Why houses/condos may fall in value but apartment buildings do not.

There is a common misperception that all real estate classes are created equal. House prices are falling in some cities in Canada, primarily because the rules to get mortgages have changed, such as increased debt-coverage ratios, higher down payments and shorter amortization. This allowed our Finance Minister Hon. Jim Flaherty to tighten consumer debt without raising interest rates! This leads some to believe that those (modestly) falling house prices will also affect other real estate classes, such as apartment buildings. Nothing could be further from the truth.

With the tightening of mortgages for single family units more people chose to rent, or longer; thus lowering vacancies and driving up rents and rental property values – an unintended, but expected consequence. If you look across our portfolio you will see higher rents and lower vacancies across the board compared to 2 or even one year ago. Thank you, Jim Flaherty!

An asset we bought in Dec. 2010 went from $14.65M to close to $20M not even 2 years later. This translates into a price of about 160,000’s per unit, up from the 120’s when we bought it less than two years ago. That’s a great cash-on-cash ROI on the roughly $5M cash invested into this asset that is co-owned by two of our LPs: PRISM A and one still open for investment, Kings Castle LP.

To get a perspective on what is going on, lets use the example of  a typical young married couple in Calgary. They can rent a nice 900 sq ft two bedroom unit with a balcony in one of our three storey walkup buildings for $1200, or so. Or they could spend a bit more, say $1500, and rent a nicer, newer, yet often smaller 850 sq ft two bedroom downtown condo. Alternatively they could buy that brand new condo for perhaps $300,000. Let’s do the math: 5% down: $15,000 – no problem. New mortgage of $285,000 at 2.99% plus CHMC fees = $295,000, amortized over 25 years : $1410/month plus condo fees of 30 cents a foot or $250, property taxes of $140 plus $50 insurance = $1850. So, more expensive per month to own that same condo with $15,000 invested with no guarantee for future upside for a while. Hmmm honey .. let’s rent a while longer. That discussion is happening in tens of thousands of rental apartments across the country, and people stay put longer.  Moreover that doesn’t even allow for folks who move to booming cities like Edmonton, Red Deer or Calgary. So you can see why rents have rocketed upwards lately.

In the run up to the boom, with rising prices, buying new was a no-brainer and people would opt to buy rather than rent due to sizable equity upside. Not such a no-brainer anymore. Construction is slowing too as investors don’t get a decent yield,  especially true in booming Alberta with construction costs also on the rise .

Result: low low vacancies and rising rents. To the point, a few short years into the future, if rents in our assets are up another $250 or so and interest rates remain the same the math will make sense to buy again. Then again if interest rates move higher .. even a slight 1% rise from 3% to 4%, it would increase the monthly mortgage payment by almost $200 to own that condo. So renting could well be en vogue for a while, just like it is where I used to live in Europe where roughly 50% of the population rents [Canada is still only about 35%].

What does this mean for an investor if rents go up $250, roughly a 20% sizable increase over the current rent of $1200?  If rents rise 20% values of the underlying asset go up roughly 20% too. However, lets say you only put  40% down and mortgaged the rest at super low rates of 3%? A 20% upside is a 50% ROI on your cash invested, so this makes investments in rental real estate such a powerful investment even in a flat (or declining) condo/house market!

Further market analysis: Sub 100/door in any major city in AB is usually garbage unless you get lucky. We’re buying an asset in a B area in B condition for high 90’s/door next month in Kings Castle LP with the cash at hand. Little decent inventory around but still far better cash-on-cash return with lower risk than the stock market, and higher than bonds.

An asset we bought for 30’s/door in Fox Creek, AB in 2005 and sold for 70’s/door in 2007 with a triple digit cash-on-cash ROI is now listed in the 80’s/door .. in a town of not even 2500 people halfway between Edmonton and Grand Prairie.

CAP rates in Vancouver are around 4%, or lower even. A building that just sold in Kitsilano, for example, sold for 28 times annual rent .. twice what you’d pay in Edmonton .. say 12-14 .. CAP rates in Calgary are around 5%, and in Edmonton 5.5% to sub 6%, similar to Burnaby, New Westminster or N-Vancouver.

