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Posts Tagged ‘Real Estate’

In the last post, I examined the potential returns and risks of investing in a condo for Pete.  However, the analysis isn’t complete until we consider alternate investment vehicles. For instance, there are many studies illustrating that the stock market outperforms residential real estate in the long run: here is one from Ibbotson. Logically this makes sense: businesses pay a portion of their revenues to employees who use this income to pay for their homes. Real estate cannot appreciate faster than business revenues indefinitely, otherwise where would the money come from to afford these homes? The fact that real estate has appreciated so much faster than earnings for so long suggests a market imbalance in need of a correction.

Specifically, this blog is focused on the benefits of wide moat, dividend paying equities, and this is the sector of the market I would recommend to Pete. There are a number of strategies Pete could consider. Most simply, he could invest in an ETF like the XDV which focuses on quality dividend payers. However, this wouldn’t be my first choice since XDV is heavily weighted toward the financial sector (over 60%). In the May issue of Moneysense, Norm Rothery provides an alternate portfolio of quality dividend payers which is not as heavily weighted in financials, see Generous Dividend Growth Portfolio. Another method that I’ve discussed on this blog is David Stanley’s Beating the TSX index which will also generally be weighted toward financials, but guarantees buying the cheapest stocks amongst a basket of quality dividend payers. This strategy has returned 10.2% annually from 1987-2009 (see Investing by the Decade CanadianMoneySaver February 2010).

To illustrate the benefits of investing in a wide moat, dividend paying company over a condo, I am going to consider an investment in Enbridge Inc. – a boring pipeline company rarely discussed with much enthusiasm. However, it is one of the largest and most successful pipeline operators in North America. In general, pipelines are a great business since there is no other economical mode of transporting oil or gas  and therefore the only competition for a pipeline is another pipeline. However, obtaining the rights to build a pipeline once one already exists is very difficult, thus rendering  existing pipelines near monopolies for the routes they serve. Finally, pipelines get paid based on the volume of energy transported, not on the price, insulating them from fluctuations in energy prices and enabling them to provide steady cash flow. Simply, as one of the largest pipeline operators in North America, Enbridge is a wide moat business.

Enbridge has paid a dividend since 1955 that has grown from $0.0075 to $1.48 per share annually (an average increase of 10% per year). The company has generally maintained a payout ratio between 60-70% though it currently sits at 84%, a little on the high side. The 5 year EPS consensus growth forecast for Enbridge is 8.00% (see here), which is slightly lower than the company’s long-term average of 10%. Currently, Enbridge stock is trading in a range between $46-$50 with a P/E of 13.2 and P/B of 2.5, which are slightly lower than the 5 year averages for both these measures (17.5 and 2.8 respectively). So Enbridge is trading at a slight discount.

Using history as our guide, let’s examine what Pete could expect to make over 10 years if he invested $250K in Enbridge. Currently, the dividend yield is 3.5% and assuming that earnings and dividends increase 8% annually, Pete’s Enbridge stock would be worth $654,599.49 in 10 years (compared to $499,751.16 for the condo, plus $20,482.09 in cumulative rent). This is assuming Pete uses his dividends to pay the interest on the loan first and then reinvests whatever remains after tax. In ten years the yearly dividend income after interest and tax would be $9,538.66 (compared to $3,688.44 for the condo). Unlike apartment rent, dividends are taxed at a lower rate than regular income. Exactly how much lower is dependent on your tax bracket. I’ll assume an income of roughly $90K, which translates into a dividend tax rate of  22.25% although Pete could further enhance his returns by sheltering some of his Enbridge stock in an RRSP or TFSA.

Since Enbridge is free to increase its dividends as it sees fit and those dividends are tax advantaged compared to rent, an investment in Enbridge would outperform Pete’s condo by quite a bit even assuming both investments grow at the same rate. However, unlike my assumptions about the future of the real estate market, my assumptions on the future growth of Enbridge  are below its long term average and unlike Pete’s condo, the stock is trading at a slight discount to its traditional valuation. Based on this, I would be more confident with my forecast for Enbridge’s future performance  than  for the  likelihood of Pete’s condo continuing to appreciate.

