Real Estate Investing Is Far Riskier Than Public Sentiment Reflects
Real Estate investing in Canada has a lot of public confidence at the moment and it is not uncommon to hear about how it is impossible to lose or the huge gains home owners have realized over the years. It has come to the point where Canadians will undertake massive mortgages just to enter the market and those already in the market continuing to leverage themselves further to own more real estate investments. Even though public opinion on Real Estate investing is high, it is actually a high risk investment. Compared to other investment options like the stock market, the rewards are not particularly great either. If there are lower risk options with comparable returns, why is Real Estate Investing so popular among Canadians? It is complex but can be broken down to a couple different topics:
Homes are often not purchased as investments
The majority of homes purchased in Canada are owner-occupied and not bought solely as an investment. A houses ability to simultaneously meet a need for the buyer while also being an investment makes them a very different investment option than things like stocks. Even people who have no interest in investing will buy homes for this reason. There are more than 8 million households in Canada who own their home, making real estate a very common investment among Canadians. Because a majority of them didn’t buy their home solely as investments, gains are looked on more favourably as well. Often when talking about stocks you will hear the gains referred to as an average annual percentage. “My stocks went up 10% this year”. With homes, you will often hear the raw value increase instead. “My home value went up $30,000 this year”. The $30,000 increase sounds much better than 10%, but on a $350,000 home, it actually underperformed compared to the stock. Also because it is not primarily an investment, costs aren’t tracked nearly as much. A home could appreciate $30,000, but after legal fees, realtor fees and any maintenance done, the owner could actually be barely breaking even after a sale. On the flip side, if the value went down $30,000 it also isn’t viewed as negatively. This is because the loss isn’t realized until selling and the home still fulfills its purpose as a home in the meantime. Stocks on the other hand serve no other purpose than making money, so when they drop the loss is still felt whether they are sold or not. Simply put, because homes are often not purchased as an investment, they are not put under the same scrutiny that normal investments are. Being a commonly owned asset is not the only reason the returns of Canadian Real Estate is often praised. It is not only a commonly owned asset, but often the most expensive as well.
Homes are often an individuals most expensive investment
The average net saving per household in 2018 in Canada was less than $1,000. The average home price was $500,000. Homes are by far the largest investment a majority of Canadians will ever own. Going back to my previous example of earning $30,000 on a $350,000 home, while the return is not better than the average stock market returns, most Canadians can’t imagine owning a stock portfolio worth $350,000 and expecting returns of $30,000 annually. If they can’t imagine owning stocks of that value, why is home ownership attainable instead? Leverage. People can buy homes with as little as 5% down and obtaining a mortgage with extremely cheap interest for the rest. That means to buy the $350,000 home, they would only need around $20,000 up front. A 10% annual return if that $20,000 was invested in the stock market? $2,000. Referring to the previous point about costs not being tracked, even though the home increased in value by $30,000, in this scenario almost all of the $20,000 down payment would be eaten up in CMHC and legal fees and then the costs of selling would easily still put the owner in the negative, but the owners would still be happy and talking about how they made $30,000 in one year off their home and the stock investor who made $2,000 probably wouldn’t be bringing it up. The leverage not only magnifies gains, it also magnifies losses. If the stock market and housing market both had an equally bad year as the good year, the stocks would be down $2,000 and the home owners would be down $30,000 and all of the fees (close to $50,000 in total). This highlights the high risk of leverage.
Due to the returns/costs not being scrutinized as harshly on homes because they are not primarily an investment and homes being an individuals most expensive investment due to leverage; real estate investing looks extremely appealing when the market is performing. Even if it isn’t out performing the stock market. Then momentum builds.
Momentum in Real Estate Investing
A couple years into a strong market: you’ve owned your home for a few years. You talk with all your friends and family who own homes and they all talk about the tens or even hundreds of thousands of dollars they have made on their homes in the last couple years. Even though the stock market has been equally strong, if not better, but real estate investing is all you will hear about. This is again because it is a very common investment among Canadians and often their most expensive investment by far. On top of this, it is also the cost of a need, something that effects everyone. So you will hear about the increase in housing far more than the stock market, and feel it more as well. Even if you are renting, you will notice the rent increases. After hearing about housing prices inflating for decades, and experiencing it yourself during your few years of home ownership; Real Estate Investing looks like you can’t lose. Unlike the stock market, with housing after you have enough unrealized gains it is common for the owner to refinance and use that money to finance a down payment on a rental home. As long as the market performs well, this is a quick way for investor to make good money. When the market goes through a correction, however, it is very possible to lose everything. The Real Estate Investors and Home-owners who lose everything, while not uncommon, are easily disregarded.
