‘Investing’ in real estate

Oh boy ho boy I’m rich! I’m wealthy! I’m independent! I’m socially secure! I’m rich! I’m rich!

Recently the most expensive Condo in Canada went up for sale in Vancouver. According to a Re/Max press release, the luxury market is booming. As pretty much anyone will tell you, real estate of any sort is hot hot hot.

I met two people, each on separate occasions, and each one of them exemplifies a popular type of ‘real estate investing’ that is in reality not investing at all, and like all forms of gambling, could wind up costing them a lot of money. But it’s their business and their money, so I tossed in my two cents and we went on to other subjects. I’m not smart enough to get ‘into real estate’. Or rather, I’m just smart enough to know that I don’t know enough, and that it’s a bad thing to get into unless you really do know what you’re doing. Or get lucky with timing.

The first person I met was ‘in condos’. He still lived at home in the suburbs but had ‘invested’ in several condos downtown. I’ve actually never talked to anyone who’s ‘invested’ real estate about their holdings and so on, mainly because that sort tend to be tedious braggarts, but this person seemed fairly amiable and I was curious about one thing in particular. It was something I’ve often suspected, but basically wanted confirmation.

Most condo developments, particularly the newer ones, charge pretty steep maintenance fees, and it is a renters market right now. So I asked him: with all the costs, and a mortgage and so on, how do you make any money?

With the seeming wisdom of Solomon, the person smiled and said ‘appreciation’.

Of course. Prices will always go up. The market’s been so hot for the past few years that it has to continue. He said with utmost certainty that real estate prices never go down. Guess he never paid attention to what went on in Japan.

I’ve been living downtown in Toronto for several years now. Enough to see the prices of downtown 1-bedroom condos essentially double. If someone bought when I first moved downtown and planned to sell fairly soon, they’d have done very well for themselves. Someone buying now, however, and expecting the same rate of return will likely end up pretty disappointed. As any financial advisor who’s not trying to sell you something will tell you, past performance does not guarantee future results.

One of the things about living and working downtown is that I’ve been keenly aware of how much the urban landscape has changed. Around the CN Tower and along Queen’s Quay there are dozens of new buildings where once there were vacant lots and even golf courses. Most of these are one-bedroom condos, some of the larger two-three-bedroom places, and the ‘luxury penthouse’ that seems to either sit empty, gets bought by some multi-millionaire for a place to stash his mistress or gets rented out to an escort operation.

There’s even more buildings under construction, and billboards surrounding empty lots advertising yet more condos. I get this sinking feeling that some of these buildings aren’t ever going to be completed. Despite a ground-breaking ceremony over a year ago the proposed Trump Tower is still just a parking lot, and it would also be interesting how ‘Success’ on Bay Street turns out.

Even with all the people who lived at home until they turned 30 and are moving downtown now, and the empty nesters, there’s still only so many people willing to pay nearly $200K for the privilege of living in less than 500 square feet. There’s not even very good evidence that retiring baby-boomers really want to live downtown in vast numbers. Even if that were the case, that would have already been factored into current property prices by now. People who bought in the late 90s or even a few years ago have probably done pretty well for themselves – sometimes really well – but getting in now would be like showing up at a New’s Year’s party after midnight. The party might not yet be over, but the best has already past. Don’t believe me? Take a look at the current state of real estate in Florida.

There’s still a scramble to buy property in Toronto not because it is actually scarce, but because people think it is scarce and will become even scarcer. There’s actually plenty of land in Toronto, it’s just that a lot of it isn’t put to good use.

The reality is that a significant chunk of the people buying these condos are speculators (oops, sorry, I meant investors), who are driving the prices skywards. It’s the same in every hot market – Vancouver, Calgary, Edmonton and so on. Now the really smart money’s buying up chunks of Saskatoon and Regina. There’s an awful lot of people who think they are awfully clever investors, buying property that will climb forever up.

But here’s the problem. How such a person is actually an investor isn’t clear to me. To me, investing means that you put your money into something that generates an income – you have your money work for you instead of you having to do it all. Putting money, especially borrowed money, into something because you think you can sell it for more later on isn’t investing at all, but speculating. Or gambling. I don’t have a problem with that strategy, I just ask that it be called what it is.

The person I spoke too (and I have no reason to believe is story is at all atypical) isn’t renting a property for more than it costs, therefore generating a steady cash flow, but rather, counting on the price to go up. That would be fine if there weren’t an awful lot of people around with the same idea. It also depends on how leveraged this average investor is. The other thing is, that it doesn’t matter what the value of a place is right now. It only matters when you go to sell it. Same goes for every other ‘investor’. But if too many sell at once, the prices will drop. Again, just look at Miami.

