Should You Worry About a Real Estate Crash?

Q: Pat, some analysts are predicting a crash in the real estate market. Is this a realistic fear, or just another case of jumpy analysts making doomsday predictions?

Pat McKeough: Anytime anybody talks about a “crash”, it covers a wide range of activity. In the early 90s, an analyst got on the front page of the Globe & Mail because he was predicting a 25% crash in Toronto real-estate prices. And real estate brokers jumped all over him, telling him to stay out of their business, you don’t know what you’re talking about, and so on. But it in the end, it turned out he was right, at least in terms of the Toronto housing market.

That was partly because prices got high in relation to people’s incomes, so new buyers weren’t able to buy the house they wanted. Also, because of a rise in interest rates, the average homeowner’s mortgage payment went up. As a result, the price of an average house came down. This was a price adjustment, not a collapse. It wasn’t as if people were getting thrown out of their houses because prices had gone so low. It was just basically an adjustment in prices. But that only matters if you want to buy, sell or refinance.

So you can call that a crash. It’s a crash if you’re buying on margin or if you’re highly leveraged. But it’s not a huge crash the way that the crash happened in the States in the previous six or seven years, when prices really fell through the floor. Prices fell 50-60% in many areas in the States.

I don’t see any kind of crash like that here in Canada, and I think the damage is already done in the States in terms of the real estate market. But I do think that you won’t get as much growth in homes in say, the Toronto area or the Vancouver area for a number of years, because house prices have gone up high in relation to people’s incomes and interest rates are low in relation to the historical record. So there’s a possibility that people will run out of borrowing power, especially if interest rates move up again to more normal levels.

So I would say that it’s always a good idea to buy your own personal residence, because of the tax advantages. But to buy a second residence, I wouldn’t say that’s a great idea right now unless you want to be a landlord, unless you make that a part-time job. And even then I wouldn’t be too keen on the idea.

So the answer is: real estate is not a great area of opportunity right now, but it’s not terribly risky as long as you keep it a reasonable part of your total net worth.

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Below is the transcription of Pat’s comments.

Real Estate Investing: Becoming a Landlord

Q: Pat, here’s a question from a reader. Giving the continuing increase in property values, is direct investment in real estate that is, becoming a landlord, a viable option?

Pat McKeough: You have to recognize that direct investment in real estate is somewhat inaccurate. It’s more like, do you want a part-time job running a house that you own, renting it out and being responsible for calling the plumber and chasing down tenants that don’t pay and so on. There’s a lot more to that than many people realize.

When you do it on a businesslike basis, you have a company that owns hundreds of properties and it all averages out. But if you have a single property and you get into litigation with the tenant or into major repairs, there’s a lot of cash flow that you’re going to miss out on.

So I think you need to go into a real estate investment with a lot of knowledge about how wide the variation is—don’t look at the average price increase in your home market in the past 20 years. Look at the worst case scenario: what if you have to hire a lawyer to get rid of a bad tenant who’s not paying. I think that will take away some of the desire.

Having said that, many people do make great fortunes by buying real estate, using a lot of leverage, and sticking with it for 10, 20 or 30 years. But don’t kid yourself into thinking it’s the same as buying Canadian Pacific, because there’s a lot more to it.

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Winter receded much earlier than usual across most of Canada, but a large number of Canadians still spent part or all of that winter in Florida or other southern locations.

Many Canadians are buying second homes in Florida and other parts of the U.S. I was interviewed about this trend on CTV. Apparently I surprised everybody when I said that buying in Florida might make sense as a lifestyle decision but was liable to be a bad investment.

Here are some of the “buts” they raised, and my responses.

“But the prices of Florida homes have collapsed in the past three to four years—doesn’t that make them a bargain?”

There was a once-in-a-generation (if not once-in-a-lifetime) boom in real estate in the U.S. Sunbelt in the last decade. Many special circumstances added up to create this boom: stock-market gains from the Internet boom, the Federal Reserve’s low-interest-rate and easy-credit policies, plus U.S. tax policies and government subsidies aimed at stimulating mortgage lending and home buying. However, boom times don’t last forever.

This boom peaked around 2006. Since then, Florida real estate prices have dropped by about half, on average. But that only takes them down to where they were in the early 2000s. There’s no reason to think they will immediately turn around and begin rising. They may drop some more. Or they may simply go sideways for years, even decades.

