Question About A Negative Cap Rate Purchase

August 19th, 2010 · 4 Comments · Buying or Selling Your Property, Personal House, Property Management, Rental Property

I received a great question yesterday about a couple considering buying a cash flow negative property.

Rachelle,
I really enjoy your blog and have found it to be a very useful source of information.

My wife and I live in an Ontario city with a very high vacancy rate and downward trending real estate prices.  We live on our salaries, and have access to some capital and a tiny bit of extra time, and have been exploring purchasing a rental property to buy and hold to create some equity for our retirement in about 15yrs. Given the state of our local real estate market, I think it would be relatively easy to find a cash-flow positive property, but we would be earning every dime of that money the hard way with lower-end properties, lots of tenant turnovers, and definitely no appreciation.

We came up with the idea of buying a mid to upper end condo in a city we both like…Ottawa.  Although it is 8+hrs away from us, it has a very low vacancy rates, pricing seems less bubble-icious than Toronto, and we would likely even consider living in the place post-retirement.  Given the distance from our home, we would definitely need a property manager to assist with day-to-day stuff and rentals.

My question is this:  When we do the cap rate numbers for some to the pricier-properties (one’s we’d consider living in eventually) the rents we’d be able to get mean that we’d be cash flow negative by a couple hundred bucks a month (which we could handle no problem) and the Cap Rates are below 4%.  We view the monthly  negative cash flow as a price we’re willing to pay to have an investment in a market with a better shot at appreciation, as well as fewer headaches given that it is a upper end condo property, with a hired manager.  We could improve the cap rates and cash flow by looking at lower price point condos, but then we’d have to liquidate when we are ready to move up there, and who knows if the headaches would increase.  Are we crazy for even considering a likely cash flow negative property given all of the other background factors we are also considering?  We’d appreciate your thoughts on this given your experience.

Awesome Questioner

First of all you aren’t crazy, you are people of great taste and discernment because you like my blog. Secondly, you are wise because you are asking the question. Thirdly, you are being honest instead of fudging the numbers to agree with what you want to do. All in all you’re well ahead of the vast majority of investors! I’m not at all joking about this. Your honest assessment of yourself and your skills and your goals is an excellent start.

Bad Areas

I can’t blame you at all for avoiding Windsor with 15% vacancy rates. This kind of challenge is best avoided by any but the bravest of investors going in well prepared and well capitalized. You are right on with your assessment of the situation. This is an advanced level project.

My Recommendations

My thoughts are that the real estate market is going to readjust. Going forward a few months the fear will begin to take hold. It is starting now, the headlines every day talk about “the crash” At this point, opportunities will begin to appear for the wise investor. Prices will start to trend downward. So I would wait a little while…maybe 3-4 months maybe longer. It all depends on what you find.

Condos Are Crappy Investments

I don’t like condos as investments because the maintenance fees are out of your control. You buy it and then a few months later… the maintenance fees go up several hundred dollars. You don’t realize this when you buy your unit but you are actually buying a portion of the entire building along with all the associated liabilities. There are also special levies and special assessments and out of control boards. This is not such a big deal if you buy it to live in it yourself because you like it and get to enjoy the use of it. Over the time frame you are thinking about (15 years) I am reluctant to recommend it. Additionally, even though the condo you buy today seems great and you would like to live in it now, by the time you are ready to retire,  the building, the kitchen, bath and possibly even the location may be dated. Remember dusty rose and grey?

Personal Residences Are Different Than Rental Properties

I am a firm believer that people should stop considering their personal residence as an investment. It may very well turn out that way, but the purpose of your house is two-fold. It should keep you out of the cold and wet and it should please you. You should consider the value/comfort equation you are happy with. The most profitable rental properties are rarely places that would suit your lifestyle in retirement.

An Alternative

An idea I would suggest for you, is to invest in your rental property for cash flow. A major center like Toronto or Ottawa is a good idea. Then in 15 years when you are ready to retire, remortgage the properties and buy a place where you want to live. I like a minimum of three units because usually any two units will pay the mortgage. You’ll want to select a gentrifying area. You don’t want location, you want prelocation. You don’t even have to sell the property, by then you’ll have sizable chunk of equity.

In Recessions High End Properties Are Difficult To Rent

You’ll want to own properties that appeal to the majority of people by location, price and quality. Rental demand is like a bell curve, you’ll want to be at the 1/2 to 3/4 mark of the bell curve if possible to attract an acceptable quality and quantity of tenant. Price means less than value to tenants. You don’t want to set your landlord business up competing only on price. People are prepared to pay more for superior accommodation. There is a limit to this ratio, you’ll also want the price to be affordable for many tenants. If your price range is too high in recessionary slumps no one will even come to view your property. In Toronto that cut off point in regular neighborhoods seems to be around $2000 per month for a house. Even if the property is spectacular, it takes longer to rent just because the amount of people who can afford it is low.

Proximity

I like the idea of being close to your property, even if you have a property manager. Set up systems to keep an eye on what’s going on. A property a few hours away can be checked easily by going on a Sunday drive. Start an email for your tenant’s maintenance requests like 123propertystreetname@gmail.com. Both you and your property manager can check it. This way you know if your tenant is being neglected and how timely responses are. You’ll need to strike a delicate balance between micromanaging and negligence. Trust but verify. It is your money and your asset and you are ultimately responsible.

These are my thoughts, thanks for the question. I hope it helps.

If you liked this post, sign up for RSS or Email subscription (top right) You don’t want to miss a thing! Today’s bonus is the infallible ability to read minds! You used to wonder what your spouse wanted for their birthday, now you’ll know it’s your total and abject submission to their every desire, every day without complaint as long as you both shall live. Cheers!

Tags: ·····

Get Your Free Landlord Documents Now! 

4 Comments so far ↓

  • Mr. Cheap

    Great response Rachelle!

    I’d be tempted to add that there aren’t many ways to be sure of “a better shot at appreciation” and buying with negative cash flow (which almost all properties have if the investor honestly calculates expenses) is a bad idea. It’s worked out for the last decade or so because of historically high appreciation rates, but there aren’t any guarantees going forward.

    I think your general approach of buying properties with problems, and making money by fixing those problems is a FAR better approach than betting on appreciation.

    If someone insists on gambling, why not just keep things easy and buy a REIT?

    • Rachelle

      Mr Cheap,

      You are so awesomely wrong about buying REIT’s. If you believe there is a coming fall out in real estate because it is overvalued… don’t you think that REIT’s will also take a massive hit? In any case, you just gave me a great idea for my next guest post. Thanks

  • Seymour Stern

    Great article, Rachelle! I may be late in commenting, but I only recently moved to Toronto from abroad. As a real estate investor looking for opportunities in this hotbed of activity here in the GTA, your blog is cool, yet level-headed and pragmatic. Trouble is, nothing I’ve seen in the GTA makes any sense whatsoever, unless one anticipates unlimited growth. Once interest rates inevitably go up, we may see a few months of opportunity as the over-leveraged investor community implodes while more passive fixed income investments become more lucrative for those still in the game.

    • Rachelle

      Thank you Seymour, there are still opportunities out there but they really aren’t things most people would willingly buy. You’ll need to think out of the box.

      Still last year I did see a potential 14 cap building go on the market. See it was mixed use commercial, and it was in receivership after the owner died. It was 50% vacant but the apartments were in awesome shape. Every suite had ensuite laundry, and separate services. It sold for $1.2 million about $1 per square foot.

      Plus it was in a gentrifying area…

      This is like my big fish story lol