVER buy in a bad quality location for real estate.

A simplistic way of evaluation can be:
Pick a high quality location, say downtown Toronto, midtown Toronto, anywhere near the Yonge subway line.

How much do you have to put in on top after rent? Can you afford that every month? If yes, then buy it. If no, then don't buy

As each year goes, the amount you have to put in will decrease. Because more is paid off, rent increases slowly, and you will get more comfortable at what you're doing.

Mortgage rates are still ridiculously low right now. Talk to someone who's older and ask them what their rates were back then.

In the meantime, the property value is growing fast , and if it's in a quality location (which it is right? See above) The value will double every 9-10 years or faster.

Then after the mortgage is paid off in 25 yrs, you are guaranteed to be a millionaire.

Repeat for 3, 5, 10 properties
Feb 19, 2019
1834 posts
Stouffville ON
VanByTheRiver wrote:
Am I missing something?
Mostly the leverage, making money with other people's money.

But I get your point, it is also possible the rental market may be reaching the peak and the prices may be levelling off, all new purchases are cashflow negative (with 20% down, this has not been the case until last year).
Full Time and Full Service Realtor
[OP]
Member
Oct 31, 2019
435 posts
rfdrfd wrote: Ever since about 9 yrs ago, doing calculations like this will never lead you to buy any condos in Toronto in a high quality location. Yet if you bought some 8 yrs ago, you're rolling on the floor laughing.

Because of price appreciation, rent will no longer cover all your expenses in Toronto condos. At least in good locations. And one should NEVER buy in a bad quality location for real estate.

A simplistic way of evaluation can be:
Pick a high quality location, say downtown Toronto, midtown Toronto, anywhere near the Yonge subway line.

How much do you have to put in on top after rent? Can you afford that every month? If yes, then buy it. If no, then don't buy

As each year goes, the amount you have to put in will decrease. Because more is paid off, rent increases slowly, and you will get more comfortable at what you're doing.

Mortgage rates are still ridiculously low right now. Talk to someone who's older and ask them what their rates were back then.

In the meantime, the property value is growing fast , and if it's in a quality location (which it is right? See above) The value will double every 9-10 years or faster.

Then after the mortgage is paid off in 25 yrs, you are guaranteed to be a millionaire.

Repeat for 3, 5, 10 properties
No - these calculations always provided a buy signal in the past. I have personally never seen cap rates equal to or below mortgage rates - although I've only been following since 2015.

The Toronto rally in the past five years has been fully justified by the rise in rents and the decline in interest rates, contrary to what most bears have been saying. The past two months are the only exception that the math just doesn't make sense to me.

I'd love to know if someone has graphed the Vancouver residential cap rate over time. I have a feeling that it was below the mortgage rate two years ago
[OP]
Member
Oct 31, 2019
435 posts
senasena wrote: Mostly the leverage, making money with other people's money.

But I get your point, it is also possible the rental market may be reaching the peak and the prices may be levelling off, all new purchases are cashflow negative (with 20% down, this has not been the case until last year).
My entire post was about leverage. I was arguing that leverage is amazing if cap rates exceed mortgage rates and short-term bad if they are below. The only benefit that leverage gives you if the cap rate equals the mortgage rate is that, at 20% down, you get 5x exposure to price changes - so 5x inflation seems pretty good. However that could also be a curse - you'd better have a decent equity buffer if you're playing that strategy.

Cashflow negative is a completely separate argument from mine. You can be cashflow negative while still building equity; you can also be cashflow negative if cap rates exceed below mortgage rates. The clickbait articles always seem to miss this point.

However if cap rates are below mortgage rates then you are losing EQUITY by taking on leverage unless prices go up.
Deal Guru
Jun 26, 2005
10096 posts
Toronto
Guess I'm lost on what are you asking?
[OP]
Member
Oct 31, 2019
435 posts
rfdrfd wrote: Guess I'm lost on what are you asking?
I'm asking whether it makes sense for cap rates to be less than mortgage rates from an investment standpoint, since debt financing (aka leverage) provides negative return unless you are solely betting on rapid price/rent appreciation. This is the first time that I've ever seen cap rate < mortgage rate.

I don't see how it makes sense, for the reasons that I already outlined.
Newbie
Aug 1, 2012
22 posts
Toronto
VanByTheRiver wrote: I'm asking whether it makes sense for cap rates to be less than mortgage rates from an investment standpoint, since debt financing (aka leverage) provides negative return unless you are solely betting on rapid price/rent appreciation. This is the first time that I've ever seen cap rate < mortgage rate.

