My initial working hypothesis (it will evolve, so bear with me) about investing in existing real estate (as opposed to new development) is that success is largely a function of successful financing. Just as a good banker knows that his job largely consists of borrowing at 3 (%), lending at 6 (%), and hitting the golf course at 3 (o'clock), real estate investors know that if you can just borrow low and rent high, the battle is half won.*
Check out this chart from April's Economist. Among other things it shows that in Japan and Switzerland, house prices are more affordable than they have historically been, as expressed both by the price-to-rent and the price-to-income ratios. Both ratios are indexed to 100 rather than expressed in absolute terms, but it's a fair bet that in those two countries, cap rates are also higher than they have been historically.** High cap rates are the "lending at 6" part of real estate investing.
What about the "borrowing at 3" part? Looking at the back page of this week's Economist, I see that 10-year Japanese government bonds yield all of 1.37%, while in Switzerland they yield 2.20%.
These are big ifs, BUT: If mortgage rates in those two countries are correspondingly low, and mortgage financing is available, then real estate investors in Japan and Switzerland may earn good returns in the years ahead by borrowing and renting at currently available rates. Not a recommendation, but rather food for thought.
*To give a sense of what a real buying opportunity looks like in these terms: In 1986-1987, as China prepared to take over Hong Kong, investors were convinced the former British colony would go to the dogs. Real estate was severely depressed, and rental yields (which were also rising) on office property exceeded financing costs by 5 percentage points. Into this situation stepped the Chandler brothers of New Zealand, betting most of their modest $10mm fortune at the time on four heavily financed office buildings. Prices of course recovered, Hong Kong stayed Hong Kong, and the Chandlers sold the buildings in 1991 for more than $110mm,increasing their own net worth to over $40mm.
**Why do I think that historically low price-to-rent ratios translate into historically high cap rates? Here is my crude math:
1) Expressed in absolute terms, the price-to-rent ratio is the price of a property divided by the gross annual rent that can be earned from that property. A property worth $100,000 that can be rented out for $10,000 per year has a price-to-rent ratio of 10. As an aside, the average price-to-rent ratio in the US for the period 1987-2007 was about 15.
2) Invert the price-to-rent ratio and you get something called the gross rental yield. Remember the gross part. In our example above it's 10% ($10,000 / $100,000).
3) If the price-to-rent ratio is historically low, by definition the gross rental yield is historically high.
4) Now the cap rate: The cap rate is similar to the gross rental yield except it deducts from the numerator the operating expenses of running the property (maintenance, real estate taxes, insurance, etc.). It makes the gross yield a little less gross, and is a more accurate representation of how much a landlord can expect to earn from a property because, as every landlord knows, those operating expenses are real money out the door.
5) As long as operating expenses as a percentage of gross yields stay more or less the same over time, and I think they have, then it's fair to say that a historically low price-to-rent ratio translates into a historically high cap rate.