Why Invest in Real Estate?

Introduction

I tell most of my SMEE (Small and Medium Sized Enterprise) clients (and my students) that real estate investing is usually a good idea. Homeownership and owning your own business premises makes sense to me in most cases. Why is that?

Well, here are a few of my reasons:

1. Forced savings— most people are really bad at saving* so, if at a minimum they own their own home or condo or (for entrepreneurs) their own business premises, every month that they make their mortgage payments, they are paying off (‘saving’) some of the principal. This is a type of ‘wealth effect’—it creates equity on your personal balance sheet (which everyone should have) or your corporate balance sheet. It is kind of a hidden part of your ROE (Return on Equity) too. Even people who are pretty good at saving their money may eventually succumb to the temptation to spend their savings. However, if their savings are tied up in bricks and mortar, they are going to have to do more than turn on their PCs and use Internet banking to, say, buy that holiday of their dreams. Getting at your real estate equity can be relatively straightforward using something like a home equity Line of Credit or re-mortgaging your house, condo or office building (or putting a ‘reverse’ mortgage in place, something an elder might do, for example, if they are real estate ‘rich’ but cash poor) but, at least, it requires some effort and will give you time to reflect on whether this is really what you should be doing.

(* I ask my students every year, how many of you can save, say, $600 per month? Usually, one or, at the most, two students raise their hands (out of 45 or 55). When I re-phrase the question and ask how many of them could pay rent of $600 per month, well, most of them can do that. So if you had a mortgage of $600 per month (on a very small flat), they would be ‘forced’ to save a bit of money every month…)

2. Get rich slow—real estate is not a get rich quick scheme. But most markets have some real estate inflation and, at least, real estate markets don’t usually sink as fast as say tech stocks did in the great bubble burst of the early 2000s. So if general real estate inflation is say .75% per annum and you have 25% equity in the deal then you are adding an extra 3% p.a. to your ROE. Obviously, if general real estate inflation is higher than this, and it often is, this factor will play an even larger part in creating investor wealth.

3. If you own your own business premises, you have a diversification of risk. (I advise SMEEs that they should generally keep their real estate in a company separate from their operating company so that if something happens to the operating business, they can always sell their real estate holdings and, hopefully, live to fight another day).

One of my tech clients needed more and better office space. We looked at leasing 15,000 square feet of Class A office space for his cluster of companies. At that time in Ottawa, prime office space was leasing for $18 per square foot per annum triple net (that means that the tenant must pay all operating costs in addition to basic rent). Operating costs including realty taxes were in the order of $12 per square foot per annum so 15,000 square feet of space would have cost his company in the order of $450,000 per year.

After Bill (not his real name) recovered from sticker shock, I convinced him to buy his own building. He bought a beautiful two storey, 15,000 square foot, Class A office building for $100 per square foot. He put down $500,000 and got a Vendor Take Back Mortgage (known as a VTB—i.e., his financing came from the Vendor not a Bank) for the balance. His annual mortgage costs were in the order of $85,000 per annum and he took ownership of the building in a separate company. I also convinced him to buy a house (he was renting up to that point) and to pay down both mortgages as fast as he could. Now, a few years later, Bill owns a beautiful $750,000 home and an office building worth nearly $2m with almost no debt against them (and soon to be zero). So even if his tech company somehow goes away (which I doubt—these are very profitable enterprises), Bill can always sell his real estate for $2.75m and not eat cat food when he turns 65.

In many enterprises and especially technology and consulting companies, your key assets tend to walk out the door every night on their way home. Or in a fast changing global economy, your technology or key competitive advantage can become obsolete almost (and sometimes) overnight. Real estate doesn’t usually go out of fashion as quickly*. If you look at some of the longest lasting fortunes on the planet, they tend to be (at their core) real estate based—like, say, the House of Windsor, Emperor of Japan, Hudson’s Bay Company, the old Canadian Pacific** Railroad Company or the Holy Roman Catholic Church.

(* I remember a time in the 1980s when my Dad got involved with a group who wanted to build roller disco emporiums and, boy, did they ever. I’ll never forget the principal behind these developments telling me that Roller Disco (places where kids could boogie to disco music while on roller skates; they went round and round in a counter clockwise direction with lights flashing all over the place) was a ‘cash cow’. Hey, when the kids got bored, they stopped the music and then they went clockwise for awhile. I wanted to bale out of the operating company faster than if I was a paying passenger on the Titanic. However, we managed to exchange our interest in the operating business for the underlying real estate—the Roller Disco operating entity went broke less than two years later and we turned the real estate into a cool office for a new high tech company specializing in CAD systems which were just new at the time. Real estate has legs; roller disco was just a fad.)

(** CP got huge real estate concessions in prime urban locations in return for the near-impossible job of laying railroad track over the Rockies to what was then a nothing town called Vancouver. Decades later the stock price for CP moved up when the company started selling off its real estate portfolio.)

