If you study people who really understand investing in companies, you can typically find some pretty sound fundamental analysis and systems for the valuation and investment of companies that can be purchased at a fair price. In your studies, you may come across a couple of gentlemen named Warren Buffett and Charlie Munger.
If you study people who really understand investing in real estate, you can find the same thing. There are publicly traded REITs, developers, and institutions who purchase property at reasonable cap rates with fundamental analysis that ensures they’re value protected and income protected. You can unpack the annual reports of some of these successful investment groups if you want to find a real investment thesis.
Real estate companies don’t invest to lose money. Negative cash-flow and fundamental ignorance is for tech companies who think they’re real estate companies, like WeWork.
So, why do regular people invest with the objective of market timing rather than fundamentals? For the same reason people get burned every day trading options and companies they don’t understand. They’re impatient. They can’t defer gratification. They want to get rich quick.
Real estate is not a get rich quick scheme.
Real estate is a get rich slow scheme.
When you stumbled across Buffett and Munger you may have learned that they invest based on two simple rules:
- Never lose money
- Never forget rule number 1.
But…but… Buffet also said in 2008 that he was “extremely bullish on single-family housing, but could not find a way to invest in it at scale”.
That was 2008. Buffett has since started Berkshire Hathaway Homeservices in the US, acquired majority stake in Brookfield Asset Management (Royal LePage), and invested in numerous housing, infrastructure, and development groups. This tells me that Buffett understands that trading housing at scale can be profitable from the extremely well-protected role of a real estate broker. Put some thought into it: who makes the most money when consumers trade stocks?
I’ve heard every excuse in the book. Brilliant “real estate investors”, trade as if we can time the market and essentially operate as commodity traders on capital appreciation of the “asset” of housing. Not real estate, just housing. Real estate implies a footprint on planet earth an its exclusively marketable tenure with rights attached to it. Think you’ve got those rights among your box in the sky? What happens if your neighbour blows a wall out for open-concept layout and your building sinks? That happened. What happens if an absentee landlord Airbnb’s 20% of your building and it becomes Toronto’s Saugeen residence? That happened. Ever read your condo declaration end-to-end?
Canada, once a resource-based economy, had the majority of our GDP coming from natural resources. In order to achieve GDP growth with a relatively strong domestic economy, and one of the greatest places to live on earth, housing became our leading resource, now composing 78-80% of our GDP. I don’t have an issue with that, but it’s important to note because housing is traded as such: a resource, a commodity, and a store of value.
And people are paying the price for it, with negative cap rates becoming a new phenomena.
I hear “investors” tell me the same story all the time:
“well, if I’m paying $500 a month out of pocket to keep this condo investment afloat, I’m technically not losing money, because I’m earning equity in the property”
“But I’m not losing money” they’ll say. “It’s just an opportunity cost for the equity I’m earning while the unit pays for itself and appreciates in value.”
Mr. Investor, much rent is your tenant paying?
“$2,150/month + utilities”
How much are your condo fees?
And how much are your mortgage payments?
Do you know how much of that payment is interest?
“well, no, but, I can deduct interest against capital gains”
What capital gains?
“well, the unit has already gone up in value, and will continue to”
OK. Good thing you know that. I didn’t know that.
* Oh, and for the record, you can also, deduct your interest cost against positive cash flow from rental income, have you ever heard of “positive rental income”?
You would be astounded by the number of investors who want to work with my team, but only if we prescribe to their investment thesis. They defend it with all their hearts when I try to explain why it’s not profitable, too high-risk, and not economically sensible. I know property and the markets I work in very well, and they want that knowledge, but they want it applied to the investment they’ve already sold themselves in their head.
They are dumbfounded when I tell them to find someone else because it’s my fiduciary duty to make a decision in their best interest, and I cannot do that by helping them to make a bad investment. Many of them come back to my seminars and continue to read my blog, and wonder why they still only hold one asset with negative cash flow.
Here’s a breakdown of the 1-year cost and revenue structure of a negative cap-rate “investment”.
The condo investment is going to do one of three things over time:
- increase in value
- maintain the same value
- decrease in value
With this strategy, in 1 year, you lose in 2/3 of those scenarios. If you just applied some sound, conservative logic that there is an equal likelihood of each 3 happening, you’re making what would be called a high-risk, low-return investment.
Be mindful that the above scenario does not include land transfer tax, legal fees, or exit costs (legal + realtor), which would likely completely eliminate the margin you have in Scenario 1. This is important, and I’ll come back to it. At this point, the investor is probably thinking “OK, well, I’ll just hold the asset longer, like 3-5 years, and it’ll make sense” – and technically, you’re a little bit more correct than you were:
Ok, so you’ve got a little bit more juice on your 5-year horizon, you’re protected from a sideways market, and you don’t lose as much if the unit loses value. Remember when I mentioned costs, especially exit costs? Let’s evaluate those:
So, basically, even after 5 years, in a neutral or declining market, you lose. Even in Scenario 1, you don’t earn enough equity to extract anything meaningful via renewal at a new 80% LTV to redeploy and invest elsewhere. Sure, if the market grows big, you win big. But, playing 1/3 odds is gambling. Start judging it as such.
All those costs I mentioned? You still owe those if your unit doesn’t appreciate and you need to get rid of it.
This means that their equity is often smaller than their exit costs. In fact, if you really think about it, many people actually have nearly 100% loan-to-value financing on their properties:
- buying with a 5% down mortgage feigning principal residence; (remember the article about millennial mortgage fraud?)
- paying land transfer tax and legal costs out of pocket; 1.9-3.8% (minus $4,000 if you’re a first-timer);
- sale commissions built into purchase price, anywhere from 3-5%
So, effectively, just upon entry, your sunk costs are equal to your equity on most of these. Good thing your rents are paying equity a little bit faster than you’re paying for your tenants condo fees.
It actually gets scarier than this. When someone is making an investment of this nature, they are typically doing it with 5-20x leverage depending on downpayment.
- 5% down =20x leverage
- 10% down = 10x leverage
- 20% down = 5x leverage
Just for context, the only people who are allowed trading on that much leverage in financial markets are called Hedge Funds because they legally have to hedge their bets by purchasing insurance on their trades.
Understanding capital-appreciation real estate investment assumptions
Economics studies the market as if it is filled with rational consumers. If the market is filled with rational consumers, people who invest in real estate with negative cash flow must be doing so with one of the following of assumptions in mind:
- The asset will increase in value in the short-term: in fact, it has to prior to their next mortgage renewal, which is typically 5 years, otherwise their renewal is going to require a cash draw beyond the perpetual cash draw from monthly net loss.
- Rental rates will increase in value in the short-term: they have to in order for the asset to begin earning money and equity to eliminate assumption #1.
Why are we so sure real estate will go up in value in the short-term? I’m not really in a position to determine whether or not any of the above assumptions will be correct or incorrect, but I know that they’re positively correlated, which means if one doesn’t happen, the other likely won’t. I’d say that if there are better investments with less risk available in the market, I’d recommend making those investments before one that prescribes to the logic in this post.
So, knowing that this is what happens in the “investment” market, and pairing that with the knowledge Brad Lamb has shared that 60-70% of condos are sold to “investors”, we ought to ask ourselves – is the market really filled with rational consumers?
Further reading might bring you to Daniel Kahneman and Amos Taversky to shed some light on that.