Big Money Tip for DIYs

Bloomberg has a good graphic on Blackstone's (world's largest private equity firm) model for acquiring a yield in real estate. I have added a couple of notes to the graphic (in yellow) as a reminder to the DIY crowd working on building their real estate portfolios that the expense side includes the labour cost of management as well as a 10% vacancy allowance.

If I have done the math correctly, that puts the expense side of the income statement including vacancy allowance (but excluding debt service) at around 58% of gross rents.

In my May 2013 Case Study of buying a downtown Vancouver condo for a rental return; I have in the last most conservative scenario used a 5% vacancy and 5% management fee for a estimated expense excluding debt service of 39% of gross rents.

I'm willing to bet that Blackstone knows more about the real world than me so my advice to DIY real estate investors is to err on the high side when calculating your expense projections.

My last most recent comments on the current wave of big money buying up bank foreclosures are spanish-inquisition and us-housing-recovery-limited.

SCREEN TIP: If you want to view the image enlargement of the thumbnail above even bigger than the default and you are using Google Chrome as your browser, right click on the image enlargement and select "open image in a new tab" and then Ctrl + to enlarge the image even more.

The Condo Game was produced by Helen Slinger and directed by Lionel Goddard and Helen Slinger.

Are you thinking of buying a condo? If you do, you should set aside money for special strata assessments that are additional to any regular monthly "contingency" strata fees. AND read this CONDO USER'S GUIDE prepared by Ted Kesik, University of Toronto building science professor.

Here is an excerpt from the BC Housing Home Owner Protection Office website "Managing Strata Repairs FAQ"

How to sell your Pre-construction Condo
by David Fleming

Hat tip to Ben Rabidoux for tweeting this excellent review of the perils of buying un-built real estate. Time is a huge risk if market prices do not rise; then the risk of negative yield takes over. Calculate your yield.

David's Sample Pre-Constructed "Condo" and the road to attempting to sell the assignment:

• $500,000 Original Purchase Price on a 714sf Toronto Condo ($700/sf) and after 12 months, the assignment is offered for sale with the following costs included in the price: 
  
  
• $12,200 Ontario Land Transfer Tax
• $18,000 Closing Costs (can be much higher; read fine print)
• $25,000 Realtor Fees
• $3,000 Legal Fees
• $9600 Occupancy Fees
  
  
• $567,800 New Asking Price a 13.6% increase based on hard costs (now $795/sf) and in direct competition with the developer who can offer incentives to a buyer for the same or better unit.

Buy a Vancouver Condo as an Investment? 

SUBJECT PROPERTY

5 Yr old 600sf 1 bdrm condo
Good location downtown
Good amenities & condition
$1350/month Rent
$363,000 Purchase Price

There are dozens of similar offerings of MLS listed condos for sale and many more on Craigslist for rent.

If you want to use this spreadsheet for your own analysis, start here.

ALL CASH BUYER SCENARIO (Click the spreadsheet image above. SCREEN TIP: If you want to view the image enlargement of the thumbnail above even bigger than the default and you are using Google Chrome as your browser, right click on the image enlargement and select "open image in a new tab" and then Ctrl + to enlarge the image even more.

An investor buying for all cash ends up with a cash on cash Return on Investment (ROI) of 3.1% which is 1.3% more than the yield from a Canada 10 Year Bond (1.7%).

Is the yield worth the risk? Notice I have used low rates (2%) for maintenance, vacancy and management and have made no allowance for accounting or other professional services. Real estate management is time intensive and the physical asset suffers from depreciation while the value of the asset is subject to market and government caprice. 

FINANCED BUYER SCENARIO #1 (Minimum Down Payment)

An investor who puts down 37% in cash ($136,719) ends up with a negative ROI of -1.4%

Why did the buyer finance 63% of his investment? Because the lender (in this case TD Canada Trust) requires a down payment of 35% of the sale price as a non resident (investor) owner. Leverage has a cost. 

An additional 2% down payment above the 35% required was added to account for also financing the additional closing costs and property transfer taxes that amounted to nearly 2% of the sale price. In BC, the property transfer tax is 1% of the first $200,000 of sale price and 2% of the balance of the sale price. The sale price is one thing but the actual closing cost (investment) is another. We want to see what the actual "cash on cash" return is. 

