Net Earnings: (Assuming 100% financing and owner payment of property taxes and strata fees) Net Earnings = Gross Annual Rent – (Interest Charges + Property Taxes + Strata Fees)
Gross Annual Earnings = $1600 / month x 12 months = $19,200
- Interest Charges = Mortgage Interest During first 12 months of Mortgage (6% Mortgage, 40 Year Amortization) = $18,910
- Surrey Property Taxes = $2,000
- Strata / Maintenance Fees = $120 / month x 12 months = $1,440
Net Earnings = 19,200 – (18,910 + 2,000 + 1,440)
Net Earnings = -$3,150
Price to Earnings Ratio = Price / Earnings = $320,000 / -3150
Price to Earnings Ratio = -101.6 = N/A (Negative P/E ratios are not-applicable)
Now that is a bad investment. Note: Investments that lose money and have no prospect of making money are “bad investments.”
An alternative scenario: Let’s assume for a moment that our prodigious landlord had a 20% down-payment and did not factor in opportunity cost of his capital (this seems like a brain-dead idea but let’s roll with it). Interest charges now equal $15,120.
Net Earnings = 19,200 – (15,120 + 2,000 + 1,440) = $640
Our example’s Price to Earnings ratio = $320,000 / $640 = 500 (A P/E of 500 would typically be reserved for a company whose growth rate exceeds 100% per year - this is definitely not the case in our example)
$640 of profit on a down-payment of $64,000 is a ridiculously low return on investment (0.1%) and I don’t know why anyone would want to be a landlord at these rates when you can just buy a GIC which pays 4.5% very easily with no risk.
In the stock market a Price to Earning ratio in excess of 15 is considered a highly valued company. Typically companies which trade a high P/E ratio are growing quickly and earnings are expected to grow thus making the future P/E ratio smaller. This is the markets way of paying for earnings growth. Companies reduce costs and increase revenues to improve their earnings and this is why being a stock-holder can be very beneficial.
In our example of the Cloverdale townhouse, where is the earnings growth going to come from?
Will rents rise substantially? Not likely.
Will costs decrease? Even less likely.
16 comments:
Hi mohican. Other stuff to add to an earnings calculation is building depreciation (and land appreciation), taxes, insurance, and maintenance (general wear-tear plus special assessments). Earnings can include or exclude certain things (a la EBITDA). The inclusion or exclusion of land appreciation (and at what rate) is where earnings calculations get creative. If it is included it has by far the most impact on the final P/E ratio.
Also cash flows can be impacted based upon occupancy rates, delinquent tenants, and suite damage (direct payments or through higher insurance premiums).
"Will rents rise substantially? Not likely."
For interest, compare the rent of a suite in a 30 year old building to one in a newly minted building. Over time it's not only the building that depreciates. Nicely hidden by inflation.
Haha nice try Mohican, you conveniently forgot to account for pride of ownership. The value of being able to tell everyone you're a landlord and land baron is worth at least $1000 a month! /sarcasm
I am not sure of the validity of P/E comparisons of 100% levered real estate.
I think it would be better to view the unlevered PE separately, and then compare it to cost of borrowing etc.
In that case, net earnings would be $15,760 for a P/E multiple of 20. Stated in terms of yield, that would be roughly 5%. Not great, but I have seen much much worse.
I think a reasonable assumption would be for rents to approximately follow inflation, which we can approximate to be two or three percen below the cost of borrowing (assuming that the BoC continues to behave as it has in the past).
Please forgive me if I am missing something obvious of if I lack knowledge in this area.
Aside from your down payment and subsequent maintenance, isn't your renter essentially paying for your townhouse? If you were to keep the apartment for the duration of the mortgage, wouldn't your tenants have almost paid for the apartment (aside from the down payment, maintenance, and management time contributed)?
Will rents rise substantially? Not likely.
Yes, they will rise with inflation.
Will costs decrease? Even less likely.
Since your major expense is interest, of course your costs go down.
Stated in terms of yield, that would be roughly 5%.
Which because rents go up with inflation means this 5% is inflation protected, so it is like a 7-8% yield of a non-inflation protected asset.
