Condo Real Estate

Author and speaker Gail Bebee of No Hype-The Straight Goods on Investing Your Money fame yesterday sent out her e-newsletter (just go to her website to sign up) with a link to an excellent guide to condo buying, whether as an investor or an owner-resident, by financial advisor Kurt Rosenstreter. Having once been a condo owner and board member, I can vouch for the sensible advice he gives. If the rental costs don't even cover interest on a mortgage these days, let alone taxes and condo fees, as in one example he cites, then it sure is time to rent rather than own a condo.

Gail Bebee Warns on Treating Cottage as an Investment

No Hype Investing author Gail Bebee sent along the following note on cottages.

"Five reasons to avoid the allure of cottage country real estate

Toronto, August 12 – The long awaited summer weather may be tempting some Canadians to join the ranks of those who own cottages. “I don’t think owning a cottage is a good investment,” says independent investor and personal finance author Gail Bebee. “If you love the cottage lifestyle, go ahead and buy a property by the lake, but don’t buy it strictly as an investment. There are better places to put your money to work.”

Here are some of the reasons Bebee thinks owning a cottage is not a good investment:

1. Real estate is illiquid, so your money may not be available when you need it.

2. The return on your investment is not guaranteed.

3. Ongoing costs (taxes, insurance, maintenance etc.) eat into your profits.

4. Cottages demand your personal time, especially for upkeep.

5. Transferring the family cottage to the next generation often results in family quarrels, or misery if the cottage must be sold to settle an estate.

For more information on the pros and cons of investing in a cottage or to arrange an interview, please contact:

Gail Bebee

Canada’s Independent Voice on Personal Finance

Personal finance speaker and author of No Hype—The Straight Goods on Investing Your Money

Tel: 416-733-0221

gbebee@nohypeinvesting.com

www.nohypeinvesting.com"


As a cottage owner, I can only agree that a cottage should be for fun not profit. What you gain in appreciation seems to be more than taken up with maintenance and tax increases alone. Came across this useful summary of advice on how to minimize various taxes by CIBC's Jamie Golombeck in this article by Jonathan Chevreau in June.

Canadian Housing Market Sense

Finally an article that makes sense in commenting on why housing prices aren't about to implode in Canada as in the US and the UK. Read the CTV article Why the Housing Market is Not Set to Melt Down.

Oct.31 update - BMO Capital Markets publishes a 3 pager on the differences between Canada and US home mortgage lending and personal debt which supports the idea that there will not be a housing price collapse and mortgage crisis in Canada.

Strange Results in UBC Study that Says Canadian Real Estate Over-Priced

Last week I dumped on CBC for misrepresenting the study by UBC prof Tsur Somerville and student Kitson Swan titled Are Canadian Markets Over-Priced?.

Today I look at the same study from a different tack - its contents. It pains me to criticise my MBA alma mater but the conclusions - that houses in certain cities are over-priced by as much as 25%! - don't look right and they don't seem justified.

The first strange result in the study is that the cities with the cheapest houses are said to be the most over-priced. Look at the table below using numbers copied from the report.

Apart from the suspicious pattern, the conclusions about individual cities like Ottawa seem positively crazy. Slicing $80,000 (25% of $320,000) or so from the price of a house in Ottawa would make it equivalent in real value (i.e. after removing inflation) to the price in 1984 per this chart taken from the UBC Centre for Urban Economics and Real Estate website.

As they say, thanks for nothing.

The paper states it is "treating housing simply as a financial asset". What investor would be willing to take on something with zero return over 24 years? Were Montreal houses also to lose 25%, the amount they are said to be over-priced, they would be back to 1975 values in real terms (again, see the UBC website for the chart)!

In other words, I doubt whether houses can be valued purely as an investment. The type of house examined in the study is the traditional suburban family home - single family detached houses. My guess is that such houses have their rent determined by the main rental market and that rent has little effect on the value/price of the house. Probably, the owners are making sure that rental covers their cash costs on an after-tax basis and are only thinking of the appreciation in the house price or capital gain as a bonus or source of extra profit.

