Residential real estate WAS a great investment
Investors have a tough time making decisions about the future of different asset classes, so we tend to rely on the past for our direction. Unfortunately, that is rather like driving a car by looking only in the rear-view mirror. It is also what many real estate investors are doing today.
There is no denying that residential real estate has been a great investment over the past 34 years. The average house price in Ottawa went up 5.6 times between 1983 and 2017, which is an average annual return of 5.4%. (I chose 1983 because that was the top of the interest rate spike when mortgages were 18%). However, this period also coincided with two phenomena which are not likely to be repeated any time soon.
Baby boomers are responsible for a lot of the growth in real estate prices
First, the 1983 to 2000 period was powered by the Baby Boomers, who reached a level of employment seniority wherein they could afford considerably more house. By 1983, the first Baby Boomers were 36 years old, with growing families as well as wallets. I bought my first house first house in 1986, my second larger house in 1988, having made 20% in two years. The next 17 years were characterized by both growing families and growing numbers of families.
Interest rate decline explains about 50% of the growth in real estate prices
Second, interest rates began a 34 year downward path that lasted until 2017. Solely because of decreasing interest rates, a monthly mortgage payment of $1000 in 1983 could support a mortgage 3 times greater by 2017. ($66,000 @ 18%, $200,000 @ 3.5%). That explains about 50% of the increase in house prices simply because of increased mortgage carrying capacity (3.0/5.6=.54).
The following graph shows the decline in the US Ten year bond yield since 1983. Mortgage rates were higher than the Ten year bond in Canada in 1983, and declined from 18% to 2.5% or even lower in an Adjustable Rate Mortgage (ARM) . But the overall effect is the same. The likelihood of similar interest rate declines ? Zip, because you can’t go from the current 3% to – 12.5%.
Rental unit carrying costs are higher than rental income
The third reason why residential real estate will be a poor investment is the current rent to carrying cost ratio. Basically, it is hard to be cash flow positive today because of high purchase costs, high taxes and high maintenance or condo fees. (In other words, it is cheaper to rent than to own). For example, a $400,000 house or condo rents for about $1800 per month, or $21,600 per year. With an 80% mortgage, here are the annual carrying costs in Ottawa:
$320,000 mortgage at 3.5% 19,152
Taxes at 1% 4,000
Maintenance or condo fees at .5% 2,000
Annual deficit 3,552
In addition to being cash flow negative, the investor has to rely on capital appreciation to pay back her 20% down payment. Given that interest rates are likely heading up rather then down, and given the fact that family growth in Canada now depends primarily on immigration, it seems likely that real estate price inflation will be constrained, or even negative.
Even in the case of an investor paying cash, the returns are not exciting, with net revenue of $15,600 ($21,600-$6,000), generating a yield of 3.9% ($15,600/$400,000). There are many other ways of achieving this sort of yield without all of the problems associated with finding, buying, selling and maintaining real estate, such as dividend grower stocks (banks, pipelines, telcos).
Real Estate Investment Trusts (REITs) are a stress free way of investing in real estate
If all of this negativity has not turned you off real estate completely, and you are still interested in long term income and possible capital gain, you might consider a Real Estate Investment Trust (REIT) ETF. REITs are companies that own shopping centres, retirement residences, industrial buildings, office buildings, and apartments. They have significant scale advantages over the individual investor including the cost of borrowing and maintenance. Through a REIT ETF, an investor also achieves instant diversification so that even if the residential sector stumbles, the other sectors may do well. At the moment, REIT ETFs are paying a distribution of between 4.5 -4.7%. In addition, they have increased in value by about 5% per year or more over the past three years. Finally, and for me perhaps the best argument for them, is that you don’t have to deal with dead beat tenants or broken furnaces in the middle of the night. Check out these Canadian based REIT ETFs. XRE and ZRE are index trackers, while RIT is a managed ETF.