Every once in a while it’s appropriate to devote a column to young people trying to get started. An adult grandchild reading this might be willing to engage in a conversation that needs to be started.
Review: Samantha, Part 1
Income property provides four sources of income: (a) appreciation; (b) equity build-up;
(c) depreciation, and (d) cash flow. They are not equal and do not manifest at the same times. Leverage magnifies results. Suitably leveraged, income property can generate total returns greater than Warren Buffett’s Berkshire Hathaway.
Review: Samantha, Part 2
Finding what may be the best apartment investments could be a matter of knowing what to look for. The Takeaways from Pt 2 were (a) the best locations have lots of people who can afford high rents; (b) buy big units in good areas, small units in commodity areas; (c) to maximize Return on Investment, use as much OPM (Other People’s Money) as you can; (d) when interest rates are going up, refinance and lock your loan rates at whatever the current levels are (as rates continue up, you’ll eventually look very smart); (e) when rates are going down, let your mortgages slip into their adjustable period and follow the declining rates down.
We’ve talked about this before, but it’s appropriate to touch on it again as this article is intended for new-investors-in-training who may have missed some earlier discussions. The only value to an income investment is the income, thus the value of the entire project adjusts as its (net) income changes. It could go up or down. If the rental units are in an area where the only source of employment is the local asbestos factory and the company fails, the effect on the apartment’s net income could be disastrous. If net income goes down, value probably will too. It could even become unsellable. Detroit, anyone?
Alternatively, the purchase may have been made in a place where ever increasing numbers of people want to live, but buildable land is limited. Sometimes land limitations are political, like a building moratorium. Or they are amenity related, like a superb school district. Physical restrictions are probably the most obvious: both Miami Beachand Manhattanare islands, so available land is limited. And we’ve talked (September, 2011) about those few square blocks northeast of USC that rent for a lot more than what nearby apartments are getting. In all of these examples the consistent elements are demand increases faster than supply.
Other than increasing net rental income there is only one other driver to property appreciation that I know of: the capitalization rate, and it’s beyond our control as cap rates tend to track interest rates: as interest rates decline, so do cap rates; as they increase, so do cap rates.
If cap rates are at 7% the value of a building generating annual NOI of $100,000 would be $1,428,500. As rates increase, at an 8% cap the value of that same stream of income would become $1,250,000 ($100,000 divided by 0.08).
The opposite is also true. If rates decreased, the property value would go up. At a 6% cap the value of that $100,000 stream of income would be $1,667,000 ($100,000 divided by 0.06).
What we would prefer, if we had the choice, is for cap rates to be really, really high when we buy property and really, really low when we sell.
An investment is often characterized as “a return ON and OF your money”. That’s why we invest. We want to get interest / dividends / rents ON our money during the holding period and when we sell we hope to get back our original investment or more. We very much prefer to have the return ON our money be a different event from the return OF our money, but sometimes it doesn’t happen that way. If you sell a painting for more than you paid for it you get the return OF your money at the same time you get a return ON your money, so the two returns can be concurrent, but if the ON is entirely separate the investment’s value can be estimated through capitalization (cap rates) and pricing the property becomes more rational.
As we’ve noted in previous articles, for our purposes the definition of an investment is simple: an investment is simply the purchase of “a stream of income”. We presume the return of our money upon sale. It’s a matter of faith. If faith is absent . . . we don’t buy.
We don’t think it’s generally a good idea to buy something on a speculative basis, such that your money is tied up for an unknown period in the hope that someday you’ll meet somebody who will buy it from you, and you’ll be able to squeeze out a profit. The people who are good at this sort of thing are known as businessmen. That’s what David Gold did in 1982 when he started the chain of 99 cent stores. He bought “stuff” in the hope (successful, as it turned out) that it would eventually sell. He was assuming the (speculative) role of a businessman. Later, when the stores went public investors bought the stock based not on whether David could sell the bananas before they went bad, but because the profit on the soaps and soups would offset the potential loss on bananas. Notice that sufficient diversification morphs speculation into investment. And that’s why we don’t focus unduly on the return OF our money upon resale. With diversification, the odd loss is more than overcome by gains on the remaining portfolio.
With apartment buildings, diversification is accomplished by (a) multiple units, (b) multiple buildings, or (c) both (a) and (b).
Cap Rates 1 – Because few people are taxed exactly the same, cap rates are based on the annual cash flow from an investment before income taxes and before mortgage payments.
