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ALWAYS CONSULT YOUR INVESTMENT PROFESSIONAL BEFORE MAKING ANY INVESTMENT DECISION

August 15, 2017 | The Big Question

A best-selling Canadian author of 14 books on economic trends, real estate, the financial crisis, personal finance strategies, taxation and politics. Nationally-known speaker and lecturer on macroeconomics, the housing market and investment techniques. He is a licensed Investment Advisor with a fee-based, no-commission Toronto-based practice serving clients across Canada.

 

For the first time in more than four years, the average Canadian house costs less than it did the year before. Soon it will be considerably less. Even in Van and 416. But it’ll take a big drop, and a long time, for most Canadians to lose their fixation with bricks. This autumn should speed that along, with the October 25th rate hike and the universal mortgage stress test.

In the meantime, people like Devon struggle with the notion of risk.

“I have been following your blog for couple of months now and I think you are doing an awesome job,” his note starts out with the obligatory suck-up. “I do share the same view as you, that the housing market is due for a correction, so back in May I sold my house and moved in with my parents. I now have around $800K of cash that I need to find investment opportunity for.” So far, so good. Smart boy, this Devon.

“I know that you encourage a diversified portfolio (ETFs, preferred shares, bonds, etc…) that on average can make 6%/yr. But given the all-time high of the US stock market and the geopolitical uncertainty (Donald Trump), it is too risky to buy into the stock market now? At a high level, how would you construct a portfolio in this environment?

“I was thinking another option is to buy 2 condos, $400k each, and rent them out for $2k each. That would give a 6% return. The rental market is crazy hot so it shouldn’t be a problem to find tenants. I know there will be risk of bad tenant, additional expenses maintain the properties, and tax credits might not be as good as buying stocks. But as a long term investment is being a landlord a good way to investment your money?”

This is something many struggle with. They see “investing” meaning “stocks” which translates into “danger.” Meanwhile real estate looks benign and is so, so easy to fall into. Without a doubt, society has tilted in favour of properties, thanks bigly to cheap loan rates, mortgage-pimping banks and mom. But as this pathetic blog always points out, risk is everywhere. The best way to control it is to have diversification and balance, and putting all your money into a couple of condos blows up both of those principles.

If D buys those two units he’ll pay $20,000 in closing costs and end up with $820,000 invested. Condo fees, property taxes and insurance will equal at least $800 a month, and the average rent in Toronto for a one-bedder is $1,800. That leaves a return – without any vacancies, repairs or the cost of fishing iguanas out of the toilet – of $12,000 a year per unit, or 2.9% on an investment of $820,000.

But wait. That twenty-four grand is considered income in Devon’s hands, and lumped on top of his regular, working-dude wages. If he earns the average (about $80,000) his marginal tax rate is 31.5%, and he ends up paying $7,500 on the rent. Net return: $16,500, or 2%. Sucks, of course.

And what of risk? Bad tenants, condo fee increases, higher property tax or special assessments (they’re coming for glass-walled buildings) are all beyond his control. More concerning should be illiquidity and net loss – the consequences of a real estate market that can lose altitude fast. If condo values correct a modest 15%, D is screwed over for $123,000. If he decides to bail, he faces paying commission of $40,000 – if he can find a buyer.

Incredibly, there are thousands of people who do this. Blindly.

So what happens if D goes balanced & diversified with a liquid portfolio of ETFs of the kind oft described here? If the last seven years is a guide, he might make about 6.5%, with most of the returns in the form of capital gains and dividends. Given the tax breaks, his actual net return would be a tad over 5% – putting him about $24,000 a year ahead. Of course, ETF portfolios do not come with condo fees, property tax, insurance premiums or guys who pee off balconies. There is no 5% commission when you sell and no land transfer tax when you buy. And they’re instantly liquid, the cash flows a couple of days after you push the button.

But what of risk?

It’s everywhere. Trump. That Kim dipstick. Record Dow. But while the US continues to expand, and global growth has returned (both good things), investors need to dampen volatility and squish risk by having the right assets in the correct weightings. That’s why 40% in safe (fixed income) assets and 60% in growth stuff (of which a minority is exposed to US markets) makes so much sense. The same rising interest rates that can sink real estate, propel preferreds. Of course higher rates also tank bonds (keep the weighing low) while they signal more robust economic growth (helping equities).

The bottom line? Investing in a liquid, well-built portfolio beats the pants off buying two apartments. In every regard. Even now, in the Trumpian era, and especially given the trajectory of Canadian real estate.

But investing is hard. Condos are easy. And nobody can see your ETFs, the way you can point to a building. There may even be some women who are not turned on by dividend income, high liquidity or low embedded MERs. Imagine.

Think this through, Devon. We’re pulling for you.

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August 15th, 2017

Posted In: The Greater Fool

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