Monthly Newsletter: September 2006

Is the small-scale real estate investment market dead? In these days of properties being sold at 4 or 5 caps, one has to wonder what the motivation is to pay these kinds of prices. If you are going to buy a triplex in Toronto for investment, what kind of reasonable yearly return should you expect? If your ROI is under 5%, does it really make sense to assume the business risk? Properties require hands-on management, have frequent maintenance issues and are often difficult to dispose of quickly. In that sense, real estate is not a very liquid investment relative to stock or other paper-based vehicles. REITs are returning 7% to 9% in some cases and are relatively hassle-free. They also can be cashed in quickly if need be. It always makes sense to live in your income property when possible, but does it make sense to become an absentee landlord in today’s market?

At Plex Realty, we pride ourselves on staying on top of this market and knowing when are the right times to get in and get out. It would be a very self-serving statement to say that you should always buy income properties because that’s our stock and trade. But is this true? If returns in Toronto are lower than in the past markets and rents are stabilized, what’s the prognosis for bottom-line returns to increase? Should you buy today or wait and see what the next cycle may bring? There are two very legitimate sides to this argument. I’ll let you decide for yourself.

It can be argued that the income property market in Toronto does not provide as much as could be expected from other types of investments, such as the stock market or mutual funds. If so, is the return high enough to be worth the extra risk involved and the fact that the money may be tied up for an extended period of time? What are the local market conditions, and how are they likely to change over the course of two, five or ten years? A purchase in the Annex may be significantly different to one in Parkdale long-term. It is certainly easier, and in many ways safer, to rely instead on other types of investments. For instance, investing in mutual funds requires little work, is easy to understand, and historically has provided a very reasonable return. Investing in real estate presents both unique problems and opportunities. Real estate is a non-liquid, localized investment vehicle. It is immobile, of limited supply, indestructible, and physically real. It is difficult to own buildings – they require maintenance, tenants, and regular updating.

Many investors feel that it is illogical to purchase property that might have yielded a higher return five or even two years ago. From a practical standpoint, traditional measuring sticks are being redefined. If you’re looking for 10 to 12 times your gross rents to determine market value, you’re going to have a hard time finding a suitable property, at least in the central part of the city. As I said at the outset cap rates have come down. The only way to determine if they are too low is to consider alternative investment strategies and see what kinds of returns you can achieve elsewhere. Since there’s a lot of risk associated with real estate, you have to decide what minimum percentage return justifies an income property purchase.

The most successful businesspeople (not just in real estate mind you) are those who often go against the grain. They see opportunities where others see nothing. I enjoyed a biography that I saw recently on the Reichmanns. When downtown Manhattan real estate hit all time lows in the 1980s, Paul Reichmann swooped in a bought and redeveloped many key locations that local players had passed on. A couple of years later things turn around and those purchases tripled in value. It actually paved the way for guys like Trump to start redeveloping. The point is that if everyone thinks a property is too expensive, there may be hidden opportunities.

This point ties into the other side of our argument. There is still one primary reason for investing in Toronto real estate even in a lower market –in a word, profit! Owning real estate can often lead to returns that are double those of more conservative strategies. This is based on the fact that in real estate there are actually three ways to make a return on the initial investment. There are the monthly cash-on-cash returns that we have discussed thus far. There is also the yearly reduction on your principle invested and there are the possible capital gains upon disposition. Added together, these three types of Return on Investment can add up to a significant total return–one that justifies the greater risk and involvement. This is what makes the risk and bother worth it.

Many realtors believe that the Toronto market still has room to move up in prices. Our home prices are still low compared to some other large cities in North America. They also think that rents will increase again to levels we saw a few years back. I think the condo market has bitten into the rental market for sure, but I don’t think current rent levels are going to go down. If rents are going to hold and possibly increase then over the long-term, buying an income property today in a secure location starts to make sense again.

You also have to remember that your returns get better each year. If you intend to buy a multiplex and hold it for a decade, then it won’t make too much of a difference to you if you made 5% in year one instead of 8%. If the market has improved at that time and you have renovated the property over the years, I’m sure that your investment will have paid off handsomely. Many of my clients who have owned income properties for several years are pleased with the continual passive income.

Let’s take a hypothetical situation of a multi-unit building that only returns 4 or 5% today. An investor upon seeing it decides the price is too high relative to the rents and decides to wait for something better to come along. A second investor decides to buy it and start slowly cleaning up the suites to try and make modest gains in rent. Investor #1 a year later is still waiting and has determined, if anything, that the market has actually gotten worse. He continues to wait. Meanwhile Investor #2 has been able to increase his rents a bit and going into year 3 his return is starting to approach double digits. Moreover, the value of his building has increased from the capital improvements. Naturally he can’t cash in on this gain, but he will at some point. The point is that waiting isn’t always the smartest move. We only have a finite number of above-average income properties in Toronto, and they don’t come up for sale that often. If one does and the returns are marginal but it is a great building or in a great spot, one could make a case for it.

So to summarize: the reasons to buy an income property today would be capital appreciation (particularly if you renovate your property over time) and the chance of improved returns over the long term. The reasons not to buy would be that the returns are too low relative to other “safer” investments. As always I suggest that you learn and study the income property market, set reasonable investment goals, and stick to your guns. If you’d like to discuss this in more detail, please drop me a line at paul@plex.ca. I’d love to hear your feedback on this.

Happy Labour Day everyone. The kids are back to school and many of us are wrapping up our summer fun. Let’s get busy!

P.A.