“Why are investment properties
This was a question sent to me recently and I feel my answer has value for others as well.
Factors That Determine Value
First I believe we need to understand how value is determined for real estate. There are several methods for determining value and they are as follows:
1) Highest and Best Use
No matter how old or new a property is, if the land it sits on could be used for a more prosperous business, then the value of the real estate will be determined by the developer of the new business.
For example, a cash flowing triplex on a busy corner lot may be determined to have a value of $400,000 based upon condition and cash flow.
But for a developer wanting to build a McDonalds or Tim Hortons at that busy location, the land may be worth $500,000.
2) Replacement Cost
This value is determined based upon building the exact same property with the same use.
This cost is usually higher than current market value because of the high cost of labour and materials. This determination of value is used by insurance companies.
With single family homes, this is the most common way to estimate the market value because you are simply comparing other properties of similar style/age that have sold in the same neighbourhood.
Adjustments are made to allow for different features and you would come up with a range of values.
4) Cash flow
This method is not used for single family homes simply because there is no cash flow related to a single family home.
However, when you start looking at rental properties, you start to enjoy cash flow. And the more profitable the property, the more valuable it becomes, so as an investor, I will pay a very fair price for a good quality cash flowing property.
To determine the profitability/cash flow you simply take all of the actual income related to that property and deduct ALL of the related expenses (excluding the debt service).
More Down Payment Isn’t The Answer
When it comes down to an investor looking for an investment property, the investor is looking at the overall condition and most importantly the cash flow (profitability).
If there is little or no cash flow, then the investor can’t afford to borrow the money from the bank to purchase it.
And if the bank did lend out the money, then there would be very little if any cash flow left over for the investor.
The thing that drives me crazy in a scenario like this is when the real estate agent says to the investor that they simply need to put more money down to make the property cash flow.
This is a sure sign that the real estate agent is not an investor themselves.
Another issue is when the real estate agent and or seller doesn’t declare all of the related expenses or they use potential (theoretical) rents. By doing this, they can make the property look more profitable at the time of purchase.
Reason #1 – Non-Investor Real Estate Agents
How does the asking price get so high in the first place?
What happens with the smaller investment properties (up to 12 units) is that far too often the listing agent doesn’t know how to properly evaluate the property. The agent will apply the “Comparable” method to determine a value.
For example, a triplex recently sold for $500,000 and it was in decent shape with full market rents and it made sense from an educated investor’s perspective.
So the agent thinks,
“Well my triplex looks the same and is in the same neighbourhood,
therefore, it must be worth $500,000 as well”
And they list the property.
Reason #2 – Novice Investors
A less educated investor comes along and sees the property and buys the property based upon the sale of the other triplex.
The challenge is that this triplex has way below market rents and the expenses are the same as the other property. And when you look at the cash flow, the less experienced investor discovers that they overpaid.
The challenge is that we now have 2 triplexes that have sold for $500,000 which sets a precedent for other agents and investors to follow. Plus the less educated investor wants to sell his triplex for at least what he paid.
And so the cycle continues…
Reason #3 – Competition With Deep Pockets
For larger apartment buildings, there is also massive competition from foreign investors, local pension funds and REITs who are all looking for places to park money for safety.
And often times they are willing to accept lower returns.
The only way we will see investment properties come down in value is when less educated investors stop buying them AND when real estate agents start pricing them properly.
The banks are already helping by tightening up their internal lending guidelines and only lending up to a value that they feel it is worth based upon cash flow or purchase price (whichever is lower).
For those investors who are less educated, this is a great reminder of why they must invest time and money to gain the knowledge to learn how to buy smart and reduce the risk of overpaying for an investment property.