The Globe and Mail, Report on Business
Published June 12, 2010

We’re starting to see stories about a softening real estate market in Canada. Listings are up, sales are down, and even the always bullish industry executives are predicting lower prices in the coming year.

It reminded me of a quote I saw recently: “Real estate is the drunk driver on the economic highway.” This statement, attributed to Tom Barrack, the CEO of real estate investor Colony Capital, speaks to the fact that residential real estate can be volatile. Yet that same volatility highlights why it can be fertile ground for a disciplined, patient investor. There are a number of reasons for this.

First off, it’s cyclical in the best way – the cycles are generally long while memories are always short. The most recent trend, up or down, is assumed to be sustainable. For an investor willing to take a longer view, this is a good thing.

Second, real estate is a topic that produces lots of “armchair” experts. Despite a lack of rigorous analysis, views are strongly held and overconfidence is rampant. Again, this is good for someone who is less entrenched and has a broader perspective.

The third reason is that buying decisions are often steeped in emotion (“It’s perfect. I have to have it!”), and based on non-economic factors (“The baby will be here soon.”). Music to an investor’s ears.

And finally, houses are easy to borrow against. Thus, the potential for overindulgence.

Despite these attractive investment features, there are reasons why I don’t invest in real estate beyond my personal needs. For one, I have a day job, and this type of investing is time intensive. It also doesn’t help that transaction costs are extremely high (commissions, legal fees and taxes), and there are significant carrying costs (maintenance and more taxes). Both have to be factored into the investment return.

But if I did have time and could find the equivalent of a discount broker, many of the rules I use for investing in stocks would apply.

Because leverage is involved, real estate prices are sensitive to changes in interest rates. Purchases are often financed up to 90 per cent with debt, so mortgage payments are a key factor in determining prices.

For almost 30 years, we’ve been in a bull market for interest rates and with every tick down, property values have gone up. Given that we are somewhere near the end of the rate declines, investors have to recognize that a huge tail wind is swinging around.

After such a long up trend, it’s easy to forget that residential real estate is cyclical. And as with all cycles, there is only one thing that’s easy to predict – the farther prices stray from their fundamental value, the bigger the downturn will be. If you think back to periods when prices were rising at a mind-blowing rate, there was always an equally astonishing decline to follow. Torontonians, for example, didn’t see the high prices of the late 1980s again until well after they’d rung in the new millennium.

Living in a hedge fund

House owners deploy a strategy that is at the core of hedge fund investing – buy long-term assets with short-term financing. The strategy dials up the investment’s return potential, both on the upside and downside. In the case of a house, if rates stay low and prices rise, it’s a beautiful thing. If financing costs rise and cause prices to fall, however, it’s not so good.

When people tell you that their house has been their best investment, they are undoubtedly telling you the truth. But it’s not because prices have gone up more than the stock market over long periods of time, it’s because a house investment is highly levered. And the math is powerful. When a $400,000 house bought with $100,000 of equity goes up 25 per cent, the value of the equity doubles. As Americans found out in recent years, however, high gearing works both ways.

Ultimately it comes back to valuation. Prices have to make sense in the context of the local economy. Do income levels support the price levels? Do people want to live there, and are more coming? Are the demographics going to help or hurt in the future? And what are apartment rents and vacancies doing?

If the continuing income from a real estate investment is barely covering expenses, and the long-term supply and demand outlook doesn’t justify current prices, then I am flat out speculating. When I’m ready to sell, I’m betting a greater fool will pay me an even more uneconomic price.

When I apply my investing skills and experience to the Canadian real estate market, I see a super cycle coming to an end. By plugging low interest rates into mortgage calculators, prices have been driven higher. But rents are coming down. After-tax incomes are likely to be under pressure in the post-stimulation era. And it doesn’t feel like the right time to be adding leverage to a portfolio.

Regardless of what happens, when it comes to real estate, I always want to be the designated driver. That means being be opportunistic, patient, well-financed and stone cold sober.

Related reading:
Become Your Own Hedge Fund Manager. Buy a Home.
When a Trend Reverses, the Slide Won't be Painless or Short
U.S. Housing: Long, Extreme Up Cycle...Quick, Painless Down Cycle?
An Orderly Decline of the Housing Market? Not.