Cooling real estate industry still a good investment

Despite higher land transfer costs, property tax hikes and a shortage of homes, last year, across the nation, first-time homebuyers and real estate investors persevered. Now, halfway into 2008, the patience of would-be buyers is paying off.

Riding the six-year tumultuous real estate ride (particularly in the last 36 months) — with record-setting sales prices amidst the fallout of the U.S. subprime debacle — has meant watching, waiting and (for some) praying for a slowdown of the red-hot Canadian real estate market.

Yet this oft-predicted cooling will not spell doom and gloom for Canadian real estate owners. Instead, it smacks of market rebalancing, says Gregory Klump, chief economist with the Canadian Real Estate Association (CREA), the national industry organization that represents more than 94,000 real estate brokers, agents and salespeople.

“Last year, sales reached their all-time highest levels — ever — setting back-to-back records in the Canadian market,” says Klump. “Yet, since the middle of last year, sales have been receding — which was predictable as the rising prices across the country were eroding affordability. These fewer sales, in conjunction with price increases, simply means that while sales may recede, there will not be a market correction [like in the U.S.] — just no podium, double-digit finishes.”

For example, TD Economics reported a national average home price growth of 11% in 2007 — the largest national real estate gain recorded to date, says Klump.

The same TD forecast also predicted a “modest national average growth price” in 2008, at 2%, and 2009, at 3.5%. “Sales are significantly lower than in the banner year that was 2007,” write the report authors. “But they are returning to 2004-2006 levels, held up by solid economic and financial fundamentals.”

No U.S.-style meltdown

In fact, Canada will not experience the extraordinary slump because market fundamentals and standards are vastly different here from what they are in the U.S., says Klump.

“Canada’s housing market is on much firmer footing than the U.S. market,” explained a report released in May by RBC Economics Research. The authors stated three reasons why Canada would not undergo “a U.S.-style correction” — more conservative lending practices; a tight labour market; and the market surplus is much more manageable north of the border. While the report authors do suggest that certain areas — such as Calgary, Edmonton and Saskatoon — are “now coping with the aftermath of such a rapid run-up in house prices,” the worst that will happen is an erosion of sellers’ bargaining power.

“It has been a seller’s market, but now we are experiencing a more balanced market where we are seeing more listings — more product — available for sale, and fewer sales. Last year could be considered a frenzied year and this year [2008] we are returning to a more balanced, normal market,” says Klump.

Blair Carey, associate and research analyst at Abacus Private Equity, an independent investment firm with a dedicated division to real estate and more than $1.5 billion in assets under management, agrees.

“The demand and supply economy is shifting in residential real estate,” says Carey, who also does not see a meltdown, but a slowdown in Canada’s residential real estate market.

Real property holdings

Carey believes that this will allow a lot of smaller investors — those with $10 million or less to invest in real estate — to consider real property holdings in their overall portfolio.

As such, Carey’s first suggestion when examining real estate is for investors to look at their own home.

“When managing money, I would talk to clients about their book portfolio and their real asset portfolio,” says Carey. “How much capital is in the business, the cottage, the car, the house, and all their stuff? This should be included in the client’s perspective, even if it’s not considered part of their portfolio.”

Carey believes that, by helping people get a true picture of what they own, he can help them better appreciate the unique investment aspects of real property holdings.

“What other investment allows you to leverage roughly 75%? That’s one of the key components about real estate — its ability to be highly leveraged.”

For example, if an investor wanted to purchase a three-storey walk-up listed at $1 million, the bank could finance up to 75%, or $750,000, of that purchase, explains Carey. “Now the building may be appraised for $1 million and you may leverage that purchase, but the cost of that $750,000 is another thing.”

Climbing interest rates could put a pinch on buyers, explains Paul Gardner, partner and portfolio manager at Avenue Investment Management, a Toronto-based private investment firm.

“I’ve never been in an environment that has been inflationary that was not caused by housing — so this [current market situation] is quite unique. But you would have to assume that climbing interest rates would hurt the consumer.”

Gardner qualifies, though, that investors should only start to worry if interest rates were to go up 200 basis points or more.

Another positive aspect about real estate, explains Carey, is the taxation benefits. “If the investment is structured properly, the cash flows generated can occur in three ways: property appreciation; interest income expenses; and through operating expenses.”

