Go Leafs go! For the first time in almost a decade we have playoff hockey in Toronto again. Wouldn’t it be great to see the Leafs get past the first round. TFC and the Jays are off to slow starts, so the city will be putting all our hopes with the Leafs. I hope you all enjoy the games and that when I check in with you next month they are still playing.
The Toronto income property market continues to be challenging. The long and short of it is that there have simply not been enough new listings over these past few weeks to keep up with the current demand. This is causing some people to pay a little more than they should. See my thoughts below on buying properties with cap rates under five that offer little or no returns.
In a hot market, the bottom line returns on income properties are often sacrificed. Many of my clients know the minimum returns that I am after when I am analyzing the rent rolls. We use cap rates to objectively evaluate how an investment property would compare to other investments outside of real estate. I like the property to completely cover itself with a 20% deposit and I want to see at least a cap rate of five. Ideally the return should be closer to 5.5%. Ten years ago, a 5.5 cap wasn’t that hot, but nowadays in the GTA, this would be perfectly acceptable. Yet over the past few years, we have seen cap rates drop as low as three on some income properties in the nicer areas of town, and quite often average properties are only hitting cap rates in the fours. One could question whether there is any investment value at all if you are not making a decent return each month. Owning investment real estate does have some inherent risks, so what would motivate an informed purchaser to buy something with less than a five cap?
If you are buying real estate for investment only and are not going to live in the building, then your monthly income statement has to be one of your primary considerations. You are essentially buying cash flow. The net income a property makes each month will ultimately determine what you feel that building is worth. If you are losing money every month, then it is not a very smart investment. Yet, buildings routinely trade where the return is negligible, and sometimes close to nothing at all.
There are three scenarios where I can envision a buyer knowingly overpaying for a multiplex. The first is if the buyer is going to live in the building. A luxury duplex in Rosedale, Yorkville or Playter Estates may not generate a great cap rate, but it would be a very desirable place for most folks to live. Quite often, buying an income property allows folks to get into a neighbourhood that they might not be otherwise able to afford. A $2000 offset goes a long way to helping you cover all your costs each month. Owners suite tend to be in better overall shape than tenant suites, and those buildings with a killer owner’s suite often sell very quickly.
The second reason why investors may sacrifice yearly returns is for perceived capital gains down the road. If a market improves over time many folks see increased equity in their real estate holdings. Consider what we have seen in Toronto over the past years. Some areas of town have seen properties almost double in value. Most people have made money and improved their net worths just by hanging on to their homes. I see this as quite risky strategy since you can’t be guaranteed of anything. While there have been some huge gains made in the Toronto market over the past few years, what if we don’t see a run up like this again for another ten years? Many real estate experts expect prices to hold more than continue to increase at the rate we have become accustomed to. Betting on the market to improve is not investing, it is speculating. Unless you have a crystal ball, you can never be sure how your building will perform over time. With an income statement you know what you are getting every month.
The third reason why an investor may choose to buy an income property with little or no return is that they don’t care about the money each month, but rather they are more interested in owning the building free and clear down the road. If you have the deposit money sitting in a bank account not earning a lot of interest, then an income property becomes a good way to shift that money into something that will earn money for you over time. If your tenants are paying down your mortgage over time, then at some point in the future, you own the building out right and your tenants have paid for it. Your deposit is always safe in the property. Sometimes people move into their income properties later on in life long after the tenants have paid off a good portion of the building for you.
A last point is that maybe a four cap can become a six cap with some cosmetic improvements to the suites. This would be clear justification for paying a little more for a building, but don’t forget to add all your renovation costs to the price of the building when you are determining your future cap rates.