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Buy expensive RE with cheap debt, or cheap RE with expensive debt?


permabear
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I had this conversation the other day with a friend. He was saying he should get into the housing market (Toronto, Canada) because interest rates are so low, and now is the time to do it! I was arguing that because interest rates are low, people are being encouraged to enter the RE market and prices have been pushed up. He responded: if interest rates go up, prices will drop, but from a monthly payment standpoint, it may work out to the same. This got me thinking...

 

These scenarios work out to exactly the same annual payments and the sum of interest and principal repaid over the term (5 year term, paid annually) are equal. Which one would you pick (or are you indifferent) and why? Note: this is a hypothetical situation on the same property

 

Scenario 1 (Most expensive RE, Cheapest debt) - $500,000 mortgage, 5% interest rate, annual payment: $115,487, total interest paid over term: $77,437

 

Scenario 2 (Cheaper RE, More expensive debt) - $437,788 mortgage, 10% interest rate, annual payment: $115,487, total interest paid over term: $139,649

 

Scenario 3 (Cheapest RE, Most expensive debt) - $387,132 mortgage, 15% interest rate, annual payment: $115,487, total interest paid over term: $190,305

 

I think my answer is, I would be indifferent. The real question for me would be, what is the discrepancy between cap rates and interest rates in any given scenario.

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14% difference (500K/437K) suddenly makes RE from expensive to cheap? Sorry, no.

 

The answer really is buying cheap RE with cheap debt. Or at least with refinansable debt in dropping rate environment. Like Florida in 2010 or so.

 

You can make or lose money in both scenarios you mentioned, but it will depend on context. Just don't delude yourself that 14% difference makes RE cheap.

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I didn't say it was objectively cheap. It is cheaper than Scenario 1.

 

The mortgage in Scenario 2 is a goal seek to get to a mortgage amount that will produce the same annual payment at a 10% interest rate. I'm not deluding myself, I'm asking a hypothetical question about the tradeoff between the price of RE and price of debt.

 

You could also run the analysis with a 15% interest rate if you want a cheaper mortgage:

 

Scenario 3 - $387,132 mortgage, 15% interest rate, annual payment: $115,487, total interest paid over term: $190,305

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The issue is that you have to have pretty gigantic changes in the rate for the price to differ substantially with payment staying the same. E.g. it took about 20 years to go from 15% to 5%. So I think your scenarios are too abstract and also too unlikely to discuss. Sorry. Have fun. :)

 

if interest rates go up, prices will drop, but from a monthly payment standpoint, it may work out to the same.

 

You can see from your example that rate change would have to be huge for relatively small change in prices. So if we are talking about genuinely overpriced RE, the prices can drop a lot without much change in rates. You are more likely to end up with 500K/5% going to to 400K/6% than your scenario 1->2. If you are talking about genuinely undervalued RE, it's the opposite: you'll likely get 200K/10% -> 300K/9% or something like that.

 

In yet other words, RE prices do not depend just on rates. They depend on a lot of other factors and rate dependency is not direct and linear as in your scenarios.

 

 

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I had this conversation the other day with a friend. He was saying he should get into the housing market (Toronto, Canada) because interest rates are so low, and now is the time to do it! I was arguing that because interest rates are low, people are being encouraged to enter the RE market and prices have been pushed up. He responded: if interest rates go up, prices will drop, but from a monthly payment standpoint, it may work out to the same. This got me thinking...

 

These scenarios work out to exactly the same annual payments and the sum of interest and principal repaid over the term (5 year term, paid annually) are equal. Which one would you pick (or are you indifferent) and why? Note: this is a hypothetical situation on the same property

 

Scenario 1 (Most expensive RE, Cheapest debt) - $500,000 mortgage, 5% interest rate, annual payment: $115,487, total interest paid over term: $77,437

 

Scenario 2 (Cheaper RE, More expensive debt) - $437,788 mortgage, 10% interest rate, annual payment: $115,487, total interest paid over term: $139,649

 

Scenario 3 (Cheapest RE, Most expensive debt) - $387,132 mortgage, 15% interest rate, annual payment: $115,487, total interest paid over term: $190,305

 

I think my answer is, I would be indifferent. The real question for me would be, what is the discrepancy between cap rates and interest rates in any given scenario.