For example, if an investor purchases a duplex for $500,000 and chooses to live in one unit while renting out the other, then, from a tax perspective, the rental unit would depreciate over a 20-year period. Through tax calculations, this would be equivalent to $7,500 that can be deducted off the net revenue (in other words, the income earned in rent). “If an investor made $20,000 in rental income each year, which is about $1,500 a month, then they would only pay taxes on $12,500. The other $7,500 would be tax-free based on depreciation calculations.”

Carey emphasizes, though, that the investor should not consider this a tax-saving strategy, but a tax-deferral strategy: “Where you do pay taxes is when you actually sell the property.”

Of course, Carey suggests an investor speak to a professional before embarking on this type of investment strategy.

REITs

For many people, cash flow is an essential component to any real estate investment, explains Martin Zegray, CFA and senior vice-president at Realstar Management Partnership, a national property management firm. “One of the major benefits to real estate investing — in all its forms — is the cash flow or annual return.”

For instance, investors can purchase units in a real estate investment trust (REIT) and confidently expect an annual 5% to 8% return on their investment, says Zegray. Considering stocks with dividend payouts typically pay out at 1% to 2%, a REIT investment can be a good way to produce income from an investment, explains Zegray.

Zegray adds that while REITs declined last year, in terms of returns, the investment is still a good option for those looking to diversify while receiving an income off investments. “REITs tend to fluctuate in the short-term market, but they are not driven by market fundamentals. The recent decline was due to the assets underlying those REITs and that was due to the problems in the U.S.”

This is not to say there are no risks with REITs. Zegray recalls how, in the early- to mid-1990s, many public enterprises such as Olympia & York and Bramalea Ltd. suffered and closed because their REITs were over-leveraged. “Today, there is a lot less debt, and many institutional players, like large pension funds and insurance companies, are less aggressive and less willing to get into that debt. Now REITs leverage at 50%; in the past they leveraged at around 75%.

“The good thing about this type of investment is that it moves slightly out of cycle with other investments — such as stocks. This different cycle is one more reason why investors buy into REITs: added diversification these holdings provide.”

Commercial properties

As with many investment sectors, there are always sub-sectors that do not follow typical cycles. In real estate, commercial properties are that anomaly.

“Commercial real estate has a lot to do with the supply side of the equation,” explains Carey. “For example, when was the last time a green field moved from zoning, to development, to building, to sale and then lease as an industrial park?” Carey asks rhetorically. “It’s not a regular occurrence in most cities. Instead, industrial or commercial developments grow in a piecemeal, organic fashion.” This mitigates the stronger fluctuations in supply and demand that can be seen in residential real estate holdings.

Unfortunately, most investors that want to move into the commercial property side need to set aside 10% of their portfolio — at the equivalent of at least $10 million — in order to start playing in this investment arena, explains Carey.

Real estate is for everyone

Since most investors do not have $100 million in a portfolio with 10% ready to invest, many advisors try to stick to real estate basics.

Wayne Robinson, president of W.A. Robinson & Associates, an Ontario-based investment firm, believes that home ownership should be a priority for all investors, regardless of the market.

“My advice: home ownership,” says Robinson, a CFA with decades of experience in investments that include real estate. “Everybody thinks paying rent and investing is the same, but that’s not true. Even owning real estate indirectly is different from actually owning it outright.”

Yet Robinson has a caveat — be prepared.

“Often, the biggest mistake is that someone didn’t take into consideration the eaves-trough falling down. As a renter, the landlord simply fixes this, but as the landlord you have to fix this. Often, a young person or couple doesn’t have the $595 to hire a guy off the street to fix this — then you have plumbing issues, a leaking roof — those are often very large costs and when you pay for these over five years and compare that to renting its easy to assume that renting is much cheaper, from a cash flow point of view, but that’s not accurate. When you purchase a home and pay it off for the next 240 months, you are paying off an asset.” According to Robinson, that’s a key difference.

“We all need to live somewhere,” he says. “Often the home is the single largest asset and the asset doesn’t get paid off until age 60. Still if you look at it from an analytical perspective, guys like me are supposed to say that it might not be the best option.”

Joan Dal Bianco, vice president or real estate secured lending at TD Economics also believes that now is a particularly good time to buy. “When you add up better house prices with interest rates still at historically low levels, unemployment at 30-year lows, a strong economy and financing options that take the pressure off first-time buyers, there may in fact be no better time to buy a home than right now.”

Originally published in Advisor’s Edge Report in August 2008