Toronto is running in second position for the title of most heated apartment market in the country. Cap rates have been compressed to a point that is only beaten by Vancouver. Sales volumes are at a level unmatched by any other Canadian city.
In this final version of the “stress test your asset” series, we will apply pressure to a hypothetical apartment building in this highly active market.
I will use the same stress benchmarks as found in my previous articles on retail assets and industrial assets. The first unpleasant milestone on the road to insolvency is when your property stops cash flowing. CMHC and lenders alike partially determine a loan amount using the debt service coverage ratio (DSCR).
A CMHC-insured apartment needs to generate a stabilized net operating income (NOI) that totals 130 per cent of the annual mortgage payments. Our first measure of stress is when this buffer of income decreases to a point where all of the NOI is used to pay the mortgage. The second point of pain is when the investor’s equity has been reduced to $0.00.
I’ve used the following resources to construct a fictitious but typical apartment investment located in Toronto:
- Colliers Multi-Family Report Mid Year 2014;
- Colliers Cap Rate Report Q2 2014;
- CMHC Ontario Rental Market Report Spring 2014.
Three different debt levels
I’ve then applied three different debt levels to create a low, mid and high leverage structure. In a previous article, I identified that the maximum loan amount allowed via CMHC averaged 70% of the purchase price of a Toronto apartment. I’ve used this as the midpoint of leverage.
For the low-leverage variation, I’ve used 60% of purchase price and adjusted the CMHC insurance premium downward accordingly. For the high-leverage option, I’ve structured a deal that is becoming increasingly popular in tighter markets across the country. The capital stack consists of a first mortgage which is at the maximum allowable by CMHC coupled with a vendor take-back (VTB) second mortgage.
Vendors are increasingly offering this as part of their marketing efforts when selling a building since it diminishes the equity required and broadens the potential purchaser pool. Interest rates for these can range from 3.00%-8.00% and are usually interest only. For our highly leveraged option, I’ve used a four per cent interest rate and a total loan-to-purchase price of 85%, the most the DSCR could support.
The first influence we are going to examine is gross rental income. What would happen if the monthly rental rates you see on craigslist.org started dropping? The moderately leveraged property, although still at the CMHC maximum, could withstand a decrease of 11.9% while the low-leverage property is secure until 10.1% is reached.
Our highly leveraged property would see the end of positive cash flow with a 5.1% drop in gross rent. While this may seem like a small buffer, it’s worth noting a decrease in rental rates is the least likely to occur of the factors we will examine.
Vacancy incredibly low in Toronto
Vacancy is at incredibly low levels in many markets across Canada, but particularly so in Toronto. The ever-increasing number of investment condos entering the rental pool is expected to alleviate some of the demand, but major movement upwards in vacancy is unlikely.
That being said, how much can they move before your NOI is reduced to only cover your debt obligations? The highly leveraged option would need to see vacancy rates rise from 1.9% to 6.4%. The mid-point of our analysis could handle a vacancy rate of 13.3% while the most conservative debt structure can sustain cash flow until 20.4%.
Interest rate risk is real as rates cannot remain at historic lows indefinitely. Many prognosticators thought we would see a rise in bond rates in 2014, but that has failed to materialize. At some point, this prediction is likely to come true and it will impact cash flows on properties purchased in today’s low cap rate environment.
I’ve used an interest rate of 2.59% to reflect current market conditions in my underwriting. Rates would have to rise to 6.60% to push our low-leverage property to the brink. Our mid-point would reach it at 4.83%, while the high-leverage structure can only go as far as 3.50%.
Apartment cap rates have remained compressed due to low interest rates, stability of cash flow and sustained domestic and international demand from investors. But they could rise if any of these pressures were diminished. What we need to measure is the increase required to reduce the equity in a property to zero dollars.
I’ve used an underwriting cap rate of 5.00%, which is at the high end of the spectrum. Our safest debt structure would still retain some equity until cap rates had increased to 8.15%. The moderate leverage would reach the same threshold at 6.84% while the highest can only go to 5.66%.
The figures presented here are not meant to be indicative of typical market changes. You can’t have significant movement in one aspect of cash flow without the other variables reacting accordingly. These numbers are merely meant to establish the boundaries and limits for each factor, as examined in a hypothetical bubble.
The real market is much more complex.
Adam Powadiuk is a Business Development Manager with First National Financial, Canada’s largest non-bank lender. He is active in most markets in the country with a focus on investment real estate. All feedback is welcome and he can be reached at firstname.lastname@example.org.
Colliers Cap Rate Report Q2 2014