The study authors themselves acknowledge possibilities other than a price rise or decline to balance their equation:

• "If we underestimate the rate of expected house price appreciation, we will predict an equilibrium house price that is too low, below the actual figure, potentially suggesting a market is over priced that is really not." (p.3) A case in point is Ottawa, which comes out by their estimation with an expected rate of capital appreciation of only 2.7% (that's why I highlighted it in red in the previous table), much less than any other city and only half that of Toronto and Vancouver. Maybe their estimate of future Ottawa price appreciation is way too low? Add 2% to Ottawa's expected growth rate, which would make it comparable to all the other cities and presto, Ottawa is not over-priced at all.
• "Changes in the economy and in interest rates will yield different results." (p.3) If interest rates fall, the proper house price goes up according to the study's formula. A Bank of Canada policy decision to lower rates could thus instantaneously solve the problem of over-priced houses by the author's measure - no need for prices to actually fall.
• "The assumption about rents presumes that this is the correct expected flow of revenue from the unit." (p.3) If rents rise, then the problem of over-priced houses disappears.
  

That's not to say there are no over-priced markets in Canada where prices might stagnate or fall slowly or suddenly. But if there are any such cities amongst the ones examined in the study, I'd bet more on the highest-priced ones like Vancouver, Toronto and Calgary than lowly Ottawa, Montreal, Winnipeg or Halifax.

If the authors really wanted to come to a definite conclusion as they did, rather than a much less certain "might be over-priced by one measure whose assumptions are debatable" which is what I think is all they can claim, then they should have carried out the other tests they mention on page 1: "historic rates of price growth, comparing price growth with income and population growth, or measuring price to income ratios." If these other tests all came to the same conclusion I would have much more faith in the study's bold assertions.

Those who think that their house is a wonderful sure-fire investment are well advised to take note of the series of charts in the study's appendix showing the evolution of historical prices. Every major Canadian city in the study has had a lengthy period in the 1980s and 90s when real prices fell significantly and stayed low. Pity the person in Regina who bought a house in 1982 and had to wait till 2008 - 26 years - before they got their money back after inflation, let alone made a return.

Real Estate Gloom and Doom is Latest Canadian Media Fad

Real estate prices have been falling in the US so the same must be true in Canada, right? That such must be the case seems to be the compulsion of mainstream media these days. Witness stories like CTV's headline Average Home Price Drops 5.1% and last week's CBC Urban Real Estate Values Set to Plunge.

Fortunately, the Internet allows one to dig a bit, go back to the original source and check the tone and slant as well as the facts. In neither case does the negativity of the story match the source.

The CTV article comes from a Canadian Real Estate Association press release with the, shall we say, slightly less dire title Fewer new MLS® residential listings in August. The press release is mainly about a drop in activity, not prices, and that drop is from record levels. As for the headline price decline, it is an average that was influenced by retreats after large run-ups in a handful of major markets like Vancouver, Victoria, Calgary and Edmonton. CREA's economist puts out a more balanced view, "Sales activity is down in a number of resale housing markets in Western Canada that earlier posted hefty price increases. Prices continue rising in other markets where price gains have been more modest." As the press release says "average prices recorded year-over-year gains in 20 of 25 major markets". In direct contradiction to the atmosphere and and context of the US situation, CREA says "there is no real estate bubble that will burst and send prices to new lows". Now CREA may be wrong about certain markets (like Vancouver, which seems to me the most over-priced by far) but why is CTV not reporting the way CREA presents the data?

CBC's effort is based on an academic study from UBC called Are Canadian Housing Markets Over-Priced? The paper does answer yes, certain ones are over-priced by up to 25% (I very much doubt the conclusions in the paper as I will explain in another post), but it does not specify how the price re-adjustment will occur. The paper says "House prices can correct through sharp rapid declines, through longer and slower declines, or by staying essentially flat for a long period." The study authors go through the usual prevarication that they do NOT know which of the possibilities will happen. So please, CBC editors, don't put words in their mouths and pick the most sensational option. Or does CBC want to be known as tabloid press?

