January 3, 2018 0 Comments Other Categories

Limits of Real Estate

My Post-15

Those financially illiterate, and equity-volatility-averse, will hold onto their properties until very old age, despite cash-on-cash returns that lag behind that of equities. They preach paid-off 0-debt properties producing consistent rent cash flow, taxable at their top tax bracket. They will pay the price in lower returns to have something tangible. Outside GVA, GTA, appreciation of real estate is relatively modest and only a little above inflation in many places. Those seeking best value for their dollar shift to equities due to the decreasing advantage of investing in real estate over stocks and equity funds. With mortgages, return on equity (ROE) decreases with time compared to stocks and funds as the equity increases in each property as they are paid off. That is, more of one’s own useable cash is on the table. Real estate generates high ROI from leverage due to a low initial investment relative to the asset value – leverage unavailable with typical equities.

Many investors use income reduction hence tax-saving techniques. These in turn lower the Line 150 (Net Income) on Notice of Assessments typically used for real estate financing purposes. For those people not worried about RRSPs, there is little direct advantage of writing above $55,300 income (max. CPP contribution limit). For those who don’t care for CPP, then there is little benefit of reporting over their personal tax credit amounts, which is often so low that it’s near impossible to get a worthwhile mortgage. The remainder is often kept in a corporation with the lower corporation tax rates, income split to other shareholders- especially family members, and/or re-invested into the company for tax deduction purposes and to grow the corporation. The problem with this is it severely hampers their ability to obtain credit. The lenders prefer the reverse: high reported income, and for the longer the better. With increasing interest rates, credit tightening by the likes of OSFI, and banks’ increasing risk aversion, financing real estate is becoming increasingly harder, especially with each additional property the investor finances. Banks then ask for higher reported income and downpayments, to reduce risk and ROI, effectively negating the tax and ROI benefits of writing lower income and downpayments.

Real estate and stocks/funds cannot be compared directly percentage to percentage return. Real estate typically involves much higher transaction costs, formalities associated with the increasingly stringent banking system, illiquidity due to long time to sell, maintenance costs associated with the physical building, and the risk associated with tenants (vacancy, high maintenance, not paying rent). Also there is the time value of handling people and having to physically go to them and their properties, show properties to potential tenants, responding the tenant inquiries/complaints, etc. While these figures can be highly variable, the additional upkeep costs then commands a higher ROI to be on the same playing level as stocks/funds. Rational people have to be compensated to take on additional burdens of one investment avenue over another.

Another word about real estate, currencies, stocks, and other high-risk investments:

To make a comparison of returns of stocks vs. real estate, quality stocks often make similar or more between appreciation and dividends, or only appreciation.

From an investor standpoint, real estate is often worse on a cash-on-cash basis, after all the associated maintenance and transaction costs.

Those who pour their money into GTA, GVA property, are usually looking for a means of diversification in a politically stable country (Canada being 1 of the top), or to take advantage of the high leverage (though diminishing with tightening regulations).

As for crypto currencies they are just in their major boom phase. North Korea also uses them heavily to dodge sanctions.

Many industries have their major boom phases, like the 2008 dramatic run of gold, and the rapid rise of Alberta’s oilsands and Canada’s TSX as commodities pulled it up – especially the smaller exploration companies. It was possible to make unnaturally high returns with the heavy use of debt in a booming industry (another example – US Shale industry).

e.g. In Fort McMurray, back then with the looser mortgage rules and high migrant worker population paying as much as $1000/mo. bedroom rent, it was not unrealistic to see 350%+ with only 7% YoY.

Those who finance/lease their construction equipment, trucks, etc. in industry, even higher. Some oilfield trucks, as long as you keep them working 10/12 months of the year, they’d make about $30,000 profit/month after running costs and manpower cost; $300,000 over the year. Unit itself for an almost new @ $300K, though you can find used as cheap as $40,000 today from the local auction where they collect bankrupted companies’ equipment. Put only $50K down and finance remainder 250K. It’ll cost you about $750/mo. in interest, but 292500/50000 = 585% ROI. Much higher for those who buy older, rapidly depreciated (but potentially high maintenance) units or just lease, but it’s a much more dangerous game.

Currently I do work for one client who bought one of such units for about $40,000. Typical income is $1250/day on average, though sometimes can be as much as 2000. Operator paid 270 for that job, running cost about 270. 710/day profit; works 50/52 weeks of the year for a $177500 profit; 444% ROI (though in 2016 it made about $190K; 475% ROI). The problem with the liquid waste hauling industry is the high volatility of work and turnover of operators; it is very difficult to find a quality operator who sticks around.