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Buying a rental building
A Redditor explains the business case
I have been asked a few times in threads or in direct messages to give a demonstration of what it is like to try and buy a rental apartment building in the city of Vancouver. Since it only takes me a minute to highlight some major factors, I thought to provide in the below:
Just a random pick… have a look at this one: https://www.realtor.ca/real-estate/22429549/1298-w-10th-avenue-vancouver. Let’s assume that you get an okay deal on the property and pick it up for $28M. But after property transfer tax, financing, legal, due diligence, etc. it comes in at $29.5M anyway.
With a total price of $29.5M and net operating income (NOI) of $950,000 (mentioned in the listing), the cap rate (or return in perpetuity) is $0.95M/$29.5M=3.2%. NOI is the earnings before debt payments and taxes. Banks' typical bare minimum is a debt coverage ratio of 1.2:1. This means that for every $1 in debt payment, you need NOI of $1.2.
So the maximum debt payments (principal + interest) you can have on this building would be $800,000 ($950,000/1.2). If we assume a 25yr commercial mortgage and that you have a good track record, personal/corporate guarantees, and other things, you get an interest rate of 3.75% (good commercial rate). This means you would need to put $16.5M in down payment and take a loan of $13.0M.
Since your NOI is $950,000 and your debt payments are $800,000 per year, your net cash flow before tax is $150,000. This is a 0.9% cash on cash return on your $16.5M cash investment. You still need to pay a corporate tax of around 26%. Keep in mind about half your debt payment is principal. You can put more cash down to increase the cash flow (lower debt payments), but that also concentrates more risk in a single, low yield asset with low liquidity and high transaction costs.
On balance, it’s better than holding most bonds, but from a risk-adjusted perspective, it doesn’t make much sense to the corporate or professional investor. This is why you see so many pension funds and REITs owning rental buildings. They are the only ones with the balance sheet and mandate to tackle such an investment. To meet pension obligations or REIT dividend expectations, institutional investors plan for gradual rent increases beyond maintenance costs as well as property value appreciation.
Hopefully, this gives you some insight into the investment side of an apartment building. And the challenges are sometimes harder with smaller properties (economies of scale favour the bigger buildings).
It's also a simple example of why rentals have been an ignored investment over the past 25yrs, and why we have such low stock now.
Edit: Someone asked for a tl:dr on the post, here is my shot at it...
Interest rates have been in decline for 25yrs or more. This means mortgage service costs have stayed the same despite bigger loans. This meant that it was easier to build housing for ownership vs rental. The ability to finance and exit a condo project in 3yrs to 5yrs is much more attractive than waiting for 30yrs for payback from a rental. Sky-high land costs have meant rental owners need to increase rents fast to keep up. But they are constrained by various factors. Therefore, everyone built condos, not rentals, and here we are… looking at a decrepit old brick building for sale at the sweet price of almost $30M and unlevered cashflow yield (cap rate) of 3%.
A cap rate of 3.2% seems very low. As I understand it, the cap rate for a rental building in the city of Vancouver (where the vacancy rate has historically been very low) would be a small premium over the risk-free rate. And long-term bond yields for government of Canada bonds are up somewhat. (Not nearly as much as short-term interest rates - people’s long-term expectation is that the Bank of Canada get inflation under control.)
If cap rates are up, this pushes sales prices down. Combined with rising construction costs, this makes rental projects less viable.