Real Estate or Securities? Where to Invest…
It seems that the debate about which asset class is a better investment has raged on for decades. At different stages in the market cycle, sentiment shifts and money shifts from real estate to securities, and then again more money flows back into the real estate market. Ask someone who bought waterfront property in West Vancouver a few decades ago for what now seems like pennies on the dollar or someone who invested early in Apple shares and you will likely get very compelling and well-supported arguments for where you should be investing your money.
Ask a stockbroker which is the better investment and 9 out of 10 times you know what you are going to hear. Similarly, ask a Realtor where one is best to invest their money, and again, the Realtor is likely to promote the asset class that, via commission income on your investment, is putting food on the table and their kids through college. Both may wholeheartedly believe in the asset class they are recommending, but they are biased, they have a vested interest, and they are immersed in their specific field, witnessing the successes of the clients they are working with on a daily basis.
Given my unique background where I have spent a significant amount of time in a licensed capacity advising clients on both sides of the fence, I am often asked for my opinion on what I feel is a better investment. To be completely honest, my answer may surprise you…The better investment is the one that makes the most sense for you given your unique circumstances, investment objectives, risk profile, time horizon, market knowledge, skill set, etc.
I know, I know, that is a pretty weak answer. But, it is the truth. At the end of the day, whether it is a single-family rental property, an apartment building, a commercial plaza, a balanced mutual fund, or a speculative penny stock, all of these are simply tools that you can use to grow your wealth and achieve your financial goals. No matter your circumstances, I strongly advocate a goals-based approach to investing, where you have to look at what you are trying to achieve, and then focus on which asset class gives you the best chance of doing so with the most reasonable risk/reward profile. For the majority of the population, they simply wouldn’t have the required knowledge to ascertain this on their own. This is why it is so important for investors to surround themselves with a qualified professional team who can provide sound advice and guidance to ensure you achieve your financial and lifestyle goals.
Let’s take a look at some of the primary benefits of investing in each category:
–Leverage: Ever wonder why your banker will lend you 95% of the purchase price of your primary residence and currently only charge you 2-3% interest? You know those financial towers in Downtown Vancouver, Toronto, New York, etc., they are full of smart people who have determined it is a safe investment in an asset class that traditionally rises over time. Currently, lenders will provide up to 80% financing on investment properties. Looking at our most recent monthly market recap, the average home price in Nanaimo is up 17.5% in the past year. If you purchase a $500,000 dollar property, (roughly the average home price in Nanaimo currently), with 5% down as your primary residence, your $25,000 investment before transaction costs, taxes, etc., is up $87,500, a cash-on-cash increase of 350%. On an investment property with 20% down, your $100,000 investment is also up $87,500, a cash-on-cash increase of 87.5%. Of course, these are abnormally high returns, but 2-3% annually which could reasonably be leveraged 20x (based on 5% down) returns 40-60%. With 20% down, 5x leverage on 2-3% appreciation produces very respectable returns of 10-15%. If you have invested in a positive cash flow investment property, add this to your monthly return as well as increasing equity resulting from the mortgage paydown. Taken together, your cash-on-cash increase is likely outpacing a balanced portfolio of securities, especially considering the low interest rate environment we are currently operating in. While some investment brokerages offer margin accounts, the interest rates charged on borrowed funds are typically much higher, and it is challenging to borrow more than 50%.
