No doubt, some of you read the title of this article and thought ... huh?
Well, "market cap compression" is just a fancy term for when prices for commercial real estate continue to rise. The market cap has an inverse relationship to the price/value of a commercial property. In essence, as the price/value of the property goes up, the market cap goes down or becomes "compressed." In the past few years we've seen significant market cap compression in the commercial sector, which is primarily a function of low interest rates coupled with no real alternatives to park investment dollars. The question is, what does this mean for the average investor either looking to buy their first property or their fifth?
1. Look outside of major urban centres
I've always been a major advocate of investing outside of the major urban areas such as Toronto, Calgary and Vancouver. As much as I would love to buy properties in those cities, the cap rates for multi-unit residential properties have reached historic lows and thus don't make economic sense for investors looking for cash flow. Five percent market caps have now become the norm in Toronto. I've even started to see caps as low as 3.5%. With caps that low, your investment property is unlikely to cash flow. Further, when the mortgage resets after the initial term, investors are opening themselves up to signficant risk if and when interest rates rise.
Why look to the smaller urban centres? Because cap rates in the smaller urban areas tend to be a percentage point or two higher than their more densely packed counterparts. That's not to say that all smaller areas are created equally. Investors need to focus on the key metrics to find the right place to invest which includes GDP Growth, low unemployment, low vacancy rates, population growth, etc... Smaller cities that investors should be looking in include, but is not limited to, Kitcher/Waterloo, Guelph, Cambridge, Hamilton, Durham region (Pickering, Ajax, Whitby, Oshawa) and Kingston.
2. Watch the bond markets
The bond markets are a critical metric and commercial investors need to keep an eye on them as they are used to establish the ultimate cost of funds (mortgage rate). Over the past 30 days, the Canadian bond markets have seen a significant increase in bond yields which will ultimately place upward pressure on commercial mortgage rates. In the longer term, if the movement in bond yields proves to be a trend and not just a blip, market cap compression will begin to reverse as cap rates have a close correlation to the cost of funds. Investors need to be weary in the short term that they aren't buying commercial properties today based on the recent trend of extremely low cap rates and getting financed at the new higher mortgage rates.
3. Lock into longer terms
With mortgage rates at historic lows, even with the recent run in the bond market, locking into longer term rates such as 5 and 10 year terms will make economic sense for most long term investors. This type of certainty allows for predictable cash flow and signficant mortgage paydown during your mortgage term. More importantly, it significantly mitigates the risk of rising interest rates.
4. Ensure you have a healthy spread
The key to profitable investing is to ensure that you have a healthy spread (the spread is the difference between the market cap and your cost of funds). Market cap compression in the larger cities such as Toronto have all but squeezed the spread in most cases to zero. To illustrate this point, the average 12-plex in Toronto has a cap rate of approx. 5%. The cost of funds for this type of property are typically between 4-5%. In essence, there is almost no spread, which means that the investment property is unlikely to cash flow. Even worse, the investor could be in a negative cash flow situation having to pull money out of their pocket every month. I personally like to work with spreads of 2.5% to 3% to ensure healthy cash flow and to provide a buffer should interest rates rise upon rate reset.
5. Be weary of too much leverage
Real estate investing and leverage go hand in hand. In fact, without leverage, most real estate investors wouldn't exist as they wouldn't be able to pay for their property entirely in cash. As much as I love leverage and have used it extensively to make significant gains, it must be approached with extreme caution. Basically its the old adage ... too much of a good thing. While taking on large amounts of leverage/debt may seem like a great idea now that interest rates are at historic lows, one must keep in mind that in all likelihood, when the mortgage resets in 3, 4 or 5 years from now, on a balance of probabilities, mortgage rates will be significantly higher than they are today. If you are overleveraged this can pose a significant problem with your cash flow and your ability to service your debt. As a rule of thumb 65% to 75% LTV, in a longer term (5 or 10 year) are usually a pretty safe bet.
Wednesday, August 28, 2013
Monday, August 19, 2013
True Tales About Termites
Termites are tiny wood-boring insects that are extremely destructive to homes and other buildings. They have been around since the beginning of time because they are adaptable to ever-changing environments. The most common type found, subterranean termites, is extremely tough to control. They’re of increasing concern to homebuyers in North America because they can cause serious structural damage.