“But prices seem so cheap compared to what you pay in Canada.”

That’s right. But real estate prices are always a local affair. Real estate prices are also cheap right across the border, in places like Buffalo, New York and Detroit, Michigan. They’ve been cheap for decades.

“But even if prices take years to recover, you’ll have use of your vacation home whenever you want.”

That’s right, and this may make it a good lifestyle choice. But there are always plenty of Florida rentals to choose from if you aren’t tied down to going to the same place on every visit. It’s much cheaper to rent for a month or two than to pay a full year’s cost of ownership.

“But you can rent the place out to generate income.”

That’s true. But most renters want to rent the place in the same periods when you want to be there. You’ll get low rent, if any, the rest of the year. Then too, expectations of nice weather supply a lot of Florida’s appeal, but weather varies. A couple of cool winters could hurt rental and buyer demand for your property. So could a hurricane or two. Meanwhile, costs accumulate.

Investing in real estate: You’ll need help from the real estate market to realize a profit

Costs may be higher than you think. Beyond the purchase price, you’ll also have to pay real estate taxes and condo fees, if that’s your choice of a dwelling.

On top of that, there’s insurance and maintenance. In addition, due to the heat and humidity, you have to run the air conditioning year-round to avoid mould. By the time the housing market stabilizes, new condos will come up for sale and compete against decades-old units. Let’s say when you sell, you pay a 5% real estate commission. You will need the real estate market to go up by 5% or more every year, just to break even.

If you make any money on the sale, you’ll be liable for capital gains taxes, unlike the tax-free capital gains you can earn on your Canadian home.

You will find attractive investment opportunities in Florida’s depressed real estate market, but not in the kind of properties that most Canadian buyers are seeking. If you’re investing in real estate primarily for profit, you should look at multiple-unit rental housing or commercial properties, especially those with big parking lots or extra land. Investments like these can give you current income, plus long-term development possibilities. That’s a potent combination for patient investors.

Buying a second home in the U.S. Sunbelt may be a good personal lifestyle choice. But it’s a risky investment, and a bad place for any significant portion of your retirement savings.

Tomorrow in my weekly YouTube video, I’ll discuss the prospects of profiting from rising property values in Canada by becoming a landlord.

In every week’s Inner Circle Q&A, members see Pat McKeough’s analysis and recommendations on stocks and key investment topics of the day that other members have asked about. You can view it immediately when you become a member of this unique investment group. Click here to get started right away.

RIOCAN REAL ESTATE INVESTMENT TRUST $25.79 (Toronto symbol REI.UN; Units outstanding: 267.0 million; Market cap: $6.9 billion; TSINetwork Rating: Average; Dividend yield: 5.4%; www.riocan.com) is Canada’s largest REIT. It has interests in 331 shopping malls in Canada, including 10 under development. These properties contain over 91 million square feet of leasable area.

RioCan also owns stakes in 38 malls in the U.S. through joint ventures. In addition, it owns 14% of Cedar Shopping Centers, a U.S. REIT whose malls are mainly in the northeastern U.S.

In the three months ended September 30, 2011, revenue rose 15.1%, to $236 million from $205 million a year earlier. Cash flow per unit rose 5.7%, to $0.37 from $0.35. RioCan’s units yield 5.4%.

RioCan continues to see lots of growth opportunities in Canada and the U.S. In 2011, the trust bought interests in 38 properties (24 in Canada and 14 in the U.S.) for $1.1 billion.

The units trade at 16.5 times RioCan’s forecast 2012 cash flow of $1.56 a unit. That’s a high multiple, but it’s still reasonable in light of the trust’s highly profitable properties and 97.5% occupancy rate. As well, national and multinational chains, like Wal-Mart, account for 86.0% of RioCan’s rental revenue. That helps cut its risk.

RioCan is our #1 safety-conscious buy for 2012.

But if you want to hold a range of REITs, you can do so through the iShares CDN REIT Sector Index Fund, an ETF lets you hold 13 in all. And you’ll still have lots of exposure to RioCan, because it’s the ETF’s largest holding. Here’s a closer look:

ISHARES CDN REIT SECTOR INDEX FUND $15.72 (Toronto symbol XRE; buy or sell through brokers; ca.ishares.com) holds the 13 Canadian real estate investment trusts (REITs) in the S&P/TSX Capped REIT Index. The weight of any one REIT is limited to 25% of the ETF’s value.

iShares CDN REIT’s expenses are just 0.55% of its assets. The fund yields 4.7%.

