Why real estate investing still makes sense

Source: New Condo Guide

By Peter Kinch www.peterkinch.com

A new year has begun and you’re analyzing your finances, planning for the future and wondering where you can get the best return on your money. As we approach another tax season, you’ll be inundated with multiple mutual fund companies promoting the tax advantages of parking your RSP money with them. You’ll start to look at hard assets such as gold or precious medals. And, of course, you’ll look at real estate. The hard question is, which vehicle will produce the best results? My answer to this question will always be the same: the action is dictated by the goal.

First and foremost, it is important to understand that all of the above options are simply vehicles designed to accomplish and end result. The first step is to determine what that desired end result is, and then ask yourself, which vehicle will move me closer to that goal? You may have a variety of arguments or reasons to choose one vehicle over another, but here are four reasons why you may want to consider real estate as your investment vehicle of choice, along with one caution:

1. THE POWER OF LEVERAGE

Leverage is a tool that can work for you or against you, but there is no denying the fact that it is a very powerful tool. Let’s take the example of two investors sitting on $100,000 cash.

One investor chooses to put their capital into either the stock market or precious metals. If they spend $100,000 – they receive in return $100,000 in either stock or a precious metal asset. If their investment were to increase (i.e., perform) at a rate of 20 per cent over the course of a year (although I don’t presently know of any funds offering that return) their investment of $100,000 would product a $20,000 return.

The other investor chooses to use her $100,000 cash as a 20-per-cent down payment and purchase a $500,000 property in an area that has good economic fundamentals and produces a positive cash flow every month. Let’s assume that this property increases by only five per cent over the course of the year. That would make the value of the property $525,000 – effectively a $25,000 increase in your asset value – not including the amount of debt reduction or positive cash flow over the course of the year.

So on the surface, investor #1 had an investment that outperformed our real estate investor by four times (which would surely impress friend at a cocktail party) but actually made less money due to the fact that it wasn’t leveraged.

That’s the power of leverage. The key is to understand that it can also go the other way – and that is the importance of having a long-term strategy and investing in areas with strong fundamentals and good cash flow.

2. INTEREST RATES

Two keys to being able to develop a successful real estate portfolio are affordability and cash flow, and an underlying fundamental to both of those is the rate you pay for borrowing money.

The good news for Canadian investors in 2013 is that you have a virtual guarantee of continued low rates.

Due to the ongoing global credit issues, the Bank of Canada (BoC) has indicated its intent to keep rates low through to 2014. But it is important to note that the BoC can only influence the prime lending rate – which is used to determine your variable rate mortgage.

It is important for consumers to remember that the fixed rates are governed by the bond market and that although the BoC has indicated it does not intend to increase the prime lending rate, that does not guarantee that long-term rates will not rise in the meantime. A return of money to the market will cause a drop in bond yield, which will result in an increase in long-term rates even if the BoC leaves prime unchanged.

A further threat to low interest rates is that even though we will not likely see a rise in prime, we have already seen the disappearance of the discount on variable-rate mortgages. Due to a lack of liquidity in the global markets, the cost of borrowing has increased for lenders. As such, variable-rate mortgages are less profitable and they have cut back on the discounts they offer. The net result for borrowers is that the amount you pay on a variable mortgage is not as attractive as it was a year ago.

Having said that, we need to be very clear that even without a discount, a prime lending rate at or about three percent is ridiculously cheap and allows for great investment opportunities. There are multiple opportunities within the Canadian marketplace that can create positive cash flow as long as the interest rates are below four percent and you can easily get a five-year term today well below four per cent, so the ability to get a cash-flowing property and lock that in for five years will be as good in 2013 as it’s ever been.

3. SEEKING SAFE HARBOURS

As the global financial markets continue going through more drama than a daytime television show, the fallout is consumer angst resulting in low consumer confidence.

When consumers lack confidence, they tend not to make big-ticket purchase. Real estate is obviously one of those items and this alone could result in a slight drop in market values. However, it is the exact same angst and fear that drive consumers to seek out safe harbors in a storm, placing their money in areas perceived as protected from the roller-coaster that the stock market has become. This is the reason we have seen records in the price of gold. Investors are speaking with their pocketbooks and saying loud and clear that they are losing confidence in the market and want a tangible asset that they can own and hold. What could be more tangible than real estate and if you were looking for a safe harbour in real estate, which country would you invest in?

Canada has been seen globally as one of the few countries to have survived the last global recession relatively unscathed. In fact, our banking system and domestic economy have become the envy of the world. If fears of another global recession start to gain momentum, don’t be surprised if you start seeing more international money start to make its way toward Canadian real estate as a safe harbor – which may bode well for those who buy in early 2013 before the rush.

4. SOUND ECONOMIC FUNDAMENTALS

Regardless of where you buy real estate, you should make your purchase based on sound economic fundamentals. There is no such thing as a Canadian real estate market – it is regional. You can have solid fundamentals in one town while another within 100 kilometers could have an economy solely based on exports to the U.S.

I fully expect the American economy to be hit even harder due to the eventual fallout in Europe, but that will only impact regional Canadian economies that are dependent on trade with the U.S. to support them.

Although we are still largely an export-dependent country as a whole, there are a lot of regional pockets that have a strong domestic economy and are expected to grow in spite of global issues. Look for strong GDP growth, followed by strong employment numbers which in turn brings a strong tenant base. A strong tenant base combined with low interest rates creates the opportunity for positive cash flowing properties. And if the property flows cash in good times and in bad, you need not worry about potential for values to fall or bubbles to burst.

The value of your property the day after you buy it is irrelevant until the day you go to sell it. If you are purchasing investment real estate with a long-term buy-and-hold philosophy, and you have purchased in an area that gives you positive cash flow, then you don’t need to worry about the hype in the headlines regarding property values. Just focus on letting your tenants pay off the mortgage over time and enjoy the cash flow when you have a free and clear asset.

So, as you look at all your financial options for the upcoming year, ask yourself first and foremost; What results do I need from the investments I plan to make? Then analyze your options in the context of your goals. If you choose real estate, simply stick to the fundamentals, take action while others worry over headlines, take advantage of low rates and use leverage wisely. Invest and don’t speculate, and both you and your children will be glad you did in the year to come. Happy New Year, and happy investing!