4. If you own rental property or if part of your home of office is rented out, your tenants are helping you with your ‘forced savings’ since they are paying off the part of the principal on your mortgage every month for you. This in a way compounds the wealth effect. When someone else is paying off all or part of the principal on your mortgage, this benefit comes accrues you. Now it’s true that you can’t use it for what my wife calls ‘IGA money’ (money you can touch, feel and spend on stuff) every month but when you sell the property (provided you sell it for what you paid for it or more), you will get the cash in your jeans from the pay down of your mortgage… Of course, you can always re-mortgage your properties without selling them and get the cash, tax-free that way.

5. Hopefully, your real estate portfolio is providing you with some cash-on-cash return too so that every month you are getting more ‘IGA money’.

6. You will have security of tenure since the Landlord (yourself) won’t raise your rent every five years or so, especially if you are doing well financially. There seems to be a rule in life that costs always rise to whatever your income is. This is as true for a company as it is for an individual; Landlords just have a sixth sense about these things and can keep on increasing your rent until you simply have to move.

7. Brand equity—you do develop a kind of brand equity in your location over time and if you own the real estate, at least you are developing brand equity in your own property not someone else’s.

8. Brand equity is important because it helps you build up your credibility; credibility and trust are hugely important in sales—people like to buy from people they like and trust. The two things often go together. Did you ever buy from someone you didn’t like and didn’t trust—not too often I’ll bet?

That’s why mega corporations spend so much money building their brand; it’s so that when one of their sales people is in the trenches competing for a sale and trying to close the deal, they often get the nod over the competition because they are a known (read trusted) commodity. Imagine if you were hearing an insurance pitch from somebody who worked for the ‘Pirate Insurance Company’ of Kinakuta versus somebody who worked for Clarica. Which one would you be more likely to put your trust in and trust your family’s future to?

Companies spend money on marketing their brand not just so you can watch the Super Bowl on free TV—they spend money on ads so they can increase sales but not in the way most people think of it. By spending $$$ on TV ads to establish a new brand (like Clarica did in 2002 and 2003), they don’t actually expect 100,000 people to suddenly call their call centre and order life insurance. They know better than that.

They understand that all the marketing in the world doesn’t sell much, if anything—they need a separate process to harvest the goodwill that they have generated in their marketing blitz. All that their marketing has done is increase the propensity-to-buy. The separate sales process involves a huge team of focused, Clarica sales people—the sales team is like the ‘facts on the ground’ in military/political speak. They are in the trenches with consumers selling one customer at a time. Each in-the-trenches sales team member has a greater likelihood of making the sale because of the mass marketing that Clarica has done but that is all that marketing dollars can do—increase the probability of a sale and only if there is actual selling activity going on.

9. Owning your own location instantly builds credibility with suppliers, bankers, employees and others whom you depend on too.

10. If you want to make any changes to the premises, you can without investing your money in someone else’s building or having to ask permission.

11. Once you have paid off your mortgage, you can either continue to have the operating company pay rent and enjoy another income stream or you can benefit from ‘tax-free, unearned’ rent. The latter is another type of wealth effect* (which is also why you want to pay off your home mortgage as fast as you can pretty much everywhere in the world today except perhaps the USA where mortgage interest on your personal home is tax deductible which changes the calculations a bit).

(* This wealth effect is also quite real. Suppose you own your own building and the mortgage is fully paid off. Now you decide to reduce your rent to zero. Your operating company’s net income goes up by an amount equal to the rent they paid in the last year of the mortgage, an amount equal to Y dollars. Now in Canada, related inter-company dividends are tax free so you could dividend out the equivalent amount to your real estate holding company. Whereas before you had income in the holding company (of course you had some offsetting expenses too), you now have inter-company tax free dividends.

For your personal home, it works a bit differently. Let’s say you have a home worth $300,000 and you have finished paying off the mortgage. And let’s say you could rent it out for $3,000 a month. If your marginal tax bracket is 50% say then you are left with $18k after tax less whatever costs you might have against this. But if you stay in the home yourself that means that you are enjoying the benefit of living there on ‘unearned rent’ (a British term) of $36k a year—which isn’t taxed. Unearned rent is also sometimes referred to as ‘imputed rent’.

Another way of looking at it is if you moved out of the home, rented it for $3k a month and rented another exactly equivalent house for yourself (you have to live somewhere after all) at $3k a month, you are gaining $18k in after tax income but paying $36k in after tax rent yourself so you end up actually losing $18k on the whole deal. It’s weird but true—people who have paid off their home mortgages may not understand the exact mechanics of this wealth effect but they sure feel it. They tell me things like: “I seem to have more money than I ever did when I was working. I just seem to have more cash around these days…”

‘Unearned’ rent is a concept that originally seems to have derived from a British sensibility that owners of real property are somehow undeserving of a return on capital. No doubt this is a class-based concern. There have been attempts to tax homeowners who have no mortgages on their residences on their ‘unearned’ rents—one attempt in Switzerland and one in Australia that I know about. Both were roundly hated by the populace and were rescinded shortly after introduction in Switzerland and never actually implemented in Australia.