Many good condition assets or in good locations are not for sale or below that CAP rate in the 130-150/door in Edmonton, the 165 to 200/door range in Calgary, or 250+ in Greater Vancouver. 

Everyone (like insurance companies, pension funds, REITs, high net worth individuals, retirees, ..) is scrambling for decent, sustainable, long term yields with low risk, apartment buildings in good locations that are impeccably managed. Provide that!

I expect CAP rates to drop further, Calgary to around 4% and Edmonton to 5%, as interest rates will stay low for a while. Long term CMHC insured money is at 2.4%, without CMHC at around 3%. So, it makes sense to borrow and buy an asset with a yield that is 50-70% higher (i.e. 4 to 6%).

I am not too familiar with GTA, Ottawa, Winnipeg or Halifax, but quality assets are there also between 5 and 6% CAP rates, about a percent higher in dubious locations.

If an asset in Edmonton that is valued today at $5M with an net operating income of $300,000 and thus, is valued using a 6% CAP rate, what would happen if the CAP rate drops to 5.5% or even 5% ? It means that this asset is now valued at $5.5 or even $6M ($300,000/0.05). Couple this with expected rent increases and you can see how the Calgary asset improved so drastically in value with rents up over 15% in 2 years along with a CAP rate drop.

We also expect interest rates to continue to stay low for quite some time, as democracies around the world try to shed their debt. As this is tougher than deflating the currency through quantitative easing, i.e. creating more borrowing capacities by their respective central banks, politicians pick the easy route.

Thus, it continues to make sense to borrow money cheaply at 2.5% to 3% and invest it at 4-6% or 50-70% higher! This is what we do, and have become experts at, in rental apartment buildings, in growth markets, in decent locations, impeccably managed, sensibly levered with cheap and widely available money. It’s like owning gold .. with a yield !

Care to join us ?

Sincerely and successful investing,

 
Thomas Beyer, President

Prestigious Properties Group

T: 403-678-3330   www.prestprop.com

 
P.S.: This LP is currently open for investment (in larger amounts only for non-residents via a PrestProp holding company to avoid these annual withholding tax issues) with optional 5% cash-flow and equity growth, with a verified target ROI of around 10%/year. 

P.P.S.: I love Europe, which I visited in September, as a vacation destination, but not as an investment environment for stocks, real estate nor debt. Canadian land or apartment building investments make far more sense as we have decent GDP growth, huge natural resources the world wants and needs, immigration, job growth, high quality of living standards, low debt and low deficits, especially in Alberta with a baby boom. With an NDP looming in BC in 2013 and high deficit & high electricity rate Ontario we will not invest in these provinces at the moment and carefully divest or maintain a position at best.

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Michael addresses the good news that is out there and why he is relatively positive about 2013 in this Mid-Week update.

Michael also talks about the “boiling pot” of the US Presidential Election, the uncertainty and potential that its resolution may end up replacing Ben Bernanke, his policies, as well as the subsequent effect that might have on interest rates. 6 minute audio:

{mp3}midweekupdateoct24{/mp3}

Update: In the last month Tyler Bollhorn bought Dara Biosciences and sold it five days later for a 40% gain. Overall in the month of September he made money on 90% of his trades. 

25 years ago, on another Monday in late October, the financial world seemed to disintegrate in a heartbeat. Though the 205 point drop in the Dow last Friday (the technical anniversary of the ’87 Crash) was somewhat reminiscent of its 108-point drop on Friday, October 16, 1987, the real action in ’87 was on the Monday that followed.  And while this Monday is not nearly as black, it is important that we use the opportunity to recall the circumstances that nearly sent the stock market into cardiac arrest. 

While there were technical reasons that allowed the snowball to gather so much mass, it was major economic problems that started it rolling. Those issues remain to this day, but have grown much, much larger. But while they terrified the market 25 years ago, they don’t rate a second look today. Whether investors have gotten wise, or merely oblivious, is the question we should be asking.

