By Calum Ross
Special to the Financial Independence Hub
Real estate investors often fail to objectively assess their existing portfolios in the same way that a holistic wealth management professional or financial planner would when dealing with equity investments.
Many real estate investors who began their investment careers following sound investment principles have got caught up in the hype and strayed from their core investment principles. When a particular asset class performs well, there is often a sentiment of irrational exuberance that develops around that asset class. When this happens, savvy investors adapt their strategy while others continue to “go with the herd” and experience the eroding effects of inertia.
The problem is highlighted today in two key ways:
- Yield on Toronto and Vancouver Real Estate Has Diminished: Rising real estate prices in these markets have outstripped the increase in rental rates that has eroded yields. This now means many real estate investors are over-weighted in one asset class, and that many new real estate investments are in reality speculative-grade investments because they don’t meet the suggested 3% interest rate cushion to sustain cash flow (a metric outlined in more detail in my recent book on borrowing to invest).
- Investors are Demonstrating Irrational Exuberance and Greed Towards Real Estate: I’m deeply concerned by the number of people who believe real estate values will continue to climb at these uncharacteristically high levels. Not only are current appreciation rates unsustainable, but the fact that rental increases are not even close to keeping pace makes real estate investment even less appealing.
There are too many investing in real estate who are chasing returns through appreciation alone. There’s an alarmingly high net inflow of money to real estate in overpriced markets even as yields continue to plummet.
Thursday’s announced press release as part of “Ontario’s Fair Housing Plan” has just exasperated the problem for real estate investors in Ontario by proposing that rent control govern a considerably larger percentage of the rental inventory.
It is very clear from this announcement that Kathleen Wynne fails to understand the psychology of investors or the fundamentals of real estate economics for the typical landlord (real estate investor). My guess is that when you are a public-sector employee with an unbelievably generous (actually ridiculous) Defined Benefit pension plan that’s funded by the public tax dollar you can’t relate to real estate investors who often need that monthly cash flow number to fund their retirement income.
How they (the Ontario government) can issue a statement that at one point states that, “in March 2017, (real estate values are) up 33.2 per cent from a year earlier”, and then follow up by suggesting they will increase rent control and not see the coming rental crisis is laughable.
The provision for allowable rent increase for 2017 is 1.5% under the current Residential Tenancies Act. This tells me the government basically has no understanding of investor math or long-term economic implications of their policies. But the same could be said for the fact our government seems to believe it is acceptable to spend more money than it brings in each year (running massive and growing deficits) and then not understand the pending financial crisis those actions create.
By making this statement the government is effectively acknowledging that investors will have to take a massive hit to their yield with only being able to increase gross rent by 1.5% (less than the rate of inflation). What the government has failed to recognize is that real estate investors also need to make returns, and if they don’t they will simply deploy their capital elsewhere. With cap rates already so low for GTA real estate assets, the increased rent control could very well cause the singe largest rental crisis in Toronto’s history.
New Ontario policy will further restrict rental supply
The government has just made it considerably less appealing for people to be landlords and this new proposed policy will only serve to further restrict rental supply with certainty. Buying real estate based on theoretical appreciation of values is real estate speculation and not real estate investing.
Smart money and those with capital don’t play the speculation game. I am currently advising most of my Toronto and Vancouver real estate investment clients to sell and seek yield in dividend-paying equities or invest in real estate elsewhere. This announcement will only strengthen my belief that Toronto real estate investors who understand math should simply sell and redeploy.
The belief by investors that prices always go up leads investors make to poor decisions, and many are no longer following sound investment principles. To help people make more informed and accurate decisions on whether to buy, hold, or sell real estate assets, I will be coming out with a white paper in the next two weeks to proactively address key calculations that real estate investors need to understand to determine if they are at risk, and that to get realistic about return by understanding true return measures.
Apply Timeless Investment Principles
By assessing market realities and applying timeless principles, investors will conclude that they must adjust their current behavior. The timeless principles outlined will include:
- Highest and Best Use of Capital: If treated as new acquisitions, real estate investors simply wouldn’t buy many of the properties they currently hold in their portfolio. They would instead favour a dividend-paying equity or a different real estate investment. The broader based implication of this is that a huge number of GTA and Vancouver real estate investors would be best served by selling their holdings and investing in other asset classes or at very least in other geographic areas.
- Greater Due Diligence at Acquisition Stage: A single real estate property often makes up a huge proportion of an investor’s total portfolio value. If investors were going to own a comparable amount of a single equity, investors would apply a very high level of due diligence. They do not often do this with a single piece of real estate. Considerable due diligence is a non-negotiable part of any substantial investment purchase, and skipping it is dangerous to one’s financial well-being.
- Stickiness of Real Estate Prices: Real estate is quick to rise but slow to fall, which is unlike equities. Since comparative market data is not as freely available and assets are not as homogenous – fact based evaluation is not as easy with real estate. This means prices don’t always reflect true value especially when inventory is low and the emotions of home buyers spill over into the same type of assets that investors are purchasing.
Sell Underperforming and Buy Better Performing Assets: Many, if not most, properties in a typical Toronto/Vancouver investor’s portfolio have shifted from investment to speculation-grade real estate due to effective yields especially when considering the opportunity cost of capital. In these cases, investors would be best served to sell and re-weight their portfolio to more diversified assets and/or sell to buy better performing real estate investments in other locations.
Being overly weighted in one asset class and having investments in that asset class no longer performing the stated objective of positive cash flow if rates returned to a more normalized five per cent range is simply irresponsible. The recent appreciation has been a great gift, but not re-weighting asset classes and diversifying your overall investment holdings would be an incredibly flawed decision, and one which no wealth or portfolio manager who is competent would even encourage or recommend you do in good faith.
Calum Ross is a leading authority on personal finance and investing in real estate and has spoken on stages all across Canada and the U.S. He has funded over $2.5 billion in mortgages since 2000, helping to create more than $1.8 billion of incremental net worth for his clients. He is an alumnus of Harvard Business School and holds an MBA in finance from the Schulich School of Business. He lives in Toronto. He is the author of the Amazon and Globe & Mail bestseller, The Real Estate Retirement Plan. This blog was published with permission here simultaneously with Calum’s blog.