One also has to think that taxing unearned rents would work against thriftiness on the part of homeowners and against social order too. Evidence abounds that people who own their own homes tend to see themselves as having more of a stake in their societies—they tend to vote in civic elections, participate in volunteerism and form the bedrock of a civil society.

In addition, home equity and real estate equity more generally are the bedrock source of friendly capital for startups. The work of Hernando De Soto in LDCs has shown that until they: a) recognize private property rights, b) give clear legal title in (and civic addresses to) real property to sitting owners and c) develop a competitive market for financing of real property (a system of mortgage financing), they can not unlock real estate capital for redeployment to productive, entrepreneurial uses.)

12. It is often cheaper to own than to buy especially in low interest rate countries like what Canada and the US are experiencing today.

13. You should want to own your own real estate without partners if you can swing it. There are still: ‘Two chairs up in Heaven waiting for the first two partners to get there and still like each other.’ (Anon.) But if you do take on a partner to acquire real estate, make sure that you both have the same financial incentives and goals*.

(* In a bankruptcy of one of my Dad’s (Jack) real estate partners, five properties jointly owned by Jack and Les (not his real name) were caught up in major court proceeding along with 75 other projects. A major, publicly traded real estate business wanted to buy all 80 properties out of Bankruptcy including the halves of the 5 projects that Jack owned with Les.

Two things saved my Dad—he had had the good sense to enter into first right of refusal agreements on all 5 properties with Les and he had me to negotiate with the major realty company, we’ll call DevCo.

DevCo was buying Les’ half of each of the 5 properties in question for $400,000. Our internal valuation carried these projects at $2.2m and that was just for our halves. Andy Jenkins (not his real name), V.P. for DevCo, told me that we had two choices—sell our half interests for $400,000 or stay in and become partners with DevCo. “Why not be partners with DevCo,” he said. “We are a national company with a national network of leasing and operating executives.” Why not, indeed.

Our concern was that DevCo had a lot of other vacant buildings near these properties—geez, they could actually make money by taking tenants out of our buildings (where they would own 50% and we would own 50%) and putting them in buildings that they owned 100%. After a couple of years, we might have been lucky to get an offer from DevCo for our half interests where we did not have to pay them for accumulated losses just to take our share off our hands.

I hate 50/50 partnerships anyway. No one is in charge; no one has final say; it’s a recipe for stalemate and disaster. If you are going to have partners, at least have someone own 51% and you know where the buck stops.

So we exercised our rights of refusal and offered to buy Les’ halves for $400,000 (it’s like a right to match). Jenkins and his boss went nuts. They told me they would ‘see us in court’ where they would argue the ‘greater good’ theory—that the Bankruptcy Judge should override our rights because the greater good (i.e., DevCo’s greater good) demanded that all 80 properties be dealt with in one fell swoop.

A couple of days before the hearing, Jenkins asked me what we wanted for our half interests. I told him $2.2m and he blanched. I argued that he was still getting a good deal—he had Les’ half for $400k and ours for $2.2m for a total of $2.6m on buildings we valued at $4.4m so he was getting them for about 50% of their value anyway. He said: ‘See ya in court.’

Ten minutes before the hearing began, Jenkins asked again. I said ‘$2.2m’. We dickered for a few minutes and settled at the courthouse door for… $2.1m.

This got Terrace Investments Ltd. going—eight years later (in 1990) we acquired the Ottawa Senators franchise from the NHL for $50m; some of DevCo’s money was in that deal.)

14. Owning your own real estate gives you more financial flexibility—borrowing based on real estate collateral is usually much easier than say using your IP to secure a loan. The financial markets are much more developed and flexible for real property (at least in NA) than for Intellectual Property. Home equity loans are generally readily available to homeowners if they have a good credit rating (and sometimes even if they don’t). Home equity loans are the largest single source of capital to start your own business. They are also used by homeowners if they get into financial trouble or lose their jobs*.

(* Appraisers are the gatekeepers to the mortgage system. Lenders both major institutional lenders (like Charter banks) and secondary lenders as well as most private lenders, base much of their loan decisions on two things—their LTV (Loan to Value Ratio) and the Appraised Value, AV.

The Loan Amount (LA) is determined by the following simple formula:

LA = LTV x AV.

So if the Appraised Value is equal to the Purchase Price, PP of a property you just bought, the Loan Amount will be:

LA = LTV x PP.

However, Appraisers tend to be conservative people and they are often being paid by the Lenders or, even if you are paying for their services, you must use the Lenders approved Appraiser. The Lender is usually sending them a lot more work than you are, so naturally they tend to look at things from the Lender’s point of view. I find commercial appraisals are anywhere from 5% to 10% below FMV, Fair Market Value.

