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Guessing Game

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Posted by Brian Ripley's Canadian Real Estate Charts

on Wednesday, 22 March 2017 07:06

 
price-guess origOn the way up in price it was easy. Make an offer higher than list price with few conditions if any and provide the vendor with everything they wanted and voilà, you own the asset if you managed to out-guess the competitive bidders lined up on their phones. 
​Liabilities were an unimportant consideration because in a few days, a similar property would sell for even more and your balance sheet then became even more credit worthy; check and check.

On the way down, guessing the price that a vendor will agree to is still a requirement; is the vendor holding a property with too little of his own equity and perhaps reluctant to take a loss at this time, or is the property being offered for the first time in let's say the last decade? A single family detached house in Vancouver has increased in price by over 120% in the last 10 years (over 160% in Toronto). The vendor's equity position is an important clue in the guessing game.

Is the vendor attempting to sell in order to repurchase in the same market? That would suggest an end price is required CLICK IMAGE TO ENLARGE

similar to the current snapshot of market comparable sales if trading sideways is the objective. Is the vendor an estate looking to settle accounts for multiple

parties? That implies that the end price is not as "sticky" because VALUE can be defined outside the parameters of "comps".

At some point definitions of value might again include an appraiser's use of the "income" approach. Investment real estate cap rates in a city like Vancouver are among the lowest in Canada and so a buyer must determine if there is value in the price. Potential investment capital can dry up and move very rapidly out of a declining market and seek out better (lower risk) returns elsewhere. Low cap rates are tolerated in a rising market but not so much when price momentum shifts to the down side. Vancouver prices peaked July 2016

A declining market requires more work on the buy side and exposes the potential purchaser with risk not seen on the way up. 

The CBRE in their 2016 Report list cap rates for "A" class apartment buildings in Vancouver at 2.5-3% (in Toronto 3.25-3.75%, in Calgary 4.5-5%). This week the Bank of Canada benchmark 10 year yield is 1.76% similar to the full month of February plot on my yield curvechart.

What we don't see in the CBRE report is what expense items are used in the developing a theoretical cap rate (Net Income / Asset Purchase Price). I suspect that only the minimum data of property tax, insurance, maintenance and actual expenses paid out are used for a given year in these surveys. Is a vacancy allowance included? Not all tenancies are reliable. Is a management fee included? Someone has to spend time taking care of the asset. Is the asset subject to sudden strata fee spikes or revelations of past due maintenance? These are important questions that any real estate investor who has been playing the game for at least one cycle trend change will ask.

In my 2013 case study, I had to lower the purchase price by 25% to get a return that piqued my interest because I included vacancy and management.

With a 25% drop in sale price, the GRM has dropped nearly 6 points (lower is better) and the CAP Rate has gone up 40 basis points (higher is better) which not a huge move but the yield on investment (ROI) has increased to more than twice the 10 year bond return and that provides an investor the incentive in a ZIRP environment to buy and hold and allow other people's money (the tenant's) to turn debt into equity.
(2013 Case Study)
Owning real estate has risk attached both at the individual ownership level and in the broader market place. It's 2017, if anything, real estate as an investment is even more fraught with unknown risk.

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