Ins and Outs of Mortgage Investment Corporations

A reader brings up an interesting question:
"I'm interested in investing in real estate, but the market is pretty volatile right now and I don't want to put a large lump some of money into real estate at this point but still would like to 'play' the market. What do you think about mortgage investment corporations like ACIC? I found their website (http://www.acicinvestor.ca)? Could you do a review of ACIC or products like this?"

I must admit to not knowing about MICs before now, so I am approaching this cautiously and don't pretend to have a final answer or a blanket answer that applies to every MIC. A due diligence process is very much in order.

What is a Mortgage Investment Corporation? (good place to start, huh?)
A MIC is a corporate structure recognized in Canada's Income Tax Act (thus the use of MIC as a proper noun) that enables small investors to pool funds and invest in (i.e. act as a lender of) mortgages. The Act allows the MIC itself to be exempt from income tax as long as it passes along all its income to the investors, in whose hands it is, of course, taxed.

A picture is worth a thousand words (perhaps more, the way I write). Here is a good summary of the flow of various funds into and out of a MIC from one of these outfits Magenta Mortgage Corporation.

Just below the diagram on the Magenta explanatory webpage is a succinct summary of the Income Tax rules about what a MIC can and cannot do. Or you can try deciphering the ITA section 130.1 yourself. Here is Magenta's summary:

(btw, to me the availability on a company's website of clear and complete information is a good sign, though by no means a final answer)

MICs go back to the 1970s, that alone being a favourable point. If their format/structure itself were bad, they should have disappeared, right?

MICs are thus a legitimate investment vehicle, though naturally that doesn't mean every MIC will be successful and a good place to invest money.

The Prospectus and Audited Financial Statements
MICs are securities and as such, are bound by the securities regulator in its home province to send a prospectus to all potential investors. The Prospectus details everything about the MIC and is essential reading. Most of the MIC websites are coy and require you to give them your name and contact info before giving you a copy (no doubt so they can do some selling). One exception is Westboro, whose very readable Prospectus is on this Documents page.

The audited financial statements tell you how the company is succeeding, how much profit it is making, how big and diversified is its lending, how much leverage it is using, percent of loans in arrears and so on. It's necessary and highly useful reading to understand a potential investment.

Each to Its Niche
Within the tax rules, MICs vary quite a lot in the types of loans and borrowers they focus on. Among the possibilities: first mortgages, second mortgages, multi-unit residential buildings, construction loans, individuals or companies, commercial properties (up to the limit), people the banks won't lend to like poor credits, bankrupts, self-employed, undeclared income

Rates of Return
This is the big carrot, naturally. The historical rates claimed went from a minimum of 8% a year up to c. 12%! That's impressive! This is cold, hard cash either paid out, either monthly, quarterly or semi-annually, as a cheque / deposit into your bank account or reinvested. That's pretty darn good considering that these cash distributions have been steady for years. For instance, check out Cove MIC's table of its returns , which averaged 10.53% since 1999.

What are the Risks?
Check out the sensible questions that the OSC suggests you ask in this information page on the Westboro site.

Fraud - less likely since a MIC must produce audited financial statements every year. Check out the financial statements and see if the MIC is subject to any lawsuits.

Losing MIC Status - failing to keep within the Income Tax Act rules would cause the MIC to have its income taxed before being distributed to shareholders and would lower returns considerably

Manager (In)competence - the success of the MIC depends to a critical degree on the experience, expertise, judgement and good faith of the managers. Do they know the business, do they know their market and do they have a record of success? Can and will they find a steady flow of new mortgages to keep the income flowing in? Think of it as a job interview.