As mentioned, RioCan REIT is the fund’s largest holding, at 23.9%, followed by H&R REIT (13.1%), Canadian REIT (8.5%), Calloway REIT (8.2%), Dundee REIT (7.0%), Boardwalk REIT (6.9%), Canadian Apartment Properties REIT (6.5%), Primaris Retail REIT (5.8%), Allied Properties REIT (4.4%), Cominar REIT (4.4%), Chartwell Seniors Housing REIT (4.3%), Artis REIT (4.3%) and Extendicare REIT (2.3%).

Most REITs, including those held by the iShares CDN REIT Sector Index Fund, are exempt from Ottawa’s income trust tax. That exemption will help keep their distributions high.

iShares CDN REIT is a buy.

Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a new or experienced investor, these weekly updates are designed to give you specific advice on successful investing, including real estate investments. Each Investor Toolkit update gives you a fundamental tip and shows you how you can put it into practice right away.

Tip of the week: “Buy a house that suits your needs, and let the potential real estate investment profits take care of themselves.”

For most of us, a house is the biggest investment and consumer purchase we will ever make. The house itself is the consumer purchase; the land underneath is the investment. Your house depreciates as surely as your car, but more slowly. Eventually, a house reaches the end of its economic life. But the land it sits on is as functional as ever.

As real estate investments, homes can have many advantages.

• Growth in nearby job and leisure opportunities raises land demand. That pushes up land values. But land supply can increase too, from rezoning of industrial or agricultural land to residential use, or from cuts in minimum lot sizes.
• Tax pluses. Home owners get a tax-free, rent-free benefit of having a place to live. Profits on home sales are also tax-free.

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• For maximum capital gain, it’s best to buy a small house on a big lot in an improving area. You may be able to get it for little more than land value. Years later, you may be able to demolish the house and divide the land into several building lots.
• Another thing to consider is the quality of nearby schools, even if you don’t have children. Properties near good schools tend to have higher values, and attract a wider range of buyers when it’s time to sell.
• For maximum investment safety, buy the most common house in your area—a two-story four-bedroom, say, or a three-bedroom bungalow. Usually, it will be easier to sell.
• For maximum enjoyment, buy a home that’s a little bigger and nicer than your family will need in the next, say, 10 years. Chances are you won’t regret it.

Our investment advice: You should be wary of buying (or holding on to) bargain-priced homes. They can turn out like stocks that seem too good to be true. Well-informed homeowners may be eager to sell due to subtle changes going on nearby. Before you buy a house, walk through the neighbourhood and take a critical look at your potential neighbours.

If you’d like me to personally apply my time-tested approach to your investments, you should consider becoming a client of my Successful Investor Wealth Management service. Click here to learn more.

This is RioCan’s first acquisition in San Antonio. The mall is 88% occupied, and has well-known anchor tenants, such as Target, J.C. Penny and Lowes. Other tenants include Best Buy and Dick’s Sporting Goods. These factors cut the risk of expanding into unfamiliar markets.

RioCan is a buy.

In the three months ended September 30, 2011, the real estate investment trust’s revenue rose 5.5%, to $83.7 million from $79.4 million a year earlier. Cash flow per unit rose 5.3%, to $0.60 from $0.57.

Canadian REIT bought $264.5 million of properties in 2011, including its June 2011 purchase of two fully leased malls in Mississauga, Ontario, for $174.4 million. Tenants include Future Shop, Famous Players, Chapters, Rona and National Sports.

The REIT pays a monthly distribution of $0.12 per unit. That gives it an annualized yield of 4.0%.

Canadian REIT’s broad diversification cuts its risk. Its geographic breakdown is as follows: Alberta, 34%; Ontario, 30%; Atlantic Canada, 14%; B.C., 10%; Quebec, 8%; the Prairies, 2%, and the U.S., 2%. Retail properties make up 58% of its assets, followed by office, 21%; and industrial, 21%.

Canadian REIT is still a buy.