Relative to the Canada 10 Year Bond Yield at 1.7%, this mortgaged real estate investment is 3.1% LESS than a zero risk bond that requires no effort. Let's reduce the financing to get a yield.

FINANCED BUYER SCENARIO #2 (In Search of Yield)

Before we address the issues of sale price and revenue, let's see what amount the investor has to reduce his financing, or in other words increase his down payment, to get a yield that is commensurate with a 10 year government bond yield.

The revised spreadsheet (left) shows that the investor must increase his down payment to 66% of his upfront cost instead of the minimum required by the bank of 37% to get a 10 year bond yield.

The lender does not care if you have a negative yield, their primary risk assessment is to determine if the market value will fall below the loan amount during the term of the mortgage; in this case the lender requires a minimum 35% spread and is in first position if the loan defaults. Read the fine print of your loan documents and consult a lawyer who works in contract law to see if the lender can attach your personal earnings or lien your other assets.

Remember this revised scenario is still using very low (2%) rates for maintenance, vacancy and management. In a flat or declining market or if the property has reached its upper revenue limit, a prudent investor would account for worst case scenarios because real estate is a "slow asset" and the real possibility is that ownership can end up being for a much longer period of time than originally anticipated during the excitement phase of purchase.

Let's look once more at our spreadsheet, but this time increase the potential costs so that we have a contingency plan in place.

FINANCED BUYER SCENARIO #3 (An Unyielding Market)

Now we have increased the maintenance, vacancy and management rates to 5% (from 2%) of gross revenue and if we have no maintenance or vacancy issues, we can build up a contingency reserve in the first year of operation of $2,430 ($810x3). 

But remember, your investment unit is subject to the strata council, a third party entity that also does not care about your yield. 

$2,430 may not even cover a modest repair to the building envelope or a strata fee increase for upcoming work. Before you purchase, read all of the strata meeting minutes as far back as records go and look at the insurance premium history to see if they are much higher than comparable buildings; this will indicate if the insurer considers the building an inherent risk. 

With the increase from 2% to 5% on the variable expense side, our financed buyer has to increase his down payment to 76% of his outlay to generate a 10 year bond yield. The 100% cash buyer now has a yield that is only 0.9% over the 10 year bond. This investment potential is diminishing.

The more that we account for risk, the thinner the margins become. The risks are high if there is little or no capital appreciation on the asset via rising market values and if expenses rise or revenue falls the yield can turn negative very quickly.

There are only two avenues to get to a better yield; raise the net income or decrease the capital cost. Let's take a look.

REDUCE CAPITAL COST SCENARIO (My Heart Races with Joy)

Many market analysts think that Vancouver has at least a 30% market value price drop ahead. Some think a greater reduction is in store. 

Currently average strata units in Vancouver are trading at 2007 price levels down over 10% from the highs set in the summer of 2011. If we believe a further correction will take place, let's get ahead of the market and reduce the price of our case study by 25% to see what happens. 

This takes our purchase price down to $272,250 which is comparable to the winter of 2005 prices and a benchmark that the Plunge-O-Meter suggests Vancouver prices will reach.

Again we are using the 10 year bond yield as a target for our leveraged investor. The leveraged investor can now reduce his cash outlay to 55% (down from 76%) and get a comparable 10 year bond yield equivalent while the all cash buyer gets more than TWICE the 10 year bond yield. Wow, this gets my heart pumping, my blood flowing and I think real estate might be worth looking at again.

With a 25% drop in sale price, the GRM has dropped nearly 6 points (lower is better) and the CAP Rate has gone up 40 basis points (higher is better) which not a huge move but the yield on investment (ROI) has increased to more than twice the 10 year bond return and that provides an investor the incentive in a ZIRP environment to buy and hold and allow other people's money (the tenant's) to turn debt into equity.

In the late 1970's and early 1980's Canadian investors looked for 8-10% and even 12% or higher CAP Rates in real estate to try and match the then 10-16% yielding 10 year Canada bond.

Today in this ZIRP environment, if you cannot yield 2-3 times more than a 10 year government bond, then you do not have enough margin to protect against an interest rate uptick or net revenue erosion from rental supply competition, expense statement shock or demands by government for more tax and or fees.

The crucial metric today is purchase price. This Vancouver condo investment case study is clearly overpriced. 

Buying real estate on a bet that its price will rise sufficiently to compensate risk is itself very risky.