Leveraging - the rules allow the MIC to borrow money but some do more than others. The spread between the lower rate of the MIC's borrowing and the lending will boost the ability to generate shareholder returns but it also increases risk. The audited financial statements will show how much the MIC has borrowed. The prospectus will say if the MIC has a policy to cap what it will borrow. Many of the MICs are fairly short term lenders - 24 months or so - which reduces interest rate risk and should allow the MIC to continually readjust its lending rate to match increases or decreases in general interest rates and keep the spread between its lending and its bank borrowing rates constant.

Default on Mortgages - mortgage borrowers may not pay back what they owe; all the MICs claim to be very careful about who they lend to but some are explicitly in a niche where the banks don't tread or in second mortgages. The MIC gets a higher interest rate but that is associated with the higher risk. At least one MIC - Cooper Pacific - has two funds, one that lends out first mortgages with an 8% return and another with second mortgages with a 12% return. "You takes your picks and you takes your chances."

Market Downturn / Geographical concentration - some MICs, the smaller ones, are concentrated in very limited markets, like Westboro in Ottawa or Edgeworth in northern Alberta. Ottawa is a stable market but what happens to Edgeworth if the oil industry cools off considerably, as it has done in the past? A general economic recession would everywhere increase the number of borrowers having difficulty to repay.

Liquidity (Can't sell) - the basic method to get your money back is not a sale in some market since MICs are not (with one exception, I found) publicly quoted companies but for the MIC to redeem the shares; the restrictions vary by MIC, whether funds can be sold / withdrawn immediately, or with 30/60/90 days notice; for smaller MICs, the Income Tax Act restriction that each MIC must have at least 20 shareholders might come into play;

A Partial List of MICs - there seem to be a lot of these around

• All Canadian Investment Corp (ACIC) - lends mostly in western Canada on multi-unit residential and commercial mortgages; min $5k investment / $20 k in RRSP (2% fee if redeemed in less than 2 yrs)
  
• CareVest Capital Inc. - lends in Ontario and western Canada; residential and commercial mortgages; founded 1994; $400 million in assets; 4000 investors
• Cooper Pacific Mortgage Investment Corporation - western Canada; founded 1994; 1000 investors; interim mortgage and construction finance; min $25k; monthly dividends
• Cove Mortgage Investment Corporation - BC; founded 1976; $42 million in assets
• Dominion Properties - Edmonton;
• Edgeworth Mortgage Investment Corporation - northern Alberta; recently founded
• First Island - BC and Alberta mortgages only; founded 1973; $155 million in assets
  
• Magenta Mortgage Corporation - Ottawa and eastern Ontario, 14 years in operation
• Sun Country MIC - western Canada; founded 2001
  
• TGL Mortgage Investment Corporation - Alberta; "high yield" mortgages
• Quest Capital Corp - unusually, a public company quoted on the TSX (symbol QC)
• Westboro Mortgage Investment Corporation - Ottawa; founded 2006; min $100k investment; aim to have $3m under investment by 2008; interesting discussion of their clientele and niche under How is it all possible

Taxes and Which Account to Hold the MIC Investment
A registered account such as an RRSP or a RRIF is the natural place for a MIC investment since it will generate all its income only as interest (and not as dividends, despite some use of the word dividends to describe the cash distributed; and don't be fooled when they are called preferred shares - the dividends are interest for tax purposes), which is taxed at the highest rate. I don't know for sure but I would hope and expect that a MIC could also reside within a LIRA or an LRIF but that would need checking out.

Some MICs want or allow you to hold the MIC investment withing your own self-directed RRSP. Others want you to set up an RRSP with a connected financial services provider.

Minimum Investment Amount
This may be the key practical point that blocks the average investor from getting into a MIC. The lowest minimum investment I found was $5,000 at ACIC and that only for a non-registered account. There is the publicly traded Quest Capital whose shares sell for about $2.05-$2.10, so you can get in for less ... but is it a good MIC?