LTV ratios vary. Most residential lenders will lend 75% of the AV. You can get mortgage loan insurance from CMHC (Canada Mortgage and Housing Corp.) or private firms (e.g., GE Capital Mortgage Insurance) which will reduce the amount of equity you require to as little as 5% (i.e., increase the LTV ratio to as high as 95%).

Commercial lenders are even more conservative and their LTV ratios are typically 65% for office, commercial and industrial buildings and as low as 50% for land (if they will even do it at all).

Commercial lenders also may only loan against the Quick Sale Value, QSV of the project which is often much less than the AV. The QSV is what they can get for your project in a power of sale or forfeiture. Therefore, we find:

LA = QSV x LTV, in some risky commercial projects. Many of these projects get off the ground either with very large amounts of equity or secondary financings.

Secondary financings include second mortgages, mezzanine financings, cashflow financing and lines of credit. Every form of secondary financing is really a form of equity; only the first mortgage is truly debt. Secondary and tertiary financings almost always have the right of redemption—which means that if the first mortgage goes into default, they have the right to cure the default and take possession of the property either through a Power of Sale proceeding or Forfeiture.

What you are typically hoping for in these circumstances is to build your project, get it off the ground, prove the revenue stream and drive the AV up so you can refinance the project and take out the secondary financings within a reasonable amount of time.)

15.Nations that are made up of homeowners and business owners who own their own real estate are usually more robust societies where ownership of real estate conveys a sense of permanence and social responsibility and civic pride.

16.Buildings don’t tend to run out on you—if you operate a consulting business, your assets go home every night. They can always find new jobs and your IP goes with them. If you own a tech business, your market position can melt away virtually overnight. (Don’t think so? How about URL shortener www.TinyURL.com being knocked off by competitor www.bitl.ly because the latter makes long URLs into 20 character URLs instead of 26 characters. Plus Bit.ly did some other smart things like make it easy to copy the new URL to your editor and let’s you see how many people have clicked on those short URLs that you have created, a very useful traffic number to have.

Here is an example:

http://www.dramatispersonae.org/EnterpriseOfTheCity/HomePage/KingOfExxon.htm (76 characters) becomes: http://bit.ly/4u3XTG (20 characters) or http://tinyurl.com/y9p6ba6 (26 characters).)

Sample Calculation of Internal Rate of Return, Cap Rate (Capitalization Rate) and ROE (Return on Equity)

Calculating your ROE is really not a simple thing. Almost certainly the best way to calculate it is to use the IRR (Internal Rate of Return). This takes into account the time based value of money and can produce an accurate rate of return for the overall project, your equity portion of the financing and the sub-debt position (second mortgage financing, VTB (Vendor Take Back) financing, debenture financing or mezzanine financing…) if any. I show how to calculate the IRR for a home owner at: http://www.dramatispersonae.org/SampleIRR2.htm.

This is a simple example but it demonstrates some important principles—the IRR on your equity is highly sensitive to leverage. For a 25% down payment, your IRR is 22.1% p.a. With just 5% down, it jumps to 56.4%.

So if you take your 25% equity and buy 5 homes with 5% down instead, you are going to end up with a much larger cash-on-cash return than if you just have one property. For one investment property with 25% equity in it, I show cash returned over 5 years is $89k. For five investment properties with 5% equity in each, I show cash returned over 5 years is $254k.

If you would like to download the spreadsheet in .xls format to your PC, please do so. GO GET IT. Now that you have it on your PC, you can fool around with the assumptions and see what different amounts of leverage do to your returns and risk profile. You can change other assumptions and conduct your own sensitivity tests…

If you are feeling really ambitious, you can try your hand at our ‘perpetual motion machine’—this model is designed to answer the following question: “How many rental homes do you need to buy (or build) and how much of your mortgages do you need to pay off before the system produces enough free cashflow that will then allow you to buy (or build) more rental properties without pumping in any more equity?” GO GET THIS ONE TOO: http://www.ottawarealestatenews.ca/PerpetualHomeBuying.xls. (Thanks to former student, Ryan Pearce, for developing this model with me.)

Minto Construction, a large Ottawa-based company, is living proof that this model works after a fashion. One of the Founders of the company, Irving Greenberg, once told me that the best day in his business life was when the Government of Ontario under (Conservative) Premier Bill Davis introduced rent control in Ontario circa the 1970s. After the introduction of rent control, Irving made more money than ever from his residential rental property. First, there was less competition as builders, developers and investors foolishly fled the market and, as a result, his vacancy rates fell. Second, he was able to buy his competitors cheaply and add substantially to his portfolio. Third, he was able to pass on rent increases every year since such increases were ‘government approved’ and tenants had nowhere else to go anyway. Fourthly, he could be picky about his tenants and damage to his units and maintenance costs went down. Fifthly, he could pass on the costs of upgrades, repairs and maintenance to his tenants again in additional government approved rent hikes every year.