Of course, getting a loan for $200K to invest in a stock is not as easy as getting a mortgage to buy a condo.  However, if Pete has enough equity in his existing home he could borrow against that. This tactic is known as the smith maneuver. Certainly, if Pete only invested the $50K he has available, in 10 years his total return would be lower at $135,044.67  and a dividend income of $4248.66 annually. It is important to understand that the outsized returns mentioned above in both the condo investment and the Enbridge stock come as  a result of leverage which implies added risk.  Of note, leverage is something that Pete can choose to take on when considering an investment in a stock, but not a choice when electing to invest in a condo since you can’t buy 1/5th of a condo, but you can buy a small piece of a company.

As well, I am certainly not advocating a 250K investment in a single stock. I am simply comparing the logic of making a large investment in a single condo with a safe dividend, paying company. Reservations about the lack of diversification are equally legitimate when considering a stock as they are when considering a real estate investment. Once again, however, the opportunity to diversify  exists when considering stocks but not for real estate.

A final word about reliability: I cannot predict whether Enbridge will outperform the stock market in general (nor can I be sure that the red hot real estate market won’t continue its run for  some time yet), but I can be reasonably confident that its wide moat business will remain intact and that its 55 year history of increasing earnings and dividends through good times and bad provides some insight into the quality and longevity of its business. Certainly, a company such as this, trading at a reasonable valuation is likely going to be a better performing investment than a condo at the height of a real estate boom.  So if I were advising Pete today on a major investment with a large leveraged position, I believe he would be better served by a basket of boring dividend payers comprised of companies like Enbridge rather than a condo in his building.  My advice to Pete is to hold off on the condo and instead consider quality dividend paying companies trading at a discount.

Full Disclosure – Enbridge is currently on my watch list and I would consider a purchase if at some point it trades at a greater discount.

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My friend Pete asked me recently whether he should invest in a condo in his building. Understandably, soaring real estate prices have mesmerized many and there is a pervasive feeling that there is money to be made.  I suggested Pete consider the following 3 questions:

1) What return can you reasonably expect from this investment?

2) What are the risks?

3) Have you considered the opportunity cost of not making another investment?

In this post I will address the first two questions and consider the opportunity cost in a follow-up article.  First, a little background: Pete lives in a new condo building in a very desirable area of Ottawa, Ontario. He has lived in the building for a few years and is very happy there – no horror stories of shoddy workmanship or skyrocketing condo fees that would suggest caution. He has about $50K in savings ready to invest and is considering the purchase of another unit in the building as an income property. Outwardly, this seems reasonable.  He is familiar and happy with the building and there probably won’t be a lot of maintenance or unforeseen increases in condo fees. Furthermore, although mortgage rates are on the rise, rates are still near historic lows and remain attractive. Finally, Ottawa in and of itself is a safe government town with a stable workforce and although real estate has done well there, it is still relatively affordable compared to other major Canadian cities.  So, all that remains (but is often overlooked) is a careful analysis of the real returns and risks of such a venture.

What is a reasonable return for this investment?

I sat down with Pete to consider the kind of return on investment he could expect.

Price of Condo $250,000
Down Payment $50,000
Rental Income Monthly $1,500
Rental Income Yearly $18,000
Taxes $2,500
Condo Fees $3,600
Income after expenses $11,900
Rental Yield 4.76% ($11,900/$250,000)
Mortgage $200,000
Mortgage Interest (5.5%) $11,000
Income after interest payment $900
Rental Yield based on Down Payment and Interest 1.80% ($900/$50,000)
Tax Rate 43.41% (Pete’s highest tax bracket)
After Tax Income $509.31
Personal Time 0

The rental yield is 4.76% meaning that for a $250K investment Pete can expect a 4.76% return based on the rent he can charge. He will need to obtain financing to purchase the condo and I’ve assumed a 5 year fixed mortgage rate of 5.5%. This is below the current posted rate of the banks but still achievable. If we factor in the cost of servicing debt, the rental yield goes down to 1.8% and the rental income becomes $900 or $509 after tax (assuming a tax rate of 43%). As per Ontario law, landlords can increase rents based on the inflation rate as measured by the Ontario CPI index (see here). The 10 year average of rental increases is 2.55%. I am going to be optimistic and assume 100% occupancy and that Pete actually implements the  rental increases. Furthermore, I have not allocated any dollar value to the time Pete will spend managing the condo. This is something that could significantly reduce returns if properly factored in, but is rarely given proper consideration.

