Investing
Realty Shift
Should you invest in real estate during times of stock market volatility?
FROM: NOV-DEC 2002 ISSUE | BY LARRY SHORT
Whenever people hear the term "the markets," they tend to think only of stocks and bonds. But Canadians have invested a considerable amount of their wealth in the real estate market. For most Canadians, their home is actually their largest single asset, particularly after the recent shrinking of their stock portfolios.
As investors watched the devastation in the stock markets since March 2000, they also saw a dramatic rise in real estate values. Those who had chosen real estate over stocks during the 1990s are now bragging about the stability of the real estate markets and how their wealth has increased. With headlines about stocks being so terrible and news that real estate is so good, many investors are selling out of the stock market and trying their hand at real estate.
Is this a wise move? Let's weigh the pros and cons of investing in real estate.
On Solid Ground
Real estate agents often say that they are not making any more land so we know that there is a limited supply. This alone is a compelling argument to look to invest there. The average Canadian most often invests in real estate in one of two ways: by purchasing a rental property or by either building or buying a home with the hope of selling it for a higher price.
Buying and selling a home is a form of speculation, and, as with all speculation, timing is critical. If you catch an upswing in the market, you can make a considerable amount of cash quickly; if you sell after a peak, you can expose yourself to some very serious losses.
Purchasing rental property can be more of a business investment decision. In ideal situations, the amount of cash required to buy the property is relatively low, the rental income may cover the mortgage payments, and there are tax writeoffs to aid you along the way.
Each investment decision must be weighed individually. Of the two possibilities, purchasing a rental property seems the safer choice. It is often hard to find compelling reasons for taking on the risk of a speculative action. Plus, I have seen many compelling rental property investment proposals. So does that mean that you should automatically start looking for rental properties to invest in? Let's first consider the demographic influences on the market.
Boom, Bust & Echo
In his book, Boom, Bust & Echo: Profiting from the Demographic Shift in the 21st Century , David K. Foot explains how baby boomers are, as a group, affecting the prices of things in society as they grow older. For example, when the boomers were in their 20s, tennis was all the rage. Now that they are hitting 50, golf is the sport of choice.
Foot points out a very high tendency for the boomer generation to act as one individual. During the 1970s, when the boomers were in their 20s, they were living in apartments. Because so many boomers were looking for apartments at the same time, the price of apartments, i.e. the rent, soared. So severe was this rental increase that many cities imposed rent control boards.
Then boomers started moving out of apartments to buy homes for the first time. This resulted in the real estate boom of the 1980s that peaked first in 1982 and then again in 1989. This rise in real estate prices was the greatest in history and has never been repeated in real terms. Foot asserts that it is likely to never be repeated again. The reason he gives is twofold. First, the bust and echo generations following the boomers are fewer in number. This means that they need fewer apartments and fewer homes to live in. Second, the boomers will not need the homes they have now, and many will eventually be looking to sell their homes to downsize. This will result in a flood of homes on the market, driving down real estate prices.
Foot's theory explains why the real estate prices rose in the '80s, but doesn't explain why they have continued to rise through the '90s and into the 21st century. And what does this mean for rental properties as a place to invest your money? Vacation homes and smaller homes catering to the wealthy will prosper as boomers begin to retire, but certainly this trend does not speak in favour of all rental properties. And here's why.
A Matter of Interest
The interest rate charged on a mortgage is a huge factor in determining the feasibility of buying real estate. Current interest rates are back to the levels last seen in the 1960s. As well, we have a lot more institutions offering mortgages, also making the purchase of real estate easier.
Buying today seems to be coming from two sources: the bust generation and the boomers themselves. The echo generation, however, is benefiting from being the sons and daughters of the wealthiest generation in history. Consequently many of these children are beginning to buy homes — at a lot younger ages than their parents did because their parents are helping them out with the down payment. Or, they are demanding and getting much better apartments and are paying higher rents to do so. Both of these trends drive up real estate prices.
The boomers themselves now want their dream homes. They are buying bigger or renovating their existing homes. So Foot may have missed an intermediary step in his predictions, which has delayed the boomers' downsizing. The boomers are building and living in their dream homes, complete with a bathroom for every bedroom, before retirement.
This means that the interest in real estate can continue beyond the boomers hitting 50. But, when the final sale does come, will the echo generation want a sprawling, six-bedroom, six-bathroom house for their spouse and two children? And will there be enough of them to buy what's available?
Foot's conclusions are not wrong; they are just deferred somewhat. There eventually will be a glut of large houses on the market, driving real estate prices down, but it has not appeared yet.
Ups and Downs
There have been fluctuations in real estate before. In fact, there seems to be a high correlation between stock markets falling and real estate rising. The 1981 stock market fall was accompanied by a real estate boom in 1981-82. This was then followed by a stock market recovery and a dramatic fall in real estate prices in 1983.
The Black Monday of 1987 saw real estate prices shoot to the roof. In Toronto in 1988, you could buy a house in the morning and sell it in the afternoon and pick up $20,000 in the transaction. Again, a stock market recovery that began in 1990 put the kibosh on real estate, this time on both the commercial and consumer fronts. So severe was that downturn that Confederation Life went bankrupt because of its real estate division. In the United States, the savings and loan crisis nearly bankrupted the American banking system and ultimately cost $300 billion to repair. A lot of small banks went under in the process.
Finally the stock market fall of 1998 due to the Asian currency crisis saw a recovery in real estate that actually held up pretty well through the stock market run to March 2000. So, although there is an opposite correlation between the real estate market and the stock market, it is not a perfect correlation.
Money will flow to whichever market is providing the best returns, and so it will flow to the stock market when a recovery does take hold there. And, as stock markets rise, so do interest rates, negatively impacting people's interest in real estate.
Real Decisions
Despite these fluctuations in the market, adding just a bit real estate to your investment portfolio could lower the overall risk to your wealth. The time to do this may not be when the stock markets have fallen and real estate has done well, since you will be buying high. Wait until the real estate returns look poor and investors are looking elsewhere — like when the stock market has its next run up.
The risk in investing in real estate is the same as investing in stocks. If you are treating your purchase as a true investment and the argument to buy is compelling, then the real estate climate is irrelevant. However, if you cannot find compelling situations, then you become a speculator and that is when you can get hurt. Your professional financial adviser can help you make the decision that's right for you.
And remember, your home may be where your wealth is.
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Larry Short, B.Comm., CIM, CFP, FCSI, CGA, is a Senior Investment Adviser with TD Waterhouse Investment Advice* in St. John's and is author of In Short: Secrets to Make Your Dollars Grow.
RBC Dominion Securities Inc. is a member company under RBC Investments. RBC Dominion Securities Inc.* and Royal Bank of Canada are separate corporate entities, which are affiliated. *Member of CIPF. This article is provided for information purposes only. Please consult with a professional adviser before implementing a strategy.