The Pros and Cons of Investing in Real Estate
Beginning in the 1970s, my father got involved in investing in real estate in British Columbia’s Fraser Valley, mostly in Chilliwack, where I grew up. My wife and I owned our own home in Chilliwack from 1996 to 2003. We lived in it for all of 2 ½ years during that time. The rest of the time we were either in Japan or we had moved to our present home in London, Ontario. Fortunately, with my dad still in Chilliwack, we had an experienced property manager.
My father-in-law also had investments in real estate, but on the other side of the Pacific, in Japan. I wouldn’t go so far as to say that my wife and I have real estate investing in our DNA, but certainly for many the idea of investing in real estate holds a great deal of appeal, especially given the steady increase in prices over many years, with the greater Vancouver and Toronto areas probably gathering the most attention.
Still, I am wary of over-investing in real estate, especially when there might be a speculative bubble developing. I mentioned Japan the previous paragraph. Beginning in the fall of 1989, Japan’s real estate market dropped steadily, eventually falling by 70% by 2001.
British Columbia has had its own real estate bubbles. An acquaintance of mine, approaching retirement, had a home that was beginning to need some significant work. Real estate prices had been increasing significantly and there was great demand. He and his wife figured that, instead of repairing their current home, they could contract to buy a new house and sell their current home with the same financial outcome. They would then have a house that was all new instead of an old house that was still going to require more repairs in the future. Unfortunately, they made the deal to buy the new house just before the bubble burst and then found they couldn’t sell their old home for anything close to the price that would have made those transactions feasible. Ultimately, they ended up losing both homes.
Perhaps the most famous real estate tycoon is the now former US President, Donald Trump. In a recent report from Paul Solman on the PBS Newshour, Solman observed that Trump’s real estate assets, tied as they are to travel and tourism, have become significantly devalued in the wake of COVID-19 and some major loans are coming due just as financial institutions like Deutsche Bank are saying that they will no longer do business with Trump. When Trump became president, it was recommended that he divest himself of his real estate holdings so as to eliminate potential conflicts of interest. He declined to do that, turning over the day-to-day management of his businesses to his sons. Ironically, if Trump had just followed the divestment recommendation and put his proceeds into an S&P 500 index fund, he would have been much wealthier, since that index is now up nearly 80% compared to when Trump became president.
While few of us are real estate moguls, as real estate is a commonly sought after investment opportunity the remainder of this post will explore some of the pros and cons of this investment category.
Significant capital growth in recent years
Since the early 1980s, when mortgage interest rates peaked at more than 20%, there has been a long steady decline. This decreasing cost to carry a mortgage has allowed borrowers to expand upward the range at which they can afford to buy real estate, driving prices higher. As of the end of 2020, residential real estate prices here in London, ON are up greater than 20% for the year.
As I write this, in the last week of January 2021, a 5-year annual pay GIC at one of the major banks has a posted rate of 0.85%. On a $100,000 deposit that is $850 per year. In a relatively modest area of London, you can rent a 3-bedroom home for about $2,000 a month. If you as a landlord can buy that same property for $400,000 with a $100,000 down payment and get an interest rate of 1.89%, which is do-able these days, after expenses you might net about $3,300 per year, which works out to about 3.3%. That may not seem like much, but this cash-flow positive situation also includes the steady paydown of your mortgage and the presumed appreciation of the value of the property.
Land is a finite commodity
One of the arguments I’ve heard finds its origin in the common-sense philosophical musings of Mark Twain: “Buy land, they’re not making it anymore.” Although one can quibble with that thought, if you want to buy property in a specific in-demand area, it can indeed feel like there is no more land to be had. Scarce commodities tend to go up in price.
Everybody needs a place to live
Many are familiar with Maslow’s Hierarchy of Needs, which posits a five-tier hierarchy of human needs. The lower or basic needs must approach some degree of satisfaction before an individual can move on to meet psychological and self-actualization needs. The most basic needs are physiological in nature and among those is the need for shelter. While some have disputed Maslow’s definitions, for our purposes I think we can agree that shelter is a basic need. From an investment point of view, therefore, it seems intuitively correct to put your money into something that provides a basic need.
Less fluctuation/volatility in value
I hold a few investments that trade throughout the day on an exchange. I can pull up a particular tool on my computer and watch these different investments ticking up and down every second. There is no comparable system that will tell me the change in the value of my house on a second-by-second basis. The best I can do is see if a comparable house is for sale in my neighbourhood and check its listing price. That relative stability in prices makes it much more comfortable to hold real estate for the long term.
In stock and bond markets you can buy a simple global balanced mutual fund or exchange-traded fund and get exposure to hundreds if not thousands of companies from around the world. If you buy a house, a duplex, or a condo, you are buying one property in one location. Some people may be able to manage two or more properties, but that is going to require more capital investment and more debt, which brings its own risks. The point is, you are putting a lot of money into a single asset and if something goes wrong there, you may not have other investment resources to balance out the risk of loss.