A rental yield of 4.76 % is not particularly attractive when you consider that rents cannot increase more than the inflation rate and the increase rate has been capped to less than 3% for the last 10 years. The investment is made even less attractive because it requires a debt to equity ratio of 4 to 1 ($200K mortgage vs. $50K down payment) with the resultant income fully taxable. However, in my experience, people do not invest in real estate solely for the rental income, but with the expectation of capital gains. That has been a good bet for the last 10 years.  According to the Globe and Mail, real estate in Canada has returned 8% annually since 2000. This is where the leverage associated with real estate investments really pays off.  An 8% ($20K) increase in the value of Pete’s condo would translate into a 40% ($20K/$50K) increase in his investment return. All the while, his renter would be paying to carry the place. That’s attractive but it’s important to realize that the return is related to the leverage employed.  An 8% return itself is not particularly spectacular. According to John Bogle, the father of index investing, a simple indexed stock market strategy can be expected to return 6-7% annually, adjusted for inflation.

Let’s assume for a moment that real estate continues to appreciate at its torrid pace of 8% annually.  In 10 years Pete’s condo would be worth $499,751.16.  Assuming a 2.55% annual increase in rent, the rental income over the next 10 years after tax and interest payments would sum to $20,482.09. In 10 years the rental income will be $3,688.44 per year and assuming only minimum payments are made on the mortgage, the balance outstanding will be $150,312.06. So the condo will double in price and the rental income will pay down the mortgage and contribute to Pete’s income.

What are the risks?

This brings us to the next question: what are the risks associated with Pete buying a condo in his building?  According to Robert Shiller, the inflation adjusted return of residential real estate in the US over the last 100 years is less than 1%.  Here is a clip of Shiller making his case. While the real estate market has posted impressive returns for the last few years, over the long term real estate has not been a particularly rewarding investment.  If you believe in reversion to the mean (a basic tenant of value investing) then the future returns of real estate will be quite poor, possibly even negative. Negative returns in real estate can be particularly disconcerting to investors because leverage works to both magnify returns in good times and losses in bad times. Returning to Pete’s situation, two years of 8% declines in the price of his condo would result in a $38K reduction in price  or a 77% reduction in equity . Compounding this risk is the understanding that real estate is not a liquid investment and in a down market Pete could get stuck holding onto his condo for a long time.

In my opinion, the massive run up in real estate prices has been fuelled by low interest rates and easy money that have allowed Canadians to rack up huge amounts of debt. This cannot continue indefinitely. According to the Globe and Mail, Canadians currently have a debt to income ratio of 147%  which is not significantly different than our American counterparts with 157% (see here).  Furthermore, 70% of this debt is mortgage related, illustrating the point that people are spending an increasing portion of their income paying for their real estate investments. According to Statscan, property prices in Canada are up 23% year over year while personal income is down 1% (as of March 2010). The only way this paradox can exist is by increasing debt loads, which is unsustainable. Given this, the assumption that real estate prices will continue to appreciate at present rates seems speculative at best.

Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results.– Warren Buffet

A basic tenet of value investing is to buy assets at an attractive price.  In my opinion Canadian real estate is not cheap and given market headwinds is unlikely to produce satisfactory returns in the future.

In my opinion, a real estate investment should be evaluated primarily on rental yield.  If we could backtrack 10 years by adjusting the cost of Pete’s condo downwards by 8% per year  and rents downward by 2.55% (in order to recreate a real world year 2000 scenario), we would get a price of $125,000 and a rental income after expenses of $9,400. The resulting rental yield would be 7.5%, a much more attractive investment notwithstanding capital gains. I can recall looking at income properties in the late 90’s and calculating rental yields between 8-10%. If rental yields come down to this level again I would consider making another investment in the real estate market. Warren Buffet recently made a major investment in US real estate when he started Berkadia, a large US mortgage broker. However, he only did that after a massive correction in real estate and after he felt the worst was over.  Obviously, this is not the case today in the Canadian real estate market.  In the next post I’ll examine some alternative and possibly more lucrative investment opportunities for Pete.

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