The MIC's Place in a Portfolio
A MIC is fixed income. But unlike a bond, the value of your principal stays the same. If you invest $10,000, that's what you get back when you redeem shares and cash out. Bond value will fluctuate with interest rates, which affects their return. The MICs return is only the interest. As for other asset classes, like real estate investment trusts (REITs), various types of equities, real return bonds (RRBs) and short term cash (i.e. things like T-bills and GICs), the MIC is most like latter - little or no variation in principal value or in returns. There is more risk however, due to the nature of the mortgage investment.

I would suspect there is little correlation of returns with any other asset class, which means that MICs offer the happy prospect of adding true diversification to a portfolio by either reducing overall variability or increasing returns, or a bit of both.

Being ever the compromiser, I would therefore tend to replace some of my cash-type holdings and some of my corporate bonds, perhaps up to 10% of my overall portfolio.

For others like retired folks who want a steady, high income stream and don't mind the tax rate, MICs may be a good vehicle.

As far as ACIC goes, I cannot offer an opinion since I didn't feel like giving them my name and details just to have a look at their prospectus and financial statements and get into their guts a bit more.

MICs are definitely worth consideration and will get a close look when I do my portfolio review shortly.

Thanks for the great question.

The Hot Vancouver Condo Market

Fancy investing in a condo where prices have gone up steeply in the last four years (a hefty 13% in 2007 alone)? Got the cool $1.1M price tag? Then Vancouver is the place for you. Such are some of the fascinating tidbits in the well-illustrated and well-packaged presentation Vancouver Condo Update given in mid April by CMHC analyst Robyn Adamache to the Mortgage Investment Association of BC.

Interestingly, Adamache forecasts a moderation of price increases to only 8% in 2008 and 5% in 2009 as speculative activity is decreasing and construction activity is at a very high level. No mention is made of the 2010 Olympics. That surely cannot dampen demand in the next few years but then what happens, especially as the stock increases with construction? Another boom to end and a flat or bust period to start again?

Rent vs Buy: a Couple of Good Calculators

Many people automatically assume that buying your home is a better investment than renting, probably because your principal residence in Canada enjoys freedom from capital gains taxes. Well, it ain't necessarily so.

Check out the Rent vs Buy calculator at Industry Canada to plug in your own assumptions and see how the balance can easily change between renting and buying as the best option from a purely investment point of view. The calculator was constructed by a top notch expert who is a familiar name in this blog - Moshe Milevsky, a Finance prof at York University, along with researchers at the Individual Finance and Insurance Decisions (IFID) Centre in Toronto. Critically its takes account of the tax difference amongst other variables. As usual the numbers entered in the assumptions are all-important - the Garbage-In Garbage-Out principle still applies. Milevsky himself has elsewhere noted other investment disadvantages of home ownership (not incorporated into the calculator) such as the lack of diversification since a huge proportion of your wealth ends up being tied up in only one asset, i.e. a house suffers from the "too-many-eggs-in-one-basket" risk and possible market slumps.

Another worthwhile Rent vs Buy calculator resides at the website of the Citizens Bank of Canada. It has the merit of showing results graphically, which shows you the cross-over point between renting and buying, as well as how closely the lines follow each other. Much of the trade-off seems to be influenced by house and mortgage one-time costs.

When I tried entering the same assumptions on both calculators, both showed the home purchase to be superior but the Citizens Bank gave an estimate almost double that of Industry Canada after ten years. One difference is that the Citizens Bank calculator includes mortgage insurance and transaction costs but the IC one does not. Without the formulas to examine, it's impossible to figure out why they differ so much. Caveat emptor applies to calculators too, it seems.

Most assumptions that I tried out seemed to show home ownership coming out ahead. But not always. Hopefully this will provide some comfort to those, including at least one of my relatives, who missed the property ownership boat and feel their retirement will suffer as a result.

As Fear Grips the Market, Bargains Appear or Are They Bargains?

