A Toronto real estate investment plan
By Richard Croft - Financial Post
Including Toronto real estate as an asset class in your portfolio is not as straightforward as you might think. The first thing to do is examine the role real estate plays in your net worth statement. I think of your net worth statement as your assets (personal and financial) less your liabilities.
Usually your two biggest assets are your investment portfolio and your principal residence. And typically, your principal residence will be the single largest, probably accounting for as much as 50% of your personal net worth statement. If we look at our net worth in these terms, then if you include real estate as an asset class in your investment portfolio, you will be seriously overweighted in a single asset class.
On the other hand, real estate is an excellent diversifier within a portfolio, and in the case of real estate investment trusts (REITs), can provide some decent tax-advantaged cash flow to your portfolio. So here’s the question: Is your home a place to live or is it an investment that will at some point be sold to capitalize your retirement years?
If the former, then by all means include real estate in your portfolio. If the latter, then adding real estate to your portfolio would defeat the purpose of optimum portfolio diversification.
Assuming real estate should be in your investment portfolio, the next step is to understand what it brings to the portfolio in terms of performance enhancement and risk reduction.
As an investment, the real value in real estate is its cash flow. If you buy a rental property, for example, you buy it on the basis of some cap rate, which is really just another way of saying the property value is based on some multiple of its cash flow.
Like any other asset, the multiple accorded to that cash flow is determined by the stability of the cash flow. If you are buying a property with a solid, long-term tenant who pays the rent –like a major Canadian bank — the cash flow is stable and the property will fetch a higher valuation.
Another way to look at cash flow is in terms of how real estate is financed. In Canada, you can borrow 75% (sometimes you can borrow even more of the purchase price) of the value of your real estate, usually financed over a 25-year term. If your cash flow is stable, you can use the excess cash flow to pay down the mortgage, and at the end of 25 years, you own the property free and clear.
That latter point is critical to understanding how real estate fits within an investment portfolio. Generally, we view real estate as a cash flow asset rather than a growth asset. As such, it is important to look at it in terms of the cash flow and the stability of the cash flow.
That explains why so many real estate investment trusts are listed on major stock exchanges. They provide solid cash flow and some limited growth. Most real estate mutual funds and limited partnerships are sold on the same basis. They seek good properties with stable cash flow and use the excess cash flow to pay down debt. In time, the property is refinanced, which allows investors to exit should they wish to sell — and, in some cases where the property value actually increases, the investors can exit the fund or the partnership with a much better rate of return.
Of course, there are periods when real estate values rise. Usually that occurs when other assets — most notably equity assets –are falling in value. Note the increase in Toronto real estate values during the 2000 to 2003 bear market for stocks. Also note the weakness in the Toronto real estate sector in the late 1980s and early 1990s when the stock market began one of the great bull markets of our time.
That performance history may surprise some of you. But think about your personal experiences at work when sitting in the lunch room. When it comes to investments, your co-workers will be focusing on real estate to the exclusion of all other assets during the boom periods. But when real estate crumbles, the focus will move to other assets, most notably stocks. Remember what the focus was during the 1990s when the stock market was sizzling. Most were talking about the stock that doubled or the mutual fund whose value exploded, not the value of their homes.
Within a portfolio, real estatee is a great diversifier. Historically real estate has a 0.32 correlation with stocks (remember -1.00 means perfect negative correlation and +1.00 is perfect positive correlation). As we have talked about in this column, the lower the correlation the better the diversifier.
One of the problems with real estate is liquidity, particularly as it relates to limited partnerships or mutual funds that hold real estate assets.
Liquidity is not normally a concern because Toronto real estate investors tend to have long time horizons and are typically seeking cash flow. But if you need money for an emergency, it will be easier to sell assets other than real estate.
Consider that when buying real estate mutual funds or private limited partnerships. If many investors want to exit at the same time, it can cause a so-called liquidity crisis. Historically we have seen so-called “stabilization measures” imposed by certain real estate funds when there has been a large number of redemptions.
The stabilization process allows the funds to pay redemptions only out of money coming into the fund, which can result from new units being sold, or from rental income received on the properties in the funds portfolio.
Without provisions of this sort, real estate funds would have to sell properties at distressed prices, which could result in enriching one group of unitholders to the detriment of others. Because real estate funds do not have the liquidity of a stock or bond fund, managers cannot move adeptly in and out of the market, and for investors who want the right to redeem, that’s a risk factor.
Richard Croft is president of Croft Financial Group, a Toronto-based investment counselling firm.
———————————————————————————
Contact the Jeffrey Team for more information