 

None of the above. But if I had to decide between one of the 3 it would be Scenario 3. You cant change the price you paid later but you can refinance.

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On just the facts written, this question is easy.  Scenario 3.  I don't see how there can be any other answer.  In scenario 3 you are paying less for the same piece of property.  The lower interest rates of the other two help even things out, but only help.

 

A few reasons it is practically better.  In scenario 3, if you wanted to pay off the mortgage, it would be cheaper.  In scenario 3, you have higher tax deductions in the US.  In scenario 3, if you sell the house at say $500K in the future, it is a big profit.  In scenario 3, there is more opportunity to save on a refinance.

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He responded: if interest rates go up, prices will drop, but from a monthly payment standpoint, it may work out to the same.

 

The worst result for your friend is he locked in a high purchase price / giant mortgage, then is forced into a higher interest rate later on that large mortgage.

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On just the facts written, this question is easy.  Scenario 3.  I don't see how there can be any other answer.  In scenario 3 you are paying less for the same piece of property.  The lower interest rates of the other two help even things out, but only help.

 

A few reasons it is practically better.  In scenario 3, if you wanted to pay off the mortgage, it would be cheaper.  In scenario 3, you have higher tax deductions in the US.  In scenario 3, if you sell the house at say $500K in the future, it is a big profit.  In scenario 3, there is more opportunity to save on a refinance.

 

This.

 

There's also the fringe benefits of insuring a lower priced property and having a lower tax payment.

 

If you care about cap rate the third scenario's lower cost basis will produce a higher cap rate assuming equivalent cash flows across your scenarios. In addition any improvements you're able to achieve in net operating income are magnified by the lower cost basis which could be useful if you're trying to sell the property as turn-key investment.

 

I think Jurgis' initial point of buying cheap with cheap is the real play. RE markets are incredibly inefficient, even within a given metro area. Cheap financing has certainly increased the number of players but to say everything inflated in price equally or that there aren't deals to be found is lazy. 

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What is not accounted for is that in a rising interest rate environment, there will likely be inflation.  Prices may come down in real terms due to payment affordability, but will be adjusted upwards with inflation.  If you have leveraged equity in a property, 3-5% inflation can translate into multiple return on your equity. 

 

What to me makes sense is real estate investment based on making money holding the real estate in the long run, not [trying to] flip it in the short run. EBVAT/S compared to price/S are the crucial paramenters for me, combined with an overall assesment of what you are buying into [quality].  The financing is part of that equation.

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I think there are two different things (a) A decision to buy or rent (b) A decision to buy or pass on an investment property.

 

For (b), you only want to buy property cheap at low rate or else pass up on it.

 

But if you are looking to buy or rent, then if you are going to stay for a long time, the relevant calculation is versus the rent.

 

Vinod

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What is not accounted for is that in a rising interest rate environment, there will likely be inflation.  Prices may come down in real terms due to payment affordability, but will be adjusted upwards with inflation.  If you have leveraged equity in a property, 3-5% inflation can translate into multiple return on your equity. 

 

What to me makes sense is real estate investment based on making money holding the real estate in the long run, not [trying to] flip it in the short run. EBVAT/S compared to price/S are the crucial paramenters for me, combined with an overall assesment of what you are buying into [quality].  The financing is part of that equation.

 

Agree 100%. Buying real estate with a somewhat long term view (at least 5-7 years) is what Zell and others have done. Look at the rent like a coupon on a bond and the price appreciation as the same as increase in a stock price. Finance it for as long as possible at the lowest rate possible.

 

 

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