The second ‘investor’ I met is similar to the first. Only he’s ‘into houses’. He had a list of properties that have been sitting, for sale, in some of the, let’s say, less upscale parts of Toronto. They weren’t areas slated for the next wave of ‘gentrification’ either. The person I spoke to knows a fair amount about architecture and remodelling and has probably watched a few too many episodes of TV shows like ‘Flip This House’. At least he doesn’t expect to get rich, but I think he’s vastly overestimating how much he’ll actually end up taking in. At least he hadn’t bought anything yet. He might know what walls can be knocked down, but that doesn’t mean he knows about real estate. Sure, the market is hot right now. And so is the resale market. But again, just because something has been hot for a while doesn’t mean that it will continue to be so. And who publishes most of the data about hot real estate markets? Real estate, brokers, companies and associations – the ones who make money on the transactions. Part of me sometimes wonders if reports from the CREA aren’t really all that different in principal than stock-brokers promoting penny-stock pump-and-dump schemes.

See, my older brother is an old hand at this. Not in Toronto, but up in cottage country. Decades ago he owned a Home Hardware franchise and was later a real estate agent. For the past twenty-five years or so, he’s gone from one dilapidated property to the next. He once bought an old barn and turned it into a gorgeous, huge house that sold for, let’s just say, a handsome sum. He bought a decrepit lakefront summer cottage and turned it into a wonderful year-round house. He eventually sold each property for far more than he bought it for, and factoring his labour in, paid himself a decent salary in the process. Remember that – he paid himself too.

He could easily build a mansion from scratch. He knows the wiring, plumbing, structural elements, roofing, you name it. And as I said, he’s made a decent living. Also, being an ex-real estate agent, he had the inside track on all the good (well-enough below market value) properties. Something not available to the average buyer, even with the internet and access to MLS and so on. But he’s not Donald Trump either.

But I get the sense that I understood more about what this ‘investor’ would likely be getting into than he did. Let’s not even get into the transaction costs involved in transferring a property – such as lawyer’s fees, taxes and so on.  This person bragged that he’d be doing all the work himself, so he’d be saving a lot, since we all know that labour is the biggest cost when it comes to renovating. I’m quite sure that supplies aren’t free either, but I digress. What he’s forgotten in the equation, and what my brother understood, is that you have to pay yourself – your own labour isn’t free. You wouldn’t do your job for free, would you?

Secondly, as long as you have a mortgage on a property and no income in the form of rent, it is costing you money as long as you own it in the form of taxes, maintenance and interest payments as well as the mortgage payment. So until you sell it, you are, in effect losing money. And what happens if the market heads south in the meantime?

There isn’t really anyway of predicting what the future will do, and you certainly can’t base what the future will do based on the past. There are people who simply enjoy buying decrepit houses, doing them up from the inside and out, then selling them. A friend of mine bought the result of one such project. If it’s a labour of love, then great, but it’s not often a way to get rich any time soon.

Buyers have been watching those same shows and they, too are getting more savvy. Here’s the reality when it comes to home renos, whether it’s a place you’ve lived a while, or a place you plan to flip. Home renovations do not bring back more money than you spend. It’s just that depending on the room, you lose less with some than with others. You lose less money if you put it in a new kitchen than you would if you were to put in a home office. But that’s just it – you still don’t get more than you put in; on average you get less. Particularly if you factor in the costs of your own labour. No matter what you do to your property you’re not going to be able to sell it for vastly more than what other houses in the neighbourhood go for. Even when I’ve shopped for a place to live, the ‘fixer-uppers’ aren’t really that much cheaper than the ones in ‘move-in’ condition.  Personally, I would prefer to buy a place that gave me room to make it my own.

His argument, of course, was the same as the person ‘in condos’. Prices always rise. I mentioned that they were already falling in parts of the US, and that the real fallout was only just beginning. He then argued that Canada is different. It’s booming here, with all the oil and a hot mining sector and the TSX is still going up. And Canada doesn’t need the US anymore now that there’s China and India. It’s not going to happen here.

The same arguments being used to rationalise high properties prices are the same ones that were used during the tech bubble in the 90s. There’s always people who believe that things are different this time, that the rules have changed. The ones who believe that are usually the ones who go broke.

Further reading: http://www.johntreed.com/flipthathousereview.html

5 responses to “‘Investing’ in real estate

  1. >>Prices always rise..
    Not sure. Sitting on the fence and looking at the trends http://www.iunknown.ca/BCRealEstate.htm
    can be safer than be optimistic sometimes.

  2. Interesting blog. I have to agree with you that buying a real estate doesn’t always generates the expected profit. It’s not easy to predict how will the market behave and what the prices will be in the future. However it is still a good way to invest money – with the advice of somebody who knows what is doing and knows the market well.

  3. Actually, residential real estate isn’t that great a way to invest. I don’t know enough about commercial real estate to know one way or the other – but bubbles notwithstanding – over the long term, houses don’t appreciate faster than inflation. See http://articles.moneycentral.msn.com/Banking/HomebuyingGuide/WhyRentToGetRicher.aspx

  4. Pingback: ‘Investing’ in real estate part II - now it’s just getting stupid « littleblackduck

  5. I partially agree with you that buying a real estate doesn’t always generate the expected profit. In my opinion this is so because if you have the right guidance, right property adviser, right property consultant then you can have profit in most of your buy to let deals.

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