real estate’s downside
A client asked me, “Why wouldn’t I invest in real estate,
Prof Bruce? What are the downsides?”
Here are some reasons:
a) Transaction costs are significant especially if you trade
frequently. Transaction costs include: legal fees on completion, accounting
fees, Land Transfer Taxes, adjustments on closing (e.g., for pre-paid realty
taxes), HST (Goods and Services Taxes, Harmonized Sales Taxes in Canada on
certain types of real estate like residential rentals and almost all commercial
property), withholding taxes for non-residents (income tax withholdings),
realtors fees, etc.
b) Lack of liquidity—real estate sales and closings can take a long
time. Widely-held stocks, for example, can be sold in a few minutes or hours.
c) Bad tenants and difficulties with rent control and other forms of
regulation (the RTA, Residential Tenancies Act, in Ontario).
d) Cost overruns on construction or renovation as well deficiencies in
e) Storms and other natural disasters.
g) Outdated design, floor plans, uses (e.g., a few years ago, everyone
wanted to build server farms until they realized that servers are small and
getting smaller and more powerful all the time and, hence, don’t take up a lot
of floor space).
h) Delays in completion of new construction or renovation.
i) Long planning cycles made more difficult by NIMBY (Not In My Back
j) Long delays in acquiring building permits.
k) Low appraisals and low loan-to-value ratios for mortgage purposes.
l) Degradation of the neighborhood/bad neighbours.
m) Increased costs—electricity and insurance especially.
n) Surprise maintenance and the costs accruing from deferred
o) Dishonest property managers. (It is surprising how much residential
rent is still collected in cash. A dishonest superintendent who runs off with
one month’s rent from all your tenants can bankrupt you in a hurry.)
p) Down cycles in the market.
q) Being upside down on equity (see below).
r) Negative changes in tax regimes like increasing capital gains
taxes, reductions in allowable Capital Cost Allowance deductions against income
and other income, rapid increases in realty taxes and gross leases where the
costs can not easily be passed on to tenants.
s) Real estate is an intensely local business; success by you in one
market does not necessarily translate into success in another.
t) Trouble getting appropriate insurance at affordable prices.
u) Political risk, civil unrest, and war directly impact real estate
w) As the population ages, more competition from retirement homes for
x) More tenants buying their own property.
y) Population decrease, changing tastes, increases in dwelling
occupancy rates (eg, millennials staying with parents longer).
z) RISING INTEREST RATES.
So there are a lot of risks in owning real estate and there is no way
to avoid these risks entirely. One way to improve the odds is to buy low which
we talked about above. A good friend of mine, Barry Lett, a real estate veteran
and a survivor of many real estate down cycles, once told me: “You don’t make
money when you sell real estate; you make it when you buy.” If you buy low
enough, it makes up for many sins later on.
Now there area few other things you can do to somewhat de-risk the
process—you can invest in more than one building, in more than one type of real
estate, in more than one neighborhood and in more than one city as well as
perhaps more than one country.
One last note. Former Chief Justice of the SCC (Supreme Court of
Canada) Bora Laskin once said that insurance companies are larger firms that
exist to take advantage of smaller companies and individuals. He obviously took
a dim view of the industry. I have always wondered why more real estate
investors don’t self-insure. This would only apply to large sophisticated
investors, of course. But if you owned 50 or 100 separate buildings in say a couple
of cities, perhaps it would make sense to only have liability insurance on
them. I mean what is the chance that all 50 of them will burn down at the same
time? You would need to do some careful analysis but you might well be better
off paying your ‘property insurance’ to yourself—build your own sinking fund
and self insure. After 15 or 20 years, I am guessing you would have quite a
sizeable fund that when you sell your portfolio, guess what, it belongs to you.
Bruce M Firestone, B Eng (civil), M Eng-Sci, PhD
ROYAL LePAGE Performance Realty broker
Ottawa Senators founder
Real Estate Investment and Business coach
MAKING IMPOSSIBLE POSSIBLE