Counting on Appreciation = Speculation

July 2nd, 2010 · 6 Comments · Buying or Selling Your Property, Commercial Property, Property Management, Rental Property

Speculating or Investing?

We’ve been pretty lucky for the last few years with the exception of the dip in the market a while back. Everyone has been able to count on appreciation in the real estate market to make money. Making money in real estate has not required any skills except for having money to put down, having ok credit, and a job. Just buy and live there and you’re making money in real estate. There’s no need to add value or do anything fancy like save up a down payment.

I’m in Toronto but Vancouver is even worse. I found this blog called Vancouver Real Estate Anecdote Archive this morning and I like it as a sample of the madness going on over there. There’s plenty of craziness going on in the GTA too. Saying we’re not in a bubble because Vancouver is in a worse bubble is not exactly going to cut it when the BS hits the fan.

House prices increases are not supported by rent/price ratios or by increases in wages. That’s a problem. My dear old dad says when two professionals working full time can’t afford a house, prices MUST go down. Income properties are being sold to new investors sick of earning 2% in their savings accounts and burnt by the stock market. The only people doing proper Cap Rate Calculations as I illustrated at Million Dollar Journey in my post Landlord Math are CMHC.

I just revived my commercial agent who’s actually one of the good guys. He’s not selling too much because experienced investors just aren’t paying what this high priced market wants right now. I did an analysis over at Canadian Money Forum after some yahoo attacked my Landlord Math post. It’s bad.  I do an analysis on an income property presently listed in Toronto and I get asked if 5% is my minimum cap rate and I follow through and calculate the rate of return for an investor who puts down $300,000 in down payment on a $1,000,000 dollar building. Using a regular commercial rate of 5% and a 25 year mortgage the return is a whole $100 per month.

If you figure your cap rate properly you’ll take 22% of the gross income just as Maintenance, Property Management and Vacancy allowances. If you leave these out of your calculations and hope for the best you’d better have deep pockets to cover the difference or a plan to increase the gross income by that amount. It’s not really rocket science.

A few days ago an investor called me because she wants to invest in Toronto. I called up my agent and got every single property currently available in Toronto. I look through and there are some interesting ones in the batch. I’m still dismayed by the way real estate agents are calculating the expenses on property. You’d think they got their license by taking 3 correspondence courses and a one week class or something. Still it’s a worthwhile endeavor to put in offers. If you buy properly I believe you can buy something stinky, ugly and unattractive that no one else wants and turn it around. I spoke about this method of adding value in my very first post at Million Dollar Journey called Making Money in Real Estate.

The bottom line for income properties is you can’t spend appreciation unless you refinance, you can only spend income. If you want to know why so many buildings have deferred maintenance, this is the number 1 reason why. They can’t afford it or have to take the money out of their own pocket to perform necessary repairs. It’s going to get even more interesting when interest rates go up.

The good news is that now that you require a little more than your underwear to buy a property rents should go up as people have to save (Gasp!) to buy. Sure if you’re right downtown you’re still getting decent tenants with good credit but lots of buildings are approving applications that would shock you.  It’s like picking the best of the bad. I still clearly remember the rental agent who told me she thought people who had gone through bankruptcy were great because they had no debts and were likely to qualify for our 30% of income rule.

I’m no fortune teller, I can’t predict the future and I don’t pretend to either. I did find this awesome quote from Warren Buffet about the perils of speculation.

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.

Figure out the fundamentals of real estate investing!

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