I’ve talked to many people about investments and many ask what my opinion is on what is the best investment. The truth to that answer is that the best investment can be different for each individual. There isn’t one simple way to build wealth. When you browse through the business section of a bookstore (yes they really exist) you’ll see many different success stories. Each author will tout their way as the best way, but the truth in the matter is, is that there are many possible ways to build wealth. Not just one.
This holds true for investing in stocks. For every person you may know that has been successful investing in stocks, there is another person who lost their life savings. That’s why the most important thing when it comes to building an investment portfolio is to choose something you are comfortable and knowledgeable about. For those that have an understanding of the free market system using equities may seem easy, for others, the prospect of building wealth through real estate makes more sense. In any case, any route you take is better than just doing nothing.
The Rise of Real Estate
Not since the 1990’s has the Canadian real estate market suffered a correction. That’s a marvelous feat of 20 plus years. Certainly for many Canadians, their property has become their best investment. This despite the notion that historically real estate has had a lower average return on investment than stocks in the long run. But this isn’t true anymore!
Over the past few years, real estate in Canada has become the hottest investment commodity, having returned double digit percentage gains. In the past this was unheard of. House prices didn’t jump by hundreds of thousands in a few months, but this seems like this is the new norm now. Houses are essentially being flipped like stocks in the short term to generate large profits.
Compare this with stocks over that same period of time, where crashes happened in 2000 and in 2008 of epic proportions. Despite the fact the markets have still been up, the emotion of riding stock prices down usually ends up with investors selling out at the bottom and losing everything. Couple that with the fact that real estate has risen faster than stocks in that same time frame and it’s a no brainer why everyone is jumping on the bandwagon.
Real estate is a different beast. Investors see value in their holdings because a house is a physical object. The land is something you can walk on beneath your feet. Stocks and equities are just imaginary paper value that represents a piece of a corporation. For the normal Joe, something he could see is going to be worth more than a piece of paper.
One of the beauties of real estate is the fact that you can leverage your investment at a ratio of 20 to 1. Put 5% down on an asset and watch it grow. Since the value of your investment is only 5% of the value of the asset, every percent that the property rises is essentially a 20% gain on your investment. That’s a huge profit. It’s also something that someone investing in stocks and equities can’t do.
As the property gets paid down, it’s not uncommon for investors to continue to leverage by taking out a line of credit against their home and buying even more properties. This strategy maintains the high leveraged ratio that can perpetuate high growth.rates.
Unlike stocks, the primary residence for any individual is not subjected to capital gains tax so long as that property was lived in by the owner. This means all the profit is completely tax free. This can be quite significant when profits from real estate can stretch into the hundreds of thousands and individuals can keep the large windfall rather than paying the government taxes.
Stocks can only grow tax free inside an RRSP or TFSA. The issue with the RRSP is that when money is withdrawn from the account, it is subject to the marginal tax rate. So the same benefit of being tax free doesn’t exist. The TFSA is completely tax free, but only a maximum of $45,500 can be invested into that account. This amount is a lot smaller than what can be invested into real estate and the tax savings aren’t as great.
Not Without Risk
Buying real estate is not without risk. Since most people leverage their investments the inverse of large gains can also happen. When you borrow a lot of money to buy an asset where you own very little, even a small percentage drop can ruin your equity.
With a 5% down payment, even a 1% drop in a home price could mean losing 20% of your equity. Many people don’t think about that because home prices have increased so substantially, but the one issue with borrowing too much is that the bank can refuse to refinance the home if the value drops too low. This hasn’t happened in recent memory in Canada, but it’s certainly something to consider.
Using leverage also presents danger when interest rates inevitably start to rise. You have to realize that with historically low interest rates, the monthly mortgage payments are as low as it will ever get. In the future, when mortgages are renewed, there will no doubt be higher payments that will have to be made, as interest rates normalize back to their 5-6% ranges. This begs to question. Can you generate enough cash flow?
It is very possible to have negative cash flow while owning leveraged properties. This may be the biggest risk of all. Cash flow is the most important part of investing, because without cash flow we would not have the ability to pay our creditors the interest that we owe on our principal. Even rich billionaires and multi-national corporations can go bankrupt because of poor cash flow problems. If all of your money is tied into an asset that is hard to liquidate, it becomes extremely difficult to pay off monthly expenditures. It’s always important to remember just how much free cash flow one would need in order to stay on top of monthly mortgage payments.
Barriers To Entry
When you are buying stocks, it’s easy. If you have $100 bucks floating around somewhere, you can go online and with a few clicks, own a few shares. Investing in property is a whole different beast. It requires substantial amount of capital, and most likely a full time job in order to pay off the mortgage on a monthly basis.
This means that to go the route of real estate investment, you would need to show that you have a stable income. You’ll also need a good credit rating in order to qualify for a low interest mortgage from a lender. If you’ve been delinquent on past debt, it’s very likely you won’t achieve the best possible mortgage rates from standard financial institutions. This can have a profound impact on the cost of owning real estate.
Remember that it’s not plain black and white in determining the best investment class for you. It’s more important to understand your own personal goals and what you are comfortable with. Don’t let others influence your decision. Do the research you need to make an informed decision on the best approach that is best for you. Ultimately the risk and results are borne on you. Don’t make the assumption that someone else will make the right decision for you.