Will costs decrease? Even less likely.
Since your major expense is interest, of course your costs go down.
What does this mean? Your interest expense does not go down at all if opportunity cost of amortization is taken into account.
Stated in terms of yield, that would be roughly 5%.
Which because rents go up with inflation means this 5% is inflation protected, so it is like a 7-8% yield of a non-inflation protected asset.
Not really because your math is bad. The rents go up by 2-3% of RENTS, not total price. Thus in this example the yield would be 5% in the first year, then rents would go up by three percent which is $1648, or a yield of 5.10 percent. And that is ignoring the fact that the expenses also grow with inflation.
The unknown is appreciation. But you can't argue that any rental losses will be "made up" by appreciation because that is a hot potato passed on to the next owner, who will have even worse yield.
It is completely bogus to include mortgage costs in any P/E or total return calculation.
We are looking at the return on a specific asset, to wit the house. The mortgage is a completely different asset, which just happens to be a liability of the homeowner. The fact that it's secured against the house has nothing to do with the investment performance of the latter.
Two identical properties obviously have the same investment returns, regardless of financing (if any), just as two shares of Royal Bank have the same return, regardless of financing.
That said, P/E for Vancouver RE stinks bigtime, any way you look at it.
Two identical properties obviously have the same investment returns, regardless of financing (if any), just as two shares of Royal Bank have the same return, regardless of financing.
Yes, just as I stated earlier. I should not, however, that most companies do hold debt directly, so the calculation of equity returns do implicitly include leverage. The individual investor can lever or unlever any individual asset to his hearts content.
Since we do have an asset with a clean unlevered yield, might as well calculate unlevered PE.
"Two identical properties obviously have the same investment returns, regardless of financing"
It's a great point that we should separate the financing from the investment itself.
As a business, however, financing needs to be included when doing GAAP equivalent earnings calculations. This depends on the situation. It's comparing Bank A that has taken out debt to Bank B that is debt free. This has little to do with their underlying business, which is your point.
Freako is right. The method he/she refers to is called the Capitalization Rate i.e. Net Operating Income / Asset Value.
5% is far better than most properties being sold today.
We sold our place last year with Cap rate at 1.7%!!!
Why would you take on the risk of holding real estate when you could get 3x that with risk free rate of Govt Canada bonds?
Not really because your math is bad. The rents go up by 2-3% of RENTS, not total price.
You are right of course. The inflation protection comes from the inferred rise of the houses value with inflation. Sorry for saying that incorrectly. The point is that the 5% yield is a real yield, and doesn't get hit with inflation.
Your interest expense does not go down at all if opportunity cost of amortization is taken into account.
That is true. Mohican's calc was not taking opportunity costs into account, but if you do then you continue to have a cost.
As patriotz says, the appropriate way to do the comparison is not to include financing the investment in the cost-benefit.
From the post:
$640 of profit on a down-payment of $64,000 is a ridiculously low return on investment (0.1%) and I don’t know why anyone would want to be a landlord at these rates when you can just buy a GIC which pays 4.5% very easily with no risk.
One nitpick: $640/$64,000 is a 1% return, not a 0.1% return. Not that the error discounts the argument; I've got almost four times that return in a bloody savings account.
Here's a reference point for sanity: until recently (when all common sense went out the window), the very sensible and hard-bitten lenders in the UK, when considering you for a buy-to-let mortgage (i.e. you are the landlord), would demand 130% rental cover of the mortgage payment. The 30% allows for expenses, repairs, vacancy, damage, etc.
Thus if your mortgage payments were £1000 a month, your rent had to be £1300 minimum.
Try applying this common-sense rule to real estate anywhere in Vancouver, Calgary, Victoria, Deadmonton, etc and see how far you get.
The inflation protection comes from the inferred rise of the houses value with inflation.
Yes, if price rises in in sync with rents and inflation, the real return is exactly 5%. If we can borrow at 6%, the real cost of borrowing is somewhere around 3-4%, so you earn 1 to 2 % return for taking on risk (related to price or duration/size of rental stream)
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