Though most simply remember the 1987 Crash as one panicked selling day, Black Monday was just the largest drop in a string of bad days. On the Wednesday before, the Dow sold off 95 points (then a record) and dropped another 58 points on the Thursday. On Friday the selling got worse, with the Dow setting another record with a 108 point drop. After thinking about it over the weekend, investors decided to preserve what remained of their gains by selling on Monday. Unfortunately, everyone got the same idea at the same time. 
 
It is true that the Crash was in some ways a technical phenomenon. As of August of 1987, stocks had surged 75% from January 1986, and 40% from January 1987. After such an upswing, it was inevitable that investors were on edge. Rather than taking profits, many on Wall Street instead hedged their positions using the new, and largely untested, trading programs that were designed to put a floor under losses if the markets turned south. But when the selling came in waves, the machines went into overdrive. Selling begat selling and an automated rout ensued. When the dust settled, the Dow was down 22% in a single day.
 
If that was all there was to the story, we would be left with a neat cautionary tale about the folly of placing too much faith in machines. But that is a distracting sideshow. In truth, the market was spooked by concerns over international trade and government debt, which then became known as the “twin deficits.” After widening earlier in the 80’s, investors had hoped that these gaps would come under control. But as Ronald Reagan’s second term wore on, those hopes faded.  
 
From 1982 to 1986, the U.S. trade deficit had expanded 475%from $24 billion to $138 billion. Most economists blamed the trend on the dollar gains in the early 1980’s, which had apparently made U.S. products uncompetitive. As it was assumed that a weakened dollar would solve the problem, in 1985 the leading western democracies and Japan announced the Plaza Accords to systematically push down the dollar against the Japanese yen and the Deutsche mark. By 1987, the plan had “succeeded” devaluing the dollar 51% against the yen. But by the second half of that year it became apparent that the Plaza Accord had failed in its real mission to cut down on the U.S. trade deficit. Despite the plunging dollar, the deficit expanded that year by another 10% to $152 billion.

At around that time, the U.S. government budget deficits also became a major concern. Everyone remembers Ronald Reagan as a small government champion, but many conveniently forget that he presided over a significant expansion in government spending. Federal deficits rose 199% from 1980 ($74 billion) to 1986 ($221 billion). Although the deficit came down to $150 billion in 1987, many were frustrated that it remained stubbornly high by historic standards.  
 
As early as August of 1987, concern over the twin deficits, which together accounted for 6.4% of the nation’s $4.76 trillion GDP became critical. Given the prior run up in stocks, this was enough to convince many investors to head towards the exits. Before Black Monday (October 19), the Dow had already declined 18% from its August peak. 

When we look back at those events from the current perspective, it almost seems comical. Government deficits now approach $1.5 trillion annually and annual trade deficits exceed $500 billion. Today’s twin deficits now add up to more than 13% of current GDP (twice the level of 1987). But today’s investors are largely untroubled. Oftentimes news of a falling dollar and wider deficits will spark a stock rally, and the issues barely rate a mention in a presidential debate.

Are investors today simply more sophisticated than they were then? Have they lost an irrational fear of deficits? To the contrary, I believe that we have arrived at a point where money printing and government stimulus has replaced manufacturing and private sector productivity as the foundation of our economy (see my lead commentary in the October 2012 edition of theEuro Pacific Global Investor Newsletter for more on this). As a result, most investors are now blind to the dangers of deficits. But that does not mean that they don’t exist. 

When America’s creditors wake up, particularly those foreign governments now shouldering the lion’s share of the burden, concerns over our twin deficits will return with a vengeance. As the problems now loom larger than ever, so too will the economic and market implications when the issues come to a head. Interest rates will surge and the dollar will fall. But the U.S. economy is not nearly as well equipped as in 1987 to withstand the stresses. Given the relative size of our imbalances, the manner in which they are being financed, and the diminished state of our manufacturing sector, higher interest rates and a weaker dollar will exact a much greater toll.

Despite this, I do not believe that the stock market is as vulnerable to another Black Monday. With the Federal Reserve so committed to its current course of quantitative easing, it seems to me unlikely that they will allow such a steep one-day drop. Also, with bond yields so low, domestic investors are currently presented with fewer attractive options. If anything, the next Black Monday is more likely to occur in the currency and/or bond markets, with safe haven flows moving into gold not treasuries.

Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show. 

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