Real Estate and Finance
Jan 2019 - Sept 2020
I am writing this entry to share my thoughts on the importance of real estate as an asset class for both: investment, and academic study. In my experience and research I have discovered real estate to be a solid wealth generator and the only asset class that offers a retail investor the chance to invest in an asset whose price rests well beyond their disposable income. Before I share my thoughts I’d like to set some ground rules: (i) I am referring to investment in residential real estate assets like condominiums and homes; (ii) My thoughts on use of leverage and pre-sale buying of real estate assets relate to investments in western markets like USA, UK, and Canada; (iii) My thoughts do not apply to real estate assets acquired by subprime mortgages nor speculative purchases; and (iv) I am not offering financial advice. Investment in real estate is risky and can lead to substantial losses and you should consult a professional financial advisor before making any investment. This blog entry is an opinion piece and could be false #disclosure ☺.
Here are the reasons why I think an investment in real estate is valuable for every investor especially new investors starting to allocate their capital:
1) Leverage: this fundamentally increases your purchasing power and allows the ability to secure an asset that is majority financed by a financial institution at a relatively low interest rate (i.e as little as 3% in US and Canada).
2) It’s an investment for the long haul that pays for itself: unlike buying a car where you can also use leverage, a real estate investment allows you to increase your equity in the asset overtime as you payoff your mortgage. The idea is to generate rental income that helps cover mortgage principal and interest payments plus other expenses such as maintenance fees. You are essentially having someone else pay off the asset after you make your initial downpayment which typically accounts for 20% of the property value, leaving the remaining 80% to be financed by your low-interest mortgage.
This hard asset can also be sold for cash to re-invest or you could refinance to take out equity from your home that you could use to make further investments. Whatever your objective, an investor with a long-term view will stand to benefit. Caveat: about speculative real estate investments and the false assumption that real estate prices do not decrease (which led to the 2008 credit crisis).
3) Pre-sale buying: this is a good strategy that doesn’t tie up capital and can yield significant returns. The idea is simple: allocate a downpayment toward an upcoming development in phases which means you might only need to commit as little as 5% at the time of purchase, and then stagger the remaining 15% of the downpayment over the course of a couple of years until closing when the property is handed over. During this period, a real estate investor will likely experience price appreciation on the property and a strong ROI which leads to my next point. But before I move on to my next point: if you are wondering about ROI lets assume you put down $40K toward a $200K property a year before closing and at the time of closing the property value goes up by 10% – that would mean your property is now worth 220K. But that’s not all, your investment nearly doubled (40K invested and 20K gained). Not bad right? This calculation of course does not include brokerage fees (typically 2 – 4% of property value), taxes, and closing costs; but even if you take those into account you could comfortably achieve an annual return of at least 10%. Compare that to the S&P return for 2018 which was in negative territory and its long-term average of circa 8%. Now think of a scenario where the property price goes up by 20% or more at closing which has been commonplace in markets like Toronto, and Williamsburg New York (to name a few). Note that time to closing for pre-sale condominiums is typically longer than one year depending on the type of property.
4) Price appreciation: real estate prices have exhibited a steady climb globally from data beginning in the year 2000 to 2018 according to figures published by the IMF. Savvy investors have taken advantage of micro booms in real-estate in several cities like Toronto and seen their wealth increase many fold as a result. You could invest in a condominium, rent it and start to pay off the mortgage and can sell the asset in a few years and benefit from the returns generated from the price appreciation. However, as much as pre-sale buying and price appreciation sound appealing, the idea I am trying to emphasize is owning an asset that pays for itself – and that’s the real benefit of investing in real estate. It’s a long game.
5) It’s an automatic inflation hedge (for the most part): if you buy real estate for an investment you would most likely rent your property. Rents increase with inflation but your fixed rate mortgage and taxes do not so that’s your simple inflation hedge.
6) The folks with three commas: according to Forbes, real estate is among the top 4 industries for billionaire investors in America and in the world – just thought I mention.
7) Importance at a macro level: Real estate constitutes a substantial proportion of the world’s wealth. In fact, it is the world’s largest asset class. As at June 2018, global real estate constituted 3.5 times the value of global GDP (Savills). According to a real estate trends report by PWC, by 2025, there will be nearly 37 ‘megacities’ up from a recent number of 23 – think about all the real estate that would need to be created to accommodate this.
8) Volatility: compared to equities, real estate is a safer bet because: (i) price of real estate does not fluctuate as frequently or capriciously as equities, (ii) its value is easier to determine than a price of a stock, (iii) It has never gone to zero (stock prices have), (iv) You can see it and touch it (hence the term ‘real’), and (v) Not that it matters but it is probably the only thing in the world Donald can’t refer to as ‘overrated’ ☺.