This morning, shares of Northern Rock (Ticker LSE: NRK), one of the biggest home mortgage lenders in the UK (18.9% of the market according to the BBC) are down 24%. That's on the day only. The 12 month decline is 41%, all of it since March this year. The company is caught in the crosswinds of the mortgage lending squeeze, though it has itself no direct connection with any of the sub-prime mortgages in the USA. Is this one of those bargains we dream about, a solid company whose shares are dragged down by external events and which will recover when the storm passes? Check out BBC reporter Robert Peston's blog posts on NRK and why central banks are bailing out commercial banks and the comments, many of which suggest NRK has its own UK sub-prime mortgage over-lending.

Is the UK government likely to allow a company with that proportion of the market to fail, especially a company that deals primarily with consumers i.e. voters? (reminds me of the old saying, if you owe the government a million dollars and can't pay, then you're in trouble, but if you owe the government a billion dollars and can't pay, then the government's in trouble). The Aug. 20 post provides a good explanation of how the US sub-prime mess has spilled into Europe.

Principal Residence as an Investment

I've recently come across some fascinating reading by York University professor Moshe Milevsky on the subject of residential real estate and personal financial risk. One of his many papers, titled Houset Allocation (yes, it is spelled with the "t"), which is available at IFID website newsletters, shows rates of return on Canadian residential real estate in 19 housing markets across the country for the 25 years ending in 2004 when the paper was written. The annual compound rates of return vary considerably - from a low of 2.74% in Edmonton to a high of 6.23% in Peterborough. Along with these are the measure of volatility, or risk, in each market, again with a wide range from 2.81% in Regina to 11.14% in Vancouver. These figures alone remind one that owning a house as an investment isn't necessarily the best, considering options which include stock markets like the TSX and the S&P 500. Would one have been better (if one had perfect knowledge of the future, of course, which we all do in retrospect ;-) having a house in Vancouver that returned 3.68% per year compounded for 25 years at 11.14% volatility, or 13.85% in the S&P 500 with 15.71% volatility or a higher 5.7% return with lower 6.23% volatility in Ottawa, where my house is?

How about the homeowner in Edmonton, facing the laggard market there for 25 years? He/she might even have thought that the tar sands would one day have to take off and cause the local house price boom that is now underway. Sitting there in 2004, how much longer should he/she wait? Maybe a job change or retirement would force a sale, preventing the gain from ever being achieved. Years ago, I bought a condo in Ottawa at the same price the original owner had paid five years earlier, then there was a bump in prices and I sold it for a 250% gain six years later, pure luck because I needed to move with my growing family into my larger house. That house bought 22 years ago, well maintained and in a good neighbourhood, has only appreciated 4.8%, i.e. below the Ottawa average. The long term can be a very long, one just doesn't know how long.

One of my relatives lost their whole investment in their house when the mill in their small town closed down and there were no buyers so they had to walk away from it. An individual asset risk of a specific house in a specific market is not a sure investment gain. That is a key point made by Mr. Milovesky in the above paper, namely that a house is a non-diversified investment. It is also likely a huge proportion of a family's total investment assets. It certainly is a big part of my net worth. If one were able to own several houses in different cities across Canada, the low correlation of price gains between the cities would allow a considerable reduction in risk. He even proposes that housing REITs be set up along the lines of commercial property REITs so that each of us could sell a part stake in our houses and buy someone else's. He says it's been done in the UK and Australia but not yet here in Canada.

As an asset class on the other hand, a house is quite un-correlated to stock markets. Ottawa residences were negatively correlated with both the TSX and the S&P 500 over his study period and so are good to hold in a portfolio. In any individual period, as opposed to the long term during which they both go up, when one goes down the other asset class goes up and this reduces risk.

Among the options Mr. Milevsky reviews for reducing housing risk for individual homeowners, only the reverse mortgage is currently available in Canada. Given the fixation of many people on the tax-free capital gain on a principal residence as being a kind of be-all, end-all justification for owning a house in Canada, the above certainly warrants some thought. I'm keeping my house but whenever the housing REIT comes along I'll be having a close look, and the reverse mortgage is a good option to know for the future too.