Cap Rates 2 – The capitalization rate is approximately similar to the “interest” rate on the investment. If you paid cash for a $100,000 taxi cab license which you leased to a driver for $500 a week after operating expenses you’d have a 26% cap rate ($500 weekly is $26,000 annually divided by $100,000). Formula 1: Annual net income divided by purchase price equals capitalization rate.
Cap Rates 3 – The cap rate reflects the risk profile of the investment. Cap rates come in bands. The first band is the equivalent U.S. Treasury rate. Since there is no meaningful credit risk – when our T-Bill is due we can be pretty sure the government will crank up the old printing presses and pay us off – this band represents the market’s estimate of annualized inflation over the term of the debt. As U.S. Treasury rates climb, cap rated automatically increase.
The second band compensates for risk. Theoretically, a 7% cap rate in periods of 3% inflation indicates the market expects this type of investment to fail 4% of the time. Practically speaking, since only short sellers enter an investment expecting it to fail, the “management risk” band becomes the expected net-of-inflation return on the investment in the 96% of successful cases.
Changing Rates – There is always a risk profile. Even U.S. government treasuries, said to be the world’s safest credit-risk investments, are subject to duration risk.
Duration risk is the effect on the value of an investment if interest rates change. Assume a perpetual $1,000 bond with a fixed rate of return of 10%. The bond is never redeemed (no return OF your money) because it’s perpetual. And every year it pays $100 interest (10% of the face value) regardless of the price paid for the bond. Formula 2: Purchase price times cap rate equals net income.
On the day you bought the bond interest rates were 10%, so the value of the bond was $1,000. But we know rates fluctuate, sometimes alarmingly so. A little time passes and market interest rates have become 2%. What’s the value of your perpetual bond? How much would somebody have to pay at 2% (the current market rate) to earn $100 a year? We’d have to capitalize the annual interest payment by the new interest rate to find that the value of the bond has increased to $5,000. Formula 3: Annual net income divided by cap rate equals value.
That’s essentially what happed to stream-of-income investments after rates peaked in 1981-82. As interest rates declined from their peaks, the value of stream-of-income investments climbed even if net income was level. The value of stream-of-income investments has been trending up for the last 30 years because interest / cap rates have been declining.
Note 1: Increasing net cash flows over this period meant property values increased higher and faster, but the trend of increasing values was established and maintained by declining interest / cap rates.
A little more time passes and rates start to cycle up. Increasing interest rates feed upon themselves, and it took a while for rates to go from 2% to 4%. It took less time to climb to 8%. From 8% to 12% happened very quickly. In this hypothetical scenario, rates peak at 25%. What’s the value of that perpetual bond now? It’s still paying $100 annually (net), and rates are 25%, so the value of the bond has declined to $400. See Formula 3. This effect on investments is the sort of thing that many people fear as the Fed begins to taper off Quantitative Easing: rates will go up and the value of investments will fall.
Note 2: Unlike perpetual bonds, apartment buildings normally experience increasing net income. As net income goes up it tends over time to offset cap rate increases. This can be reassuring and helps to mitigate but not entirely neutralize increases in cap rates.
From 1900 through 1960 typical mortgage rates were under 6%. In the early 1960’s rates began their climb, peaking at over 18% in the early 1980’s. From the 1960’s to the 80’s is a 20 year uptrend (http://activerain.com/blogsview/3746450/mortgage-rates-going-back-to-1900) in mortgage rates.
We’ve already noted that rates dropped from over 18% in the early 1980’s to beneath 4% in 2012. We had 20 years of rates going up followed by 30 years of rates going down. Our last interest rate cycle consumed about 50 years. If a new investor is in her 40’s or beyond before she accumulates enough money to make a down payment, she won’t be alive at the end of this new interest rate cycle. She may not even make it to the end of the 20 year uptick.
The interest rate cycle should not dissuade the new investor from her destiny. Twenty years to go from 6% to 18% is an average of 0.60% per year, or just over one-half point a year. Buying in good locations and properly managing your mortgage (see Samantha Part 2) should help offset that damage of an annual half-point increase in interest rates / decrease in cap rates.
Disclaimer: This article is for informational purposes only and is not intended as legal advice. For specific circumstances, please contact an accountant or your attorney.
If you’ve missed some of the prior articles, basic “beginner” guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com
Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email Klarise.Yahya@Charter.net.