Rent control was a travesty in my view—it certainly didn’t help those who most needed help, aka the poor who are disproportionately single mothers.

Minto ended up with tens of thousands of rental units in Ottawa, Toronto and Florida and tens of millions of dollars in free cashflow too.

The Cap Rate

Most real estate professionals do not use the IRR however—they use Cap Rates to compare one project with another. The Cap Rate (‘Capitalization Rate’) is an approximate measure, as all financial measures are anyway. But they are way more approximate than the IRR is. Nevertheless, it’s a handy first order of magnitude measure. The Cap Rate can be determined by simply dividing the Gross Operating Income of a property by its Selling Price.

One way to look at the inverse of Cap Rate is that it is an approximation for the number of years it will take you to earn back your capital. It is widely used in the commercial real estate sector. The higher the Cap Rate, the better it is for the Buyer and the worse for the Seller.

Another way to look at the Cap Rate is that it is a rough measure of your rate of return on the project—it measures the rate of return on the overall project not your equity (unless you finance 100% of the property with equity).

For a project with financing that is provided by both equity and first mortgage, we can determine the Cap Rate as shown below.

Cap Rate = ROR, where ROR is the Rate of Return for the entire project.

ROR = (NOI + CRF (i, A) x (Selling Price or Purchase Price– Equity))/Selling Price or Purchase Price, where NOI is the Net Operating Income, CRF is the Capital Recovery Factor, i is the cost of borrowing and A is the amortization period.

Thus,

Cap Rate = (NOI + CRF (i, A) x (Selling Price – Equity))/Selling Price. Basically, the NOI + CRF (i, A) x (Selling Price – Equity) is the Gross Operating Income for the project.

If the Amortization period approaches infinity, the CRF = i. In this case, we can say that the Cap Rate can be calculated as follows:

Cap Rate = (NOI + i(S.P. – E))/ S.P., for A à infinity.

As the Equity in a project approaches zero (100% of financing is debt), we can calculate the Cap Rate as follows:

Cap Rate = (NOI + i x S.P.)/ S.P., for E à zero.

But NOI will be zero if E = 0 assuming that the selling price is jacked up to the point where all income is used to support debt. In that case, we have:

Cap Rate = (i x S.P.)/ S.P., for E approaching zero and NOI approaching zero or Cap Rate = i. Q.E.D.

What we have done in typical engineering fashion is to look at the boundary conditions for our formula and discovered that under certain circumstances, the Cap Rate is simple equal to the cost of borrowing. This gives you a first order of approximation for determining a Cap Rate for a project and explains, in part, why real estate is so sensitive to changes in interest rates.

The higher interest rates are, the higher the Cap Rate will be and, hence, the lower selling prices will be. The opposite is also true. Obviously, Buyers want to purchase property with the highest possible cap rates and Sellers want to sell at the lowest possible cap rates.

Real estate is highly cyclic and moves largely with interest rates. As we found out above, higher Cap Rates imply lower Selling Prices but, by definition, it also means lower Purchase Prices.

Do you want to make money in the real estate business?

Then buy when everybody else is selling (i.e., when Cap Rates are the highest and interest rates are the highest) and sell when everyone else is buying (i.e., when Cap Rates are the lowest and interest rates are the lowest). A simpler way to put it is: “Buy low, sell high.”

Now this is easier said than done. People are very sheep like. We like to buy what everyone else is buying. Ever bought a suit and had the sales person tell you: “This is really in this season—everyone who is anyone is buying this.” They tell you this because it works.

It’s hard to buy real estate when no one else is and interest rates are high. Everyone will tell you not to—your CFO, your auditor, your bank, your spouse, your BOD (Board of Directors), your CAO, COO, even your CTO (Chief Techie) will not want you to—she or he will want more dough for their department instead—it’ll have a better ROR, or so they will tell you. But you are the CEO and, at the end of the day, the decision is yours.

The best deals I ever did (and if only I had stuck to Real Estate and not got into hockey and other distractions) were when the real estate markets were depressed. I bought some land in Ottawa near a major, east-end shopping centre in 1983 when interest rates were 19%. The land cost me $1 per square foot for ten acres. In 1984, I got an offer for the land at 50 cents a square foot—I thought I was in real trouble. But I went to my Dad and he reminded me about rule number 1—buy low/sell high and I declined the offer.

By 1985/86, interest rates were down by half and I sold four acres for $10 per square foot to an auto dealer and the other six acres to an industrial company for $12. We made about $4m in three years on an investment of $450k; you don’t need to do an IRR calculation or ROR or ROE on deals like this—they are good deals. (That money too later found its way into the Sens, ugh. Money in NHL hockey seems to go on a one way trip—in, but never out.)