Termites live in the soil, but feed off the cellulose in wood, breaking it down and returning it to the soil. Be forewarned that any untreated wood that comes into direct contact with the soil surrounding a home provides a perfect entry point for those destructive, menacing insects. And because they basically never stop working and eating for even a minute out of the day, their ability to tunnel their way through a home’s wooden structure and leave it destroyed is truly frightening. An average termite colony is over one million strong, and thanks to the fact that they remain unseen and cause their destruction under the surface, they can be very difficult to detect. If they are found in a home’s support beams, thereby jeopardizing the integrity of those beams, they can put the entire home at risk!
Termites live in the soil, but feed off the cellulose in wood, breaking it down and returning it to the soil. Be forewarned that any untreated wood that comes into direct contact with the soil surrounding a home provides a perfect entry point for those destructive, menacing insects. And because they basically never stop working and eating for even a minute out of the day, their ability to tunnel their way through a home’s wooden structure and leave it destroyed is truly frightening. An average termite colony is over one million strong, and thanks to the fact that they remain unseen and cause their destruction under the surface, they can be very difficult to detect. If they are found in a home’s support beams, thereby jeopardizing the integrity of those beams, they can put the entire home at risk!
Monday, August 12, 2013
Realtor Commission Rates
There was a time long ago when REALTOR commission rates were determined by the local real estate board or association.
However, that changed a few years back. Independent real estate brokerages now set their own REALTOR commission which they charge their clients. Having said this, many brokerages permit their sales people to choose their own real estate agent fees. They often insist, however, that their agents offer the cooperating brokerages, who represent buyers, a competitive real estate commission. In Ontario, a popular rate for the buyer brokerage is 2.5% plus applicable HST. This is determined by the seller and their REALTOR®, in compliance with the sales rep's brokerage policy, on an individual basis during client consultation.
Currently, in Ontario at least, with the change in market conditions from a strong seller's market to a more balanced market, we're beginning to see higher REALTOR commission being offered occasionally to buyer agents in order to attract attention.
Different brokerages may have different real estate commission policies, so a home owner certainly has various options from which to choose.
The old adage, 'you get what you pay for', often holds true in this situation. A full service REALTOR® will usually provide full service in return. And a discount or flat fee brokerage usually provides a discounted minimal service. When deciding about realtor fees, think about ...
The greater incentive you offer your REALTOR®, the greater chance your property will sell, not only because of the potential higher financial reward, but because they'll likely invest more of their own resources into the marketing of your property.
Realtor commission is negotiable. But remember that your REALTOR® may decline to accept the listing of your property if they feel the compensation is insufficient relative to the risk involved. REALTORS® work on spec, that is if (and it's often a big if) the property sells, they'll be rewarded for their efforts and risk, and compensated for their out of pocket expenses.
I also ask you to consider that in many areas, the vast majority of REALTORS® sell fewer than five or six properties annually. Fewer and fewer agents are generating an increasing number of the real estate sales. So, unless your REALTOR® is a top producer, they may not be able to afford to discount their fee.
However, that changed a few years back. Independent real estate brokerages now set their own REALTOR commission which they charge their clients. Having said this, many brokerages permit their sales people to choose their own real estate agent fees. They often insist, however, that their agents offer the cooperating brokerages, who represent buyers, a competitive real estate commission. In Ontario, a popular rate for the buyer brokerage is 2.5% plus applicable HST. This is determined by the seller and their REALTOR®, in compliance with the sales rep's brokerage policy, on an individual basis during client consultation.
Currently, in Ontario at least, with the change in market conditions from a strong seller's market to a more balanced market, we're beginning to see higher REALTOR commission being offered occasionally to buyer agents in order to attract attention.
Different brokerages may have different real estate commission policies, so a home owner certainly has various options from which to choose.
A Word to the Wise
The old adage, 'you get what you pay for', often holds true in this situation. A full service REALTOR® will usually provide full service in return. And a discount or flat fee brokerage usually provides a discounted minimal service. When deciding about realtor fees, think about ...
Incentive
The greater incentive you offer your REALTOR®, the greater chance your property will sell, not only because of the potential higher financial reward, but because they'll likely invest more of their own resources into the marketing of your property.
Bottom line?
Realtor commission is negotiable. But remember that your REALTOR® may decline to accept the listing of your property if they feel the compensation is insufficient relative to the risk involved. REALTORS® work on spec, that is if (and it's often a big if) the property sells, they'll be rewarded for their efforts and risk, and compensated for their out of pocket expenses.
I also ask you to consider that in many areas, the vast majority of REALTORS® sell fewer than five or six properties annually. Fewer and fewer agents are generating an increasing number of the real estate sales. So, unless your REALTOR® is a top producer, they may not be able to afford to discount their fee.
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