H&R REAL ESTATE INVESTMENT TRUST $23.16 (Toronto symbol HR.UN; Units outstanding: 157.3 million; Market cap: $3.6 billion; TSINetwork Rating: Extra Risk; Dividend yield: 4.8%; www.hr-reit.com) owns stakes in 39 office buildings, 117 industrial properties and 133 retail properties across Canada. H&R has a 98.9% occupancy rate.

In the three months ended September 30, 2011, the REIT’s revenue rose 11.0%, to $169.6 million from $152.8 million a year earlier. Cash flow per unit rose 5.7%, to $0.37 from $0.35.

H&R is nearly finished building The Bow, a $1.33-billion, two-million-square-foot office building in Calgary. Encana Corp. has already leased the entire building for 25 years.

The REIT recently made two major purchases in the U.S. In October 2011, it bought Two Gotham Center in New York City for $415.5 million U.S. The newly built, 22-storey tower is leased to the City of New York for 20 years.

In December 2011, H&R bought the Hess Tower in Houston for $442.5 million U.S. This 29-storey tower, which was completed in June 2011, is fully leased to the Hess Coporation. Two Gotham and the Hess Tower are H&R’s largest acquistions to date.

The REIT raised its yearly distribution by 4.8%, to $1.10, in January 2012. It will continue to raise its distributions every quarter until the annual rate reaches $1.25 in the fourth quarter of 2012.

H&R REIT is still a buy.

Pat McKeough responds to many personal questions on specific stocks and other investing topics from the members of his Inner Circle. Every week, his comments and recommendations on a selection of the most intriguing questions of the past week go out to all Inner Circle members. And every Friday, we offer you one of the highlights from these Q&A sessions.

REITs continue to be popular among investors seeking income. Recently, an Inner Circle member asked about a REIT that specializes in big-box outdoor malls and features North America’s most famous big-box chain as its most important tenant.

Q: Pat: What is your opinion of Calloway Real Estate Investment Trust? Thanks.

A: Calloway Real Estate Investment Trust, (Symbol CWT.UN on Toronto; www.callowayreit.com), owns, develops and operates big-box outdoor malls across Canada.

In all, Calloway owns 129 shopping centres and two office buildings, with 25.3 million square feet of leasable area. This REIT’s malls are mainly located in the suburbs of larger cities and have lots of room for parking and additional building.

The trust gets 58% of its revenue from Ontario, 15% from Quebec, 9% from B.C., 4% from Manitoba, 4% from Saskatchewan, 3% from Newfoundland and Labrador, 3% from Alberta, 2% from Nova Scotia, 1% from New Brunswick and 1% from Prince Edward Island.

Calloway’s largest tenants are Wal-Mart, Canadian Tire/Mark’s Work Wearhouse/Forzani Group, Winners, Best Buy/Future Shop and Reitmans.

REITs: Wal-Mart a tenant in almost 80% of Calloway’s malls

Wal-Mart is currently a tenant in 76, or 79%, of this REIT’s malls. Calloway depends on Wal-Mart for 26.3% of its revenue.

In the three months ended September 30, 2011, Calloway’s revenue rose 6.5%, to $124.9 million from $117.3 million. Cash flow per unit rose 13.5%, to $0.42 from $0.37.

Calloway REIT’s occupancy rate is a high 99.0%. Only 2.9% of its leases are maturing in 2012; 6.6% in 2013; 6.0% in 2014; and 6.1% in 2015. The trust pays a monthly distribution of $0.129, for a 5.8% annual yield.

In the Inner Circle Q&A, Pat looks at whether Calloway REIT’s focus on Ontario represents a risk as the province’s economy recovers. He also analyzes the pros and cons of relying heavily on one major tenant, Wal-Mart. He concludes with his clear buy-hold-sell advice.

Inner Circle members see Pat’s analysis and recommendations on the stocks other members have asked about in each week’s Inner Circle Q&A. You can view it immediately when you become a member of this special investment group. You will get Pat McKeough’s answers to your personal investment questions, full access to our members-only Inner Circle website, and many other membership privileges. Click here to get started right away.

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This is RioCan’s first acquisition in San Antonio. The mall is 88% occupied, and has well-known anchor tenants, such as Target. These factors cut the risk of expanding into unfamiliar markets.

RioCan is a buy.