–Control: When you buy a real estate asset, you have control over that asset and ultimately its financial performance. When you buy shares, you are betting on management’s ability to effectively manage the affairs of the company. Where this gets even more interesting is with income properties such as apartment buildings or commercial retail plazas. Essentially, these properties are valued based on capitalizing the Net Operating Income. In simplified terms, the value of income-producing real estate goes up or down depending on the financial performance of the building. Therefore, you have 2 options…Increase income or lower expenses to increase the value of the building. As an investor, that is within your direct control. For example, you purchase an older 12-unit apartment building in a great area that has been poorly managed and needs some basic cosmetic upgrades. For the purpose of illustration, the building is currently 75% vacant and average rents are $800 per unit per month. Starting with the vacant units, over the course of the next 2 years, you clean up the units and hire a new, pro-active property management company, resulting in the average rents rising to $900 per unit and you get the entire place rented out in line with current sub 2% vacancy rates in Nanaimo. Your gross rental income has increased from $86,400 to $129,600. If operating expenses stay relatively consistent at 30%, you Net Operating Income (NOI) has increased from $60,480 to $90,720. Based on current capitalization rates (4.75%) and holding them constant over the 2 years, your initial purchase price based on how multi-family properties are valued was likely in the range of $1,275,000. Capitalizing your improved NOI results in an implied value of $1,909,000, an increase of $634,000 in addition to your positive cash flow and increasing equity from the mortgage pay down. Under this scenario, a budget of $10,000 per unit for a total of $120,000 is extremely reasonable. Net, that is a gain of more than $500,000. If you put 20% down, your $255,000 down payment has translated into a significant increase in building value, all carefully planned with a minor cosmetic upgrade and replacing management. Knowing local market conditions, you (or your professional team) should have been able to identify this opportunity a mile away…
–Tax Advantages: Don’t underestimate the value of the principal residence capital gains exemption in your wealth building strategy. In 2013 while still living in Vancouver and working in the capital markets, I was over visiting family and viewed a waterfront property on desirable Fillinger Cres. in the prestigious Rocky Point area of Nanaimo, which featured a 3,200 square foot home with incredible views and excellent beach access. The home was a foreclosure at the time and ended up selling for $466,310. Today that home would easily clear $1,000,000, probably a fair bit higher. This is less than 4 years ago folks. Had I purchased with 5% down and made this home my primary residence, my $23,300 down payment + closing costs & property taxes has me up more than $500,000 tax free. That is more than a 20x return on which I will not be taxed. Now, say I sell that property and use the proceeds to purchase a $2,500,000 property with 20% down. Over the course of the next market cycle that property doubles in price which is not an unreasonable expectation given past performance. 7-10 years down the road, I sell that property for $5,000,000 tax free. While you do have mortgage payments to consider, I have now turned a $25-30k initial investment into $5,000,000 tax free in 14 years. Depending on your living standards, you are basically set for life. While this example is a bit extreme, it does highlight the potential of using real estate to your advantage as a tool to achieve your financial goals.
Other notable advantages of real estate include: it is usually easier to understand; it is a tangible asset you can touch, see and reside in; and price action is location driven so by making smart investment decisions you can largely control your exposure to price volatility.
–Liquidity: In most liquid securities, a simple phone call or click of a mouse will have your securities sold. Faced with an emergency or a great business opportunity you can generally cash out with ease, although your return will be dependent on current market conditions.
–Lower transaction costs: Discount brokerages have reduced commissions to less than $10 per transaction in many cases. You could sell $1,000,000 worth of shares and be charged less than $10 to do so. Real Estate commissions are typically based on a percentage of the sale price, so the higher the price of the home, the higher the fees.
–Less work: Investing in securities does not involve managing tenants, coordinating repairs, or cutting the lawn. While you can hire out these services, it comes at a cost. When you purchase securities, you can have well-educated, experienced professionals managing both your portfolio and the underlying assets they are holding.
–Diversification: A relatively small investment can have you invested in a balanced fund consisting of both debt and equity in a variety of sectors and geographic locations. The tech sector goes bust and in a well-balanced portfolio, you are relatively insulated. In the early stages of building a real estate portfolio, many investors have only 1-2 properties. Should the market turn in that specific location, the concentration risk is much higher.
–Unleveraged Returns: Without borrowing to invest, stocks over the long term have produced a higher annual return than houses. The Globe and Mail reported in 2013 that in the preceding 30 years, stocks returned on average 8.5%, in comparison to the 5.5% return on real estate. For those against the use of asset-backed debt, then a case could reasonably be made for securities.
For most people, both real estate and securities have a place in their overall wealth plan. With each category having both positives and negatives, it is important to remember that these assets are simply tools to help you achieve your financial and lifestyle goals. In order to achieve these goals, you first need a plan, supported by a professional team who understands the “tool box” and how the tools can best be utilized given your unique circumstances, investment objectives, risk profile, time horizon, market knowledge, skill set, etc.
If you are considering an investment in real estate or need some assistance in developing a plan of action, put our team to work for you. Contact us anytime for your complimentary consultation at 250-751-0804 or firstname.lastname@example.org
Note: Some of the above examples are over-simplified scenarios used for illustrative purposes only, ignoring factors such as transaction costs, carrying costs, taxes, etc. The discussion surrounding securities are in no way intended to be considered advice, recommendations, or any act in furtherance of a trade.