By Miles Clyne
About a decade ago, my daughter graduated from high school and was about to enter into her university years. I vividly recall her asking me one summer’s day:
Her worry was that the five years of schooling ahead of her would keep her out of the workforce so long, she may never be able to afford to buy her own home. At 17 years of age, five years is an eternity.
I looked at her with absolute confidence and said; “Don’t worry, everything is cyclical, you will be able to afford your own home.” In the past decade we saw a slight pullback in real estate about three to four years ago and then we rolled on to higher highs. My confidence is still not shaken, the excerpt below from Danielle DiMartino Booth’s recent article reaffirms why I have confidence. It is referencing US commercial real estate, but there are parallels worth considering for homeowners regardless of where you live, I’ve underlined several.
Commercial real estate (CRE) cycles tend to persist for a bit longer, about 10 years according to work by Christopher Lee of CEL & Associates, a real estate consultancy. Lee breaks typical cycles into four periods – Growth, Plateau, Crisis and Transition. Good entry points tend to present themselves in the Transition Period while good exit opportunities arise six months before or after the peak of the Plateau Period. That seems intuitive enough. Get in close to the ground floor of a cycle. Get out before the crisis hits.
Given that the current cycle is well past Transition and Growth, let’s focus on where we are in the Plateau Period. Lee’s qualifier list is as follows: Overly optimistic underwriting standards, an increase in capital raising, aggressive competition for talent, blind entrepreneurism, low cap rates, supply and demand out of balance, protracted closing period, increases in ‘guarantees,’ high investment sales activity and generous lease terms.
As for cap rates, the rate of return on a given property based on the income it’s expected to generate, they’ve leveled off since the start of the year with a few notable exceptions. Cap rates are to real estate as price-to-earnings ratios are to stocks, a valuation metric, except for the fact that the lower cap rates are, the pricier the property in question.
(Definition of Cap Rate: The capitalization rate is used to estimate the investor's potential return on his or her investment.)
You could debate that US commercial real estate may have little correlation to our home prices in Canada. But the financial analysis done to determine if prices are high or low are the same. You can look at your home as a rental property. If it costs you less when you factor in your down payment than it does to rent, and you can afford the investment, then you are likely in a good situation. Alternatively, if renting is financially more attractive than a mortgage on the same property, you know the cap rate is likely very unattractive as an investor.
If the cap rate is unattractive to an investor, why would it be more appealing to someone who would own it as a principle residence? A little homework can go a long way in giving peace of mind. Keep in mind the political traps that are being set from taxing non-resident/foreign investors, proposed empty home tax and the lawsuits launched by the Chinese banks and the perfect storm may be brewing in the Vancouver real estate market.
If understanding cap rate, making sense of the political and legal landscape are challenging, check out this flowchart for helping you make an intelligent decision. Remove the emotion from the buying or selling of a home and you might just remove a whole lot of heartache.
PS. My daughter is still saving and biding her time.