In 1994, the real estate biz was again in a slump. (These down cycles seem to come about every seven years and real estate tends to lead the national economy into a recession and lag it coming out which means it usually lasts longer than the general recession. But when real estate bounces up, it bounces in a hurry and you have to start selling right away if you want to time the market). I bought 60 acres of industrial land in Kanata for just 15 cents a square foot. I couldn’t believe it—people were just giving the stuff away—prices were lower than at any time since the Depression of the 1930s for goodness sake. By 1999, in the tech boom, serviced industrial land in Kanata was selling for $6 to $8 per square foot, if you could find it.

A client of mine is looking at buying a building in Ottawa for his packing supplies business. He is following my advice—own your own real estate. The SodaPop Building is selling for $4.8m. His biz will occupy about half the premises and the other half he will rent out. The Cap rate for his acquisition is:

Cap Rate (SodaPop Building) = (NOI + CRF(I, A) x (S.P. – E))/ $4,800,000 = ($301,736 + $313,864)/ $4,800,000 = 12.825%.

From his point of view (as the Purchaser), this looks pretty good. Cap Rates for industrial property can easily climb to 9, 10, 11, 12 or even more which would mean a much lower cost of acquisition for Paul (not his real name).

As discussed above, another way to look at the inverse of the Cap rate is that it is a rough measure of how long it takes to get your money back. Another useful engineering approach to problems is to check your units, viz:

Inverse of Cap Rate units = $/($/yr. + $/yr.) = $/$/yr. = yr.

So Paul’s new project will take 7.8 years to return all of its capital back to Paul (his equity) and to his debt holders. That is pretty fast if you think about the average homeowner taking 20, 25 or 30 years to pay off their home mortgage which many actually never accomplish.

But Paul should be much more interested in when he gets back his equity—this means he can turn around and do something else with his equity—buy more real estate, buy more equipment for his packing supplies biz, go on a nice holiday, buy a boat, whatever.

You get an approximate time for Paul to get his money back by simply dividing his Equity by the NOI. This works out to $1.2m divided by $301,736 or roughly 4 years. The IRR is a much more precise tool but it seems that the industry is just much more comfortable with a ‘rule of thumb’ cap rate approach.

Now let’s look at the cap rate for a small investment property. Let’s use as a n example, a multi-residential building, “Langlier Place” which has 12, 1-bedroom units and 36, 2-bedroom units. Note that it is important to know whether the cap rates you are using are effectively net or gross cap rates. The cap rates calculated above used gross operating income; for small investment properties it is typical to use net operating income where NOI is found by subtracting operating costs that the owner must pay from revenues received. The operating costs do not include either depreciation or mortgage interest. This is because cap rates remove from their calculation the debt structure of the owner. Obviously, a large well funded REIT, Pen Fund or Insurance Company will have a lower COF (Cost of Funds) than a typical private investor.

Therefore, for cap rates to be useful to compare one property with another similar one (similar in terms of quality, location, age, etc.) , you need to remove the impact of different capital structures.

Langlier Place—Owner’s Pro FormaLanglier Place—Appraiser’s Pro Forma

Revenues

YEAR 1 YEAR 2 YEAR 3

Rent $688,000 $694,000 $698,000

Parking and Laundry $ 24,000 $ 24,800 $ 26,400

Total $712,000 $718,800 $724,400

Expenses

Realty taxes…………………………………………………… $ 52,800

Water………………………………………………………….. $ 9,800

Hydro………………………………………………………….. nil*

Insurance………………………………………………………. $ 7,800

Maintenance and Repairs……………………………………… $ 5,500

Painting………………………………………………………… $12,000

Supplies………………………………………………………… $ 1,300

Elevator maintenance…………………………………………… $ 1,100

Accounting and Legal…………………………………………… $ 3,000

Superintendent…………………………………………………. $ 22,000

Mortgage Payments** (Principal and Interest)………….………$404,186

Total Operating Costs…………………………………………. $519,486

Potential Gross Income

12, 1-bedroom units @ market rent of $900 each……………. $129,600

36, 2-bedroom units @ market rent of $1,325 each………….. $572,400

Sub-total……………………………………………………… $702,000

Additional Income

Parking, 42 spaces @ $55 per month………………………… $ 27,720

Laundry, 5 w/d @ $30 per month…………………………….. $ 1,800

Total Potential Gross Income………………………………… $731,520

Less vacancy allowance of 6%………………………………………….-$ 43,912

Effective Gross Income………………………………………. $687,628

Operating Costs

Realty taxes…………………………………………………… $ 52,800

Water………………………………………………………….. $ 9,800

Hydro………………………………………………………….. nil*

Insurance………………………………………………………. $ 7,800

Maintenance and Repairs……………………………………… $ 5,500

Painting………………………………………………………… $12,000

Supplies………………………………………………………… $ 1,300

Elevator maintenance…………………………………………… $ 1,100

Accounting and Legal…………………………………………… $ 3,000

Superintendent…………………………………………………. $ 22,000

Property Management (3% of Effective Gross Income).…….… $ 20,629

Total Operating Costs…………………………………………. $135,929

Net Operating Income…………………………………………. $204,914Semi-Net Annual Operating Income………..…………………. $551,699

Selling Price…………………………………………………. $6,500,000

Cap Rate…………………………………………………….……..8.49%

(* Paid by Tenants.)

