Investments in real estate make up a large portion of many Canadian portfolios, whether it be for personal home ownership or for rental purposes. Supported by favourable population growth, a culture of home ownership and attractive financing costs, real estate has been a source of wealth creation for many Canadians over the past decade. This doesn’t mean, however, that investing in a rental property is appropriate for everyone.
In this article we’ll explore some key principles that investors should consider with respect to existing or potential direct real estate investments. These include a review of your ability and willingness to take on risk, your personal balance sheet, the concept of sweat equity, market liquidity and comfort with debt.
The price volatility of real estate tends to be understated due to the availability of timely information when compared to other investments. Consider for example, that while the public stock market offers up-to-the-minute price information, the only information that a rental property owner may receive with respect to the value of their property is an annual property tax assessment. Imagine if, instead, your real estate agent sent you a text every day with an offer for your home that changed depending on their estimate of your home’s value - perhaps you wouldn’t feel as comfortable with direct real estate investments.
The subprime mortgage crisis of 2007-2009 highlighted some of the risks associated with real estate as unrealistic expectations for future home price appreciation and relaxed lending standards nearly crippled the global financial system.The bottom line is to recognize that real estate values, as with all investments, will fluctuate over time and have inherent risk even if this may not be readily apparent.
Review your personal balance sheet
To properly understand an investor’s risk exposures, they must review their own personal balance sheet as each investor’s situation is unique. Similarly, the Canadian real estate market varies greatly across the country. Understanding one’s own financial situation is key to making a well thought out investment decision because overconcentration in any one investment or market increases the amount of risk assumed. The oil price plunge of 2015 for Albertans and the manufacturing slump of 2008 for Ontarians are excellent examples of the impact of being tied too closely to any one industry or economic engine.
Direct ownership of real estate outside your primary region can certainly be done but it isn’t as common as purchasing a rental in the same region as your primary residence. Logistically, it is just simpler to own a rental property locally. With a primary residence and presumably a job tied to the same economic environment, an investor is increasing their exposure to risk by adding a rental property to their personal balance sheet. An alternative may be investing in the TSX Capped REIT index which provides broad based exposure to Canadian commercial and residential real estate thus reducing some of the concentration risk. In fact, ten year returns of direct ownership, versus indirect real estate investment, indicates that indirect investment may provide more attractive returns, which we’ll discuss further below.
For some, the choice to invest in a property may be driven by the desire for passive income. Truly passive income, however, is more akin to collecting interest income received by bondholders of a public company. Rental income is different due to the sweat equity that is involved in maintaining a direct investment in real estate, which impacts the investor’s returns. Allowing a property to fall into disrepair impacts the maximum amount of rent that can be collected and the fair market value of the property. Understanding that the amount of upkeep will vary from property to property requires experience, as well as an entrepreneurial spirit. Having the willingness to put the work in and having the time and ability to do so are two very different things. Knowing oneself is a recurring theme in investing that applies here as well. Managing property takes time and effort - understanding how this effort fits with an investor’s schedule will help them to determine the appropriateness of the investment.
Real estate is transacted in private markets, so no matter how extensive a set of information on a property is, the final price of a property is the convergence of negotiations between buyers and sellers. Direct ownership is less liquid than indirect ownership (through REITs) because it takes effort to look at properties, find buyers/sellers and/or work with a real estate agent to transact. To compensate for this illiquidity, investors should demand a liquidity premium (higher rate of return) for taking on this additional risk. The uniqueness of each property creates another factor to consider, as a desirable location and features, can increase the number of people that may be interested in a property and therefore increase the ease with which to buy or sell. Nonetheless, transacting in real estate takes more time than placing a trade on a public market.
Mortgages are a hot topic with interest rates rising in Canada, and Canadians with outstanding mortgages see their cost of borrowing increase. The effect of leverage, or the impact of borrowing to purchase a home, is not often discussed, with understanding engaged mostly at how much is owing and the interest rate charged on the mortgage. As a mortgage is paid down, the owner’s equity in the property increases. However, with the mortgage being a relatively fixed charge, the owner’s equity may fluctuate depending on the home’s price. By borrowing money, this leverage amplifies the upside, but also the downside as prices decline. This was reflected best in the oil price collapse of the mid-1980’s and during the financial crisis of 2009, when homeowners’ equity was reduced dramatically as home prices fell.
Leverage or margin is used within an investment portfolio as a means of magnifying a portfolio’s movements. As with the example above, it is the investor’s equity that expands and contracts with fluctuations in the market value of the portfolio. Margin has different rules associated with it but ultimately has the same effect - magnifying the movements of the asset’s price on the equity stake of the investor. This is, of course, a highly risky strategy as markets can move rapidly and be unpredictable. Understanding the risk of a margin account is important to understanding its appropriateness for an investor.
The ease to transact, or liquidity of a market, is even more important when leverage is introduced. A forced selling event is never a good thing as these events would typically happen at inopportune times that result in unfavourable prices for the investor. The ability to access willing buyers in a timely fashion helps to convert the asset into cash more quickly. Fewer bidders on the other hand, can translate into increasing the time it takes to convert the asset into cash, and this illiquidity can ultimately hinder one’s ability to service their debt.Conclusion
Achieving an investor’s financial goals is the ultimate litmus test for any financial plan and investment strategy. Real Estate has a diversifying effect on a traditional stock and bond portfolio (as discussed in REITs: A Portfolio Perspective), and can help many Canadians reach their financial goals. The debate between direct versus indirect ownership may rest on an investor’s emotions, such as the need for tangibility of the asset. However, the broader REIT index has out-performed Canadian residential prices by 7.51% per year, over the past ten years. Although the return comparison between this index and residential property prices isn’t perfect, it is more effective than making decisions based on emotion. Using a framework of sweat equity, liquidity risk, and understanding an investor’s own unique position should help decipher the fact from fiction in making a rational decision about their investment options with respect to real estate.
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