Market cap compression: Don't get squeezed

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.