(** Mortgage is a Canadian mortgage of $4.2 million with an interest rate of 7.25% and amortization period of 20 years.)

You will notice that the Cap Rate for Langlier Place is calculated using a ‘semi-net’ operating income. This shows how difficult and seat-of-the-pants Cap rates can be. As long as you know how the cap rate you are being quoted was used, this can be a useful way to compare one property with another. But what if someone is using NOI and someone else is using a semi-net number and someone else is using gross income? Use cap rates carefully.

The ROE

Another simple (and very approximate) way to measure returns is as follows:

Total ROE = ROE (Cash-on-Cash Portion) + ROE (General Real Property Inflation) + ROE (Average Principal Repaid) + ROE (Tax Advantage on Unearned Rents)

Here is an example taken from some work I did for a client of mine who bought an 80,000 square foot industrial building, in part for their own use and in part to lease out to third parties (most of whom are in their supply chain so that there were some operational synergies that don’t show up in these calculations). I have changed the numbers a bit to protect their identity.

Sample Calculation of Approximate ROE for Acquisition of Soda Pop HQ

Cost to Acquire Soda Pop HQ Building80,000s.f. $60.00 per s.f. $4,800,000

Equity 25%$1,200,000

First Mortgage 75%$3,600,000

Annual Payment 6%20year amortization ($313,864.41)per year

Total Rent 80,000s.f. $9 per s.f. per year net$720,000 per year

less vacancy allowance 10%($72,000)per year

less real estate commission on rents 5.00%($32,400)per year

Total Net Rent $615,600 per year

less annual payment of mortgage ($313,864.41)per year

Total NOI $301,736 per year

Cash on cash ROE 25%per year

plus approximate Annual Inflation in Building Value 0.75%p.a.3%per year

plus ‘wealth’ effect of AVERAGE annual principal repayments $180,000 per year15%per year

Total approximate ROE 43%per year

Why Not Invest in Real Estate

I realize the title of this section can be read in two ways—why not invest in real estate or why not to invest in real estate. I wish to address the latter here.

What are the negatives of investing in real estate? There are many risks and real estate investing is not all rosy. Here are a few pitfalls to watch for:

a)Transaction costs are significant especially if you trade frequently. Transaction costs include: legal fees on completion, accounting fees, Land Transfer Taxes, adjustments on closing (e.g., for pre-paid realty taxes), GST (Goods and Services Taxes in Canada on certain types of real estate like residential rentals and almost all commercial property), withholding taxes for non-residents (income tax withholdings), realtors fees, etc.

b)Lack of liquidity—real estate sales and closings can take a long time. Widely-held stocks, for example, can be sold in a few hours or days.

c)Bad tenants.

d)Cost overruns on construction or renovation.

e)Storms and other natural disasters.

f)Vacancies.

g)Outdated design, floor plans, uses (e.g., a few years ago, everyone wanted to build server farms until they realized that servers are small and getting smaller and more powerful all the time and, hence, don’t take up a lot of floor space).

h)Delays in completion of new construction or renovation.

i)Long planning cycles made more difficult by NIMBY (Not In My Back Yard) behaviour.

j)Long delays in acquiring building permits.

k)Low appraisals.

l)Degradation of the neighborhood/bad neighbours.

m)Increased costs—hydro and insurance especially.

n)Surprise maintenance.

o)Dishonest property managers. (It is surprising how much residential rent is still collected in cash. A dishonest superintendent who runs off with one month’s rent from all your tenants can bankrupt you in a hurry.)

p)Down cycles in the market.

q)Being upside down on equity (see below).

r)Negative changes in tax regimes like increasing capital gains taxes, reductions in allowable Capital Cost Allowance deductions against income and other income, rapid increases in realty taxes and gross leases where the costs can not easily be passed on to tenants.

s)Real estate is an intensely local business; success by you in one market does not necessarily translate into success in another.

t)RISING INTEREST RATES.

So there are a lot of risks in owning real estate and there is no way to avoid these risks entirely. One way to improve the odds is to buy low which we talked about above. A good friend of mine, Barry Lett, a real estate veteran and a survivor of many real estate down cycles, once told me: “You don’t make money when you sell real estate; you make it when you buy.” If you buy low enough, it makes up for many sins later on.

