By Constantine Lycos
Real estate is one of the best – if not, the best – asset class for wealth accumulation and wealth preservation. It generally keeps up with inflation, and it can generate income. While it is sensitive to interest rates and macroeconomic conditions, it is far less volatile than equities/stocks, with equities being the other main wealth accumulation asset class.
As I am writing this on May 28, 2023, everyone knows that inflation spiked about a year ago and central banks around the world raised interest rates. As a result, we are looking into a potential recession in the next few quarters. Bond prices adjusted immediately to this new interest rate environment, but other asset classes such as equities and real estate have not yet. In other words, prices are too high. As a result, my main advice: don’t rush to invest in real estate.
Investment real estate is usually very closely linked to interest rates. Investors value real estate at what they call capitalization rate or “cap rate”.
Cap rate = net operating income over 1 year / market value of a property.
Cap rates move up and down with interest rates for a couple of reasons. The main one is that investors like to have positive cash flow from their real estate investments, which implies that they usually require the cap rate to be higher than their cost to finance the property, i.e., their mortgage rate.
The second reason is that if interest rates are higher than cap rates, investors may choose to park their money in bonds, t-bills, GICs, etc., instead of buying real estate as their interest income would be higher than what they would get from their real estate investment. We will get back to this later.
Let’s take a hypothetical example of a property that has:
Gross rent: $1,000 per month, or $12,000 per year. Operating expenses (insurance, repairs and maintenance, property taxes, etc.) of $2,000 per year.
Net operating income = $12,000 - $2,000 = $10,000 per year.
If the required cap rate is 5% because mortgage rates are 5%, then astute investors would not pay more than $10,000 / 5% = $200,000 for this hypothetical property. Same property, same income, but when the required cap rate is 10%, the price astute investors would be willing to pay is only $10,000 / 10% = $100,000. Under a different interest rate environment, if the cap rate is 2%, then the fair value of this property is $10,000 / 2% = $500,000.
This begs the question, how are real estate valuations looking these days? I will look at one-bedroom condos, one of the most popular real estate investments, in 2 locations – Vancouver and Calgary.
According to zumper.com, the median rent of a onebedroom condo in Vancouver is $2,700. Applying the math, by allowing $700 for condo fees, property taxes, and repairs and maintenance, we are left with $2,000 per month in net operating income, or $24,000 per year. A good five-year mortgage rate is 5.74% by tangerine.ca. Even if we assume that rates are a bit too high at the moment, that they will be coming down in the future, and that as investors we are happy with only a 5% rate, we would not want to pay more than $24,000 / 5% = $480,000. According to zolo.ca, the median price of one-bedroom condos sold in Vancouver over the last 30 days was $700,000.
According to our calculations above, that is about $220,000 more than what we should be willing to pay.
Having said that, the Vancouver market has traded at unusually low cap rates/high prices for decades for multiple other reasons: foreign buyers there are indifferent to local market economics and supply shortages due to strong net population growth associated with to migration/immigration. Vancouver offers natural beauty and lifestyle advantages that consistently see the city ranks among the most desirable cities in the world, so there is still good value for those who don't mind paying a premium for the views and scenic walks through forests and along seawalls. However, I recommend caution when considering investing in residential real estate in Vancouver (or the similarly inflated Greater Toronto Area).
According to zumper.com, the median rent of a onebedroom condo in Calgary is $1,775. Allowing $475 for condo fees, property taxes, and repairs and maintenance (things are generally less expensive in Calgary), we are left with $1,400 per month in net operating income, or $16,800 per year. Interest rates are the same as in Vancouver, but investors will probably require a higher cap rate for Calgary vs Vancouver, so say an 8% rate. We would not want to pay more than $16,800 / 6% = $266,666. According to zolo.ca, the median price of one-bedroom condos sold in Calgary over the last 30 days was likely around $250,000. (Not enough units were sold for the data to be reliable.) According to our calculations above, that is less than what we should be willing to pay. My general advice for Calgary: buy!
Investing in real estate through REITs or other investment vehicles
A lot of investors do not wish to be actively involved with the direct ownership of real estate, preferring liquid investment vehicles such as publicly traded real estate investment trusts (REITs) and other real estate funds (public or private) that use professional asset managers to manage all aspects of the investment portfolio, have good diversification, exposure to multiple sectors of real estate such as office, warehouses, storage, multi-family, single-family, shopping malls, etc.
I generally do not like publicly traded REITs as they introduce stock market volatility in what is supposed to be a less volatile asset class. Having said that, there are times when publicly traded REITs or corporations trade at extremely low valuations, and it makes investing in them attractive.
1. A publicly traded real estate stock that I like is Tricon Residential Inc. (TSX:TCN $10.81 – don’t pay over $13.00). It is a rental housing company catering to the middle-market demographic in Canada and the U.S. The company owns and manages approximately 36,000 single-family rental homes and multi-family rental units. It is very nicely profitable, generating a return on equity of 15% or more. It normally trades at around book value, but currently trades at 0.57 x book value, a deep discount. Investors sold off the stock last year due to interest rates going up and fears of an upcoming recession. I believe at this price higher cap rates in the underlying real estate portfolio are factored into the stock price as well as a recession, so there is little downside to the stock price and good upside.
2. A private real estate fund I like is the Trez Capital Private Real Estate Fund (FUNDSERV:TRZ610). This fund invests in high-quality build-to-rent development projects primarily in Texas and Florida, in single-family homes as well as selfstorage facilities. The markets it invests in have strong fundamentals in terms of population growth, high paying jobs, and reasonable valuations to buy and develop lots. The manager has a long-term track record in these areas, and it is an investment that has a double-digit long-term return potential.
3. Another sector that sometimes is separated from real estate altogether due to its unique properties is farmland. Specifically, Canadian farmland through Veripaht (UR) Fund (FUNDSERV:QWE632). Canadian farmland prices did not go up much after the massive monetary and fiscal stimuli in response to the COVID lockdowns, so valuations are still reasonable. Farmland provides a good hedge against inflation, and it provides a reasonable yield. The fund leases the farms to a variety of operators, growing a variety of crops across several provinces in Canada, giving investors diversification by location, crops, and operators. Farmland is less liquid, so only investors with long-term investment horizons should be considering it. It has been a favourite type of holding for the billionaires, with Bill Gates recently becoming one of the largest individual farmland owners in the world.