Investing in real estate, like all investments, has pros and cons. The most important thing, when considering including this in your portfolio, is to understand it and determine individual suitability. To further complicate things, these days, you can invest in real estate in many forms; for example, fee simple title ownership, limited partnerships, mortgage investments, real estate investment trusts . . . just to name a few. I refer to these as real estate products and, again, each of these products has its pros and cons. Although the underlying asset, generally, is real estate for these different products, each tends to have its unique characteristics. So, to say it’s all real estate may be oversimplifying things, and, furthermore, each may not be suitable for everyone. However, overall, real estate historically has been a very good investment.
WHY INVESTMENT PROPERTIES?
Along with appreciation in value, investment real estate offers a relatively passive source of income that can be generated; this is the one of the biggest differences between investment property and a home as a primary residence. Investment properties offer both appreciation and passive income. In addition, the rental income from investment properties generally keeps pace with inflation, so the purchasing power of the income is maintained over time (and as the property provides income, the equity or property value can also be increasing). The popular phrase “use real estate as an inflation hedge” comes to mind. If I were renting today, it would be nice to be paying rent at levels from 10 to 20 years ago – but no such luck! Rents have increased here in Vancouver, where I live, as well as everywhere else in Canada. And, if I am renting out a property, that property is also increasing in its own value, while the rent on it goes up.
Let’s look at a case study. Generally, it’s rare that investors purchase investment properties with cash and no financing so we’ll use an example of an investor I’ll call “Sam.” Sam, a chiropractor with a small practice, has a reasonably balanced investment portfolio, but also would like to include real estate in this portfolio. Sam invests in a $200,000 property with a standard 80 per cent mortgage. This means Sam comes up with $40,000 cash (20 per cent) as a down payment and the bank provides the rest ($160,000). Now let’s take an ultraconservative approach and say the property doesn’t appreciate in value at all. I think most people would be challenged to find a market anywhere where real estate hasn’t appreciated over 25 years (the standard mortgage amortization), but just to illustrate a point, Sam’s $40,000 investment has still become $200,000, now that the mortgage has been paid off and, meanwhile, his property will be providing a nice monthly income.
The example with Sam is also a good illustration of how leverage is a very powerful tool to be used with real estate to potentially multiply the performance of the investment. We can look at Sam’s investment again and isolate the other profit centre – appreciation. If we use a scenario of five per cent appreciation on the $200,000 property, it would mean the property increased by $10,000 to $210,000. Most people would likely say a five per cent increase really isn’t all that exciting, and I would agree. However, if you look at the real numbers, that is $210,000 less the mortgage of $160,000 (remember, right now, we are isolating the appreciation component and not factoring any rental income or mortgage paid down by the tenant) this gives Sam $50,000. This means Sam’s $40,000 has become $50,000 . . . a return of actually 25 per cent.
Here are other examples using the same property but with different approaches.
Let’s say Sam invests $80,000 in cash in the property, with a $120,000 mortgage. The same increase of five per cent in value (from $200,000) – that is, $210,000 less the $120,000 mortgage – would leave $90,000 from the original investment of $80,000 . . . a 12.5 per cent increase (again, with no mortgage paid down or rental income considered).
Now, if you factor in the mortgage being paid by the tenants, the numbers get even better. The fact that the interest on the investment property mortgages is also tax deductible is a nice little side benefit. Leverage can be a powerful tool if used properly.
Not lost in all this, of course, is the ability to obtain leverage. If you work with an experienced banker or mortgage broker with investment property financing, this will prove to be a big advantage. Unique to real estate is the fact that even the Canadian banks, which are regarded by many as the most conservative banks in the world, feel secure enough to provide qualified individuals capital to invest in real estate. Leverage certainly can be used for other investments to obtain similar appreciation results, but banks will often require a more secure asset, such as . . . you guessed it, real estate, for collateral as a condition of the loan. With real estate investing, the property the bank is helping you acquire is the only collateral banks generally require. Another big difference, of course, is that with real estate leverage, there is rental income to pay off the loan.
Real estate can be a very profitable asset class to include as a part of an investment portfolio, but it is important to fully understand the pros and the cons of the different real estate products and strategies available to you so that you choose the ones most suitable for you.
PLANNING IS KEY
A key starting point in this type of venture is creating a plan. A plan will facilitate your success as you move forward. It should take into consideration your objectives, time frame, desired involvement, real estate experience, knowledge, risk profile, to name just a few. It is important to have a plan that takes these factors into consideration so that you are less likely to get off track. Also, without a well-defined and personalized plan, you may find yourself moving into real estate products or markets that are not appropriate for you, or become susceptible to the hype of certain markets or some of the one-size-fits-all approaches that some may try to sell you. •
In Part 2 of this article, I will discuss some of the elements real estate investors should consider as they build a investment plan.