Now there area few other things you can do to somewhat de-risk the process—you can invest in more than one building, in more than one type of real estate, in more than one neighborhood and in more than one city as well as perhaps more than one country. To learn more about some real estate investing rules that I developed, you can refer to: If I were King (or Queen) of Exxon, I would….: http://www.dramatispersonae.org/EnterpriseOfTheCity/HomePage/KingOfExxon.htm.

One last note. Former Chief Justice of the SCC (Supreme Court of Canada) Bora Laskin once said that insurance companies are larger firms that exist to take advantage of smaller companies and individuals. He obviously took a dim view of the industry. I have always wondered why more real estate investors don’t self-insure. This would only apply to large sophisticated investors, of course. But if you owned 50 or 100 separate buildings in say a couple of cities, perhaps it would make sense to only have liability insurance on them. I mean what is the chance that all 50 of them will burn down at the same time? You would need to do some careful analysis but you might well be better off paying your ‘property insurance’ to yourself—build your own sinking fund and self insure. After 30 or 40 years, I am guessing you would have quite a sizeable fund that when you sell your portfolio, guess what, it belongs to you.

Conclusion

Now in our calculation of ROE above, there were no tax consequences from unearned rents taken into account, so don’t look for them. This is typical for commercial situations (unearned rent is a concept largely confined to homeowner situations).

Nevertheless, our client’s financial position was immensely improved by this acquisition of real estate; firstly, his cash-on-cash annual return was 25% p.a., i.e., they were pocketing over $300,000 in cash every year from their real estate ownership. The term ‘cash-on-cash return’ refers to the cash portion of your return divided by the cash (AKA cash equity) you have invested in the project.

Additionally, general real estate inflation adds 3% and average principal repayments add another 15% to their ROE. As noted above, we have assumed general market inflation in these types of buildings is .75% p.a. which results in a 3% bump in ROE. That’s due to the fact that all of the increase in building value is going to ownership. Ownership in this example has 25% equity in the deal so we multiplied by a factor of 4. Obviously, as the mortgage is retired, the percentage of equity in the deal goes up, and the ROE derived from general market inflation goes down but we already qualified this approach as an approximate methodology anyway. (The key benefit to being an equity owner is that all increase in value comes to you. Of course, if anything goes wrong, you are first to be wiped out—your debt holders have prior claim on the assets. Right?)

I have also used a simple and approximate way of calculating the order of magnitude of the wealth effect from annual principal repayment in the above example. I divided the principal amount of the mortgage by the amortization period—this gives the average amount of principal paid off a year (obviously, less principal is paid off in the early years and more in the latter part of the mortgage period). Then divide this by the equity invested in the project and you get the ‘wealth effect’ part of the ROE from simply paying off the mortgage. Bottom line—pay off your mortgage as soon as you can. Reducing debt (all debt) is one of the fastest ways to securing your financial future and simplifying your life too.

This seems to be a bit of contradictory advice—I showed earlier on that having five homes is better than having one—your cash on cash return is greater but it comes from having more leverage (debt). But actually the two concepts are internally consistent—by using more leverage, you are producing more cash which if used to pay down debt (instead of buying toys, say), actually reduces debt faster. Comprehendo?

Another way of looking at leverage is that by allowing you to buy say five rental homes instead of one, if you have a vacancy in one, your occupancy rate falls from 100% to 80% not from 100% to zero.

As long as you are not upside down on equity (i.e., your rate of return on your equity is less than the project’s overall rate of return), leverage is a positive thing. In high inflationary periods like the early to mid 1980s when interest rates were 19% to 21% and inflation was 12%, investors would buy real estate and accept the fact that their returns on equity were less than the overall project’s return and, indeed, were often negative. In simple terms, this means that they had to pump cash into their project’s every month. Say you purchased a $10 million office complex that was losing $15,000 a month. That means that somehow you have to come up with at least $180,000 per annum to keep from losing your project. However, if this type of real estate is increasing 1.5% above the inflation rate and the inflation rate is 12%, the selling price of the project is going up 13.5% p.a. or $1.35 million every year.

So investors would gamble that they could keep the property long enough to benefit from inflation. If our imaginary 1980s investor kept this building for two years and sold it for $10 million x (1.135) x (1.135) or $12,882,250, he or she would have made $2,882,250 less the cash he or she pumped in during that period ($360,000) or $2,522,250! We are of course ignoring transaction costs for the moment.

But this is intensely risky—1. you might run out of cash before you can sell it or 2. a person by the name of Paul Volcker might become Chairman of the US Federal Reserve and raise interest rates to 21% and crush inflation. So you are playing musical chairs and when the music stops, someone is always left without a chair. Make sure it isn’t you by buying smart—i.e., buy properties where cap rates are high enough that you don’t have to pump in cash every month to stay alive.

Prof Bruce

 

 

Bruce Firestone

Bruce Firestone

Broker
CENTURY 21 Explorer Realty Inc., Brokerage*
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