I don't see how it makes sense, for the reasons that I already outlined.
I like this discussion. The cap rate < mortgage rate would mean that the effect of leverage makes your operating cash flow worse.

However, what is not factored, in your analysis, is that not all buyers are investors, especially in residential real estate for single families (condos, towns, houses).
In a scenario where an institutional investor is buying an apartment building, your logic makes sense because the chances of another buyer paying more (thus lower cap rate) diminishes quite quickly when the leverage doesn't enhance their returns. Because every buyer is an investor when it comes to apartment buildings. The same logic can apply for homes in Rosedale or Forest Hill - as a rental they would never make sense. So why are they so expensive?

So the other aspect that needs to be analyzed is "would an end-user pay more in future?" This question goes back to whether there's supply-demand issue within the City of Toronto. It's equivalent to the notion of "highest & best use" in the context of real estate planning. Is it more valuable to you (as an investor) or to the end user? I've been a cash flow investor in real estate, and for the reasons you've outlined, I've completely missed out on the upside of condos - I only have two semi-detached houses

I've been trying to tackle a similar problem in this thread - been building a tool to analyze all this. I'll pm you
http://forums.redflagdeals.com/resale-c ... t-2353334/
[OP]
Member
Oct 31, 2019
435 posts
hosuplee wrote: I like this discussion. The cap rate < mortgage rate would mean that the effect of leverage makes your operating cash flow worse.

However, what is not factored, in your analysis, is that not all buyers are investors, especially in residential real estate for single families (condos, towns, houses).
In a scenario where an institutional investor is buying an apartment building, your logic makes sense because the chances of another buyer paying more (thus lower cap rate) diminishes quite quickly when the leverage doesn't enhance their returns. Because every buyer is an investor when it comes to apartment buildings. The same logic can apply for homes in Rosedale or Forest Hill - as a rental they would never make sense. So why are they so expensive?

So the other aspect that needs to be analyzed is "would an end-user pay more in future?" This question goes back to whether there's supply-demand issue within the City of Toronto. It's equivalent to the notion of "highest & best use" in the context of real estate planning. Is it more valuable to you (as an investor) or to the end user? I've been a cash flow investor in real estate, and for the reasons you've outlined, I've completely missed out on the upside of condos - I only have two semi-detached houses

I've been trying to tackle a similar problem in this thread - been building a tool to analyze all this. I'll pm you
http://forums.redflagdeals.com/resale-c ... t-2353334/
I've thought about end users preferring the stability/benefit that ownership provides to such a degree that values exceed what investors would prefer, but I was really thinking more about downtown Toronto condos (which almost feels like a deep & liquid commodities market imo). In this case I would expect prices to gravitate to the level where cap rate = mortgage rate, but I've never had a chance to test that against historical data.

A lot of people are blaming investors/speculators for high prices and if that's true then cap rate < interest implies an overvaluation imo. But if the heavy buying right now is just end users rushing to live in TO then the numbers go out the window; but I'd still expect this environment to produce some dislocations where shrewd buyers can buy relatively cheap property (assuming that rent is properly considered)
Deal Fanatic
Mar 27, 2004
8102 posts
Toronto
Cap rate is one part of the calculation only. You have to look at appreciation, and the leveraged gains. Thus the IRR is probably at least 20%
Full-time Realtor
Deal Guru
Jun 26, 2005
10096 posts
Toronto
I may not have much to contribute in the mathematical terms.

I trade stocks and have been to a proper trading school, where I've learned that the market can act illogically much longer than you can stay solvent.

So your question of make sense or not, imo it doesn't always have to make sense.

Property value and based on location. Just like houses on the East side of say Yonge Street is more valuable than the West side. Why is York Mills and Bayview so much more expensive? Why are they so special? Defies logic, doesn't make sense. But it is. That's how the game is

Imo, the more important question is how to profit from this illogically game. Spend more time in analyzing how to profit than to make sense of it. Build safety net in place and let the money roll in.
Newbie
May 4, 2016
92 posts
oasis100 wrote: Cap rate is one part of the calculation only. You have to look at appreciation, and the leveraged gains. Thus the IRR is probably at least 20%
Cap rate is only useful if you are buying it on cash...for yield purposes only. It is a flawed way of fully assessing real estate acquisition in my belief. A very active market like Toronto with all these boom it just doesn't make any sense to use cap rate. It should always be a quick litmus test to gauge your acquisition cost and thats where it stops.

In terms of price, its fully determined by the market. There is something called WTP(Willingness To Pay). The market will always determine the price based on what someone is willing to pay...
Newbie
May 7, 2019
24 posts