McClelland Minute - December 06,2009

Is this the Time to Invest or Not?

The recession in our economy has been described as a one-two punch effect on the value of real estate held for investment, particularly for those with properties dependent on commercial tenants.  If the tenants’ ability to service their rental commitments becomes shaky it may force landlords to revisit agreements, or worse yet, manage a lease in default.

Players within the industry speak of “cap rates”.  Generally speaking, capitalization is the process of converting the net operating income (NOI) of a property into an estimate of its current market value.  A property yielding $10,000 NOI per year, purchased for $100,000, would have a capitalization rate of 10%.  The more paid for the property with that NOI, the lower the return on and of invested capital for the buyer.

It is not unusual to see cap rates hover near 9% when the markets are stable and financing is easy to get; then gradually drop to 6% when conditions weaken and sources of credit tighten up; then climb back as the economy improves.  This so called “969” phenomenon demonstrates the cyclical nature of real estate in general.

We also observe a difference in cap rates between city and smaller communities in the region.  Many urban based buyers perceive a higher risk in a smaller service centre.  Certainly, there is more opportunity within a large population base to find a qualified tenant.  However, I know of several local investors who are quite content with their holdings in rural communities; the price of entry is often lower, and with residential units at least, their properties are never vacant for long, if at all.  In fact, an economy on the downturn will influence people to hold off in buying a house or commercial building in favor of remaining in rental circumstances.

So the key question, is now the time to jump in or not?  I believe commercial property prices peaked some time ago with subsequent adjustments in value.  What the future holds is anybody’s guess, but if you drive around the countryside right now you will see a definite upturn in activity.  There are extensive drilling programs underway which in turn will stimulate those businesses that provide production services.  Our agriculture sector is humming along; yes it is tough on those who depend on livestock for a living, but again that too has been cyclical over the years.

History has also proven that whenever governments spend more than they take in, inflation is likely to follow.  What is worth $1 today will cost more tomorrow to replace.

Those considering investing in properties would be wise to look at the current inventory; particularly in light of some of the creative long term financing that can be achieved.  Getting in now may well prove to be an excellent decision when viewed back from 2015.

Vern McClelland is associate broker with RE/MAX of Lloydminster.  If you have questions or comments on this article or other real estate matters, he can be reached at 780.808.2700 or through the McClelland Group website www.mcclelland.ca

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