Losses can be blamed on the individual
When the stock market or even a popular individual company fails, it is less regarded as the failure of an individual investor and more of just being part of the game. The stock market goes up and down with the economy but should trend up over time. Don’t invest money you’ll need in the short term and you should be fine is often the advice you’ll hear. On the other-hand, when a Real Estate Investor or Home-owner goes broke it is often blamed on their individual failings and not just the swings of the market. An investor goes broke, “Oh he was over-leveraged”, A Home-Owner loses their home “He got fired from his job, these things happen”. It doesn’t focus on the reason the Home-Owner lost their home instead of selling is because the market was down and they couldn’t afford to sell. In Real Estate, losses are often blamed on the individual. The difference between the views on losses make Real Estate seem like less of a risk as long as you play it moderately safe as compared to the stock market.
What does this all mean for those looking into Real Estate Investing?
The purpose of this article is not to say not to invest in Real Estate, it is to appropriately outline the risks and rewards. Real Estate has ups and downs just like the stock market, except due to leverage the swings in real estate are often multiplied compared to your cash investment. When things go up, this leads to massive gains, but when they go down the losses can be just as massive. Unlike investments into things like the stock market, real estate has high expenses. A large portion of these expenses are one-time for buying and selling. This makes using Real Estate as a short term investment not great unless you are definitely getting a deal on the initial purchase. On top of the one-time costs, there are recurring costs for the lifetime of the investment like mortgage payments, property tax and insurance. Ensuring you will have enough cash-flow to the sustain the property in all circumstances is extremely important. Being forced to sell during a market down turn could be a life-changing loss
For those buying a home as their primary residence, there is still risk but it is far lessened if the owner does not plan on leaving their market. Even if the prices drop and the owner decides to upgrade or move across the city, what they lose on the sale they should gain on buying the new home. They are essentially hedged with the market. The main three scenarios a home-owner could lose big is if they are moving to a different (stronger) market when prices are down, they are unable to sustain the cash-flow requirements of home-ownerships and lose the home, or the home is badly damaged/maintained and loses substantial value.
For those buying a rental property, there is usually substantial unrecognized risk. If a unit is left vacant, it can easily become difficult for the owner to make payments on an empty second property. Even if the home is full, compared to other businesses, you only have one customer instead of many. If they can’t pay, there could be no revenue for months. Getting the wrong tenant for a rental property can easily cost the owner tens of thousands of dollars, whether it be missed revenue, damage, or both. Buying a rental property has a similar risk as buying an individual stock of a reputable company using highly leveraged money.
As I mentioned before, Real Estate Investing is often praised about the great returns that aren’t actually great when compared to the risk involved. Why is this? Well Real Estate Investing returns are often compared to the average of the stock market (9%). Average Canadian housing prices have tripled in the last 20 years (200% gain) on top of the rental revenue they would be receiving as well. Those things combined would give the stock market returns a run for their money! Unfortunately comparing Real Estate Investments to the average returns of the stock market is not fair. The average returns of the stock market are a fairly safe and diversified investment. Like the Real Estate Market, the stock market trends upward over long periods of time. Buying a rental property is more equivalent to buying a single stock of a reputable company. Over the last 10 years, stocks like Apple, Microsoft, Facebook, Google, Amazon and other big stocks are up as much as 1000%. These returns crush those of the housing market, and unlike a rental property, require no work for the owner.
Real Estate Investing is a great way to invest and make money, but it is important to recognize the risk the involved. It is not a guaranteed way to make free money like public sentiment would indicate. Like all methods of investing, it is important to be very educated on what you are doing to minimize the chances of taking losses. This is extra important if you are using leverage because losses are magnified and you are able to lose money that you don’t actually have. If you wouldn’t go borrow hundreds of thousands of dollars to dump into an Apple or Google stock, you should evaluate whether Real Estate Investing is right for you as well.
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