Depending on the nature of the real estate market in a particular location, you may be able to sell your real estate investment property fairly quickly. On the other hand, it may take several weeks or even months to sell. Or, if it must be sold right away because of some other financial need, you may have to sell at a much greater discount than you had hoped for. Illiquidity is generally thought to capture a premium for the owner, if you are prepared to wait for a timely exit, but it can be just the opposite if you lose control over the timing of your sale.
Management of the property may make demands on your time
My dad was our property manager when we rented out our house in Chilliwack. That was easy and convenient for us. However, if you are going to take on the property management yourself, that may mean significant demands on your time. If the hot water tank in your rental property starts flooding the basement at 3 AM, you are in charge. This may make sense if you are skilled with property maintenance yourself, but cause some hesitation among others.
Nonpaying tenants may require eviction/legal action
Tenants are not always reliable. My neighbour in Chilliwack owned a five-unit building and had nothing but trouble getting tenants to pay their rent. It takes a certain degree of diligence, research, and psychological insight to get the right tenants. It also means owning a rental property that appeals to the right market. Otherwise, you may find yourself with a high turnover of unreliable tenants and consequently unreliable income.
Periods of non-occupancy, resulting in no income
It’s great to have long-term tenants. However, periodically a landlord is going to find their rental property less than fully occupied. That has to be factored in. Do you have an emergency fund, or income from other sources, to keep on paying the mortgage and other expenses for an extended period if necessary?
Income may not cover expenses
Some landlords choose to focus on the potential for capital gains on their rental properties such that they are willing to lose money on their rental income after expenses are accounted for. I understand that. A steadily rising market can more than compensate for the negative cash flow if your net worth is increasing steadily, but that may not always be the case.
Correction in the housing market in your area may require you to sell at a loss
If there is a correction, banking on an increase in the value of your property can really hurt. For example, downtown Toronto has seen about a 10% drop in the condo price over the course of 2020, thanks to COVID-19 and the ability for many to work from home. Imagine putting 10% down on a condo that you bought for $600,000. If you were losing $500 per month but counting on a 10% annual increase in the value of your condo, on a net basis, that monthly loss is a negligible figure. However, a 10% decrease calls into question your entire strategy, and you are still losing $500 per month. COVID-19 may very well have accelerated working from home arrangements that will result in a permanent decline in the value of highly concentrated downtown real estate holdings. If you are in the wrong market, you may have no choice but to cut your losses and move on.
Highly leveraged investment in real estate is risky
Financial institutions have tended to be quite reasonable about lending for real estate purchases because of its tangible nature and the tendency to appreciate over time. Even so, there is a risk involved in borrowing to invest. If we use the scenario above, and put 10% down on a $600,000 property, that means you have invested $60,000 of your own money and owe $540,000. If that property loses 10% of its value, that means your equity of $60,000 is effectively gone, but you still owe $540,000. Hopefully, you can hang on, collect rent that will cover your expenses in the meantime, and wait for a recovery.
There are other ways to invest in real estate that avoid some of these risks
Mortgage Investment Corporation
On the debt side, you can invest in a Mortgage Investment Corporation, a business which manages a pool of mortgages. As an investor, your money is used to fund the loans (mortgages) provided to purchasers of real estate.
During my brief tenure at a local bank branch, I once met a customer who told me that he was involved in private mortgages. As I recall, he pooled his money with a small group of others so as to diversify the pool of borrowers. There is risk in this approach, to be sure. Mortgages from most financial institutions are very low these days, with advertised rates often below 2%. Someone who wants to borrow from a private lender is willing to pay you a higher rate because they are unable to qualify from a regular mortgagee. They are therefore also at higher risk of default.
Airbnb or a similar service could also be an option to make some extra money if you have a spare room. Your short-term/overnight tenant is not likely to cause major damage, especially if you are just down the hall. Of course, COVID-19 has probably put this option on hold for a while.
Real Estate Investment Trusts (REITs)
One of the more popular ways to invest in real estate is through Real Estate Investment Trusts or REITs. This is the equity-side equivalent to the Mortgage Investment Corporations noted above. Instead of owning a portfolio of mortgages, a REIT owns and operates income-earning real estate. You can buy these on an exchange either directly or through an Exchange-Traded Fund (ETF). Real Estate goes well beyond the residential market, although you can certainly invest in REITs that invest in apartment buildings. Other REITs own shopping centres, malls, industrial properties, office buildings and some even own healthcare facilities. Some REITs focus exclusively on properties within a region of Canada and others invest around the world.
You don’t need to borrow to invest in these options and with at least some of these options you can diversify your investments quite widely. They are not entirely without risk, however. Mortgage-related investments leave you open to the risk of the borrower defaulting on their debt. REITs are not immune to loss either. REITs that invest in shopping centres and office buildings have been hard hit from COVID-19. But this brings up another advantage: you can sell them immediately, if you want to for minimal cost. Illiquidity is not a major risk.
Directly investing in real estate is attractive to many and has the potential for being very rewarding. But it is not without its own risks and challenges. Consider carefully whether it fits your skillset and lifestyle. In my next blog, my 83rd post, I will write specifically about whether you should consider your own home an investment.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.