McGill Personal Finance Essentials

Transcript
Module 7: The Realities of Real Estate, Part 1

Hello everyone and welcome. I’m Desmond Tsang and currently I work as an associate professor
at the Desautels Faculty of Management at McGill University.

The module we are covering today is titled: The Realities of Real Estate. In this module, we are
going to discuss some of the essentials of real estate investment along with some ways to get
involved in the real estate market down the road.

Let me first give you a preview of our time together. I’m going to start by discussing why you
should care about real estate. Next, we will go through the important factors to consider for real
estate investment. We will then look at some numbers of housing affordability and the rent-
versus-buy decision. Lastly, if you’re not ready to invest in a real property at this time, we will
look at alternate ways for you to participate in the real estate market without a huge commitment
like buying a house.

Chapter 1: Why Real Estate?

So, the first question is: why real estate? First of all, if you own your property, you do not have
to pay rent every month. And for investment, as a landlord, you are able to generate stable
income every month with the rents you collect. Also, real estate always has the potential of
capital appreciation.

Given the exciting real estate market in the last couple of years, in cities like Toronto, Vancouver
and, more recently, Montreal, capital appreciation could be very substantial for a real estate
investor. In addition, real estate gives people a sense of security since there’s the brick and
mortar underlying each investment.

There is also leverage, meaning you can use borrowed money, which we call a mortgage, to buy
real estate. And there are tax benefits when you can use many expenses to reduce taxes when you
own investment real estate properties.  Moreover, real estate offers you diversification benefits as
you do not want to put all your eggs in one basket and put all your savings into the stock market.

Finally, real estate also serves as a hedge of inflation. Imagine if you kept your money under the
bed. The money will shrink with inflation. However, the rent and value in real estate go up with
any inflation increase.

Though it is also true real estate values can go down in economic downturns. A good example is
Calgary. After experiencing a real estate bubble, caused by the rise in oil price, its housing
market has been declining in recent years.

So, if you’re into real estate, what are some of the factors you have to consider?

Chapter 2: Factors to Consider

Location
In real estate, we have the saying: “Location, location, location!” But what is a good location?
First, we would need to look at the population and income growth of a city. You would want to
go into a market with a growing instead of declining population. Because a growing city would
need more housing and that would help you to secure tenants for an investment property and to
ensure you have a stable stream of rental income.

Also, growing cities usually would mean there’s more demand for housing and more capital
appreciation. So, down the road, that would help you more when you are ready to sell. While
population is important because people need housing, you will also want people to be able to
afford and sustain the housing market. Hence, locations with a financial centre and money tend
to have a better housing market. A perfect example of this kind of location is New York. 

Quality of life is also an important location factor. People live and work in the city. So, the city
has to be a good location with low crime, good environment, decent education and health
systems.

A counter example would be the city of Detroit. Despite the fact that there are many strong
industries coming back to the city in recent years, people are still reluctant to invest in the real
estate of Detroit. Mainly because of the high crime rate and the dangerous reputation of the city.

Macro Factors
Next, macro economic factors matter a lot for the timing of real estate investments. For instance,
when the mortgage rate is low, your cost of real estate is lower. When banks have more money
and are more willing to lend, it would be easier for you to get a mortgage for your property.

If you look at the relationship of mortgage rates and home prices, they tend to go in opposite
directions.

That means investors are more likely to invest in real estate. Thereby raising housing prices
when the mortgage cost is low.

Lastly, house price dynamics are also influenced when there are constraints on the location.
Some good cities end up being ultra expensive because of these constraints. A perfect example is
Honolulu in Hawaii.

Given that it’s on an island and there’s a volcano, the city has very limited land and can only be
built on the edge of the island. As a result, its house prices are considered one of the most
expensive in the world. 

On the other hand, even though Chicago is considered as one of the financial centres in the U.S.,
its housing price is relatively reasonable. One of the reasons is that it has a lot of flat land that
enables the city to expand.
Micro Factors
Once you decide to go into the real estate market, there are also some micro factors to be
concerned about. For instance, where do you want to locate in the city? And what kind of
dwelling do you want? Usually, there are two types of neighbourhoods that are good for real
estate investing. First is the up-and-coming neighbourhood. 

These neighbourhoods usually pick up a lot in capital appreciation when people move there.
Many of you may not know that Facebook used to be located just on the main street of this little
town called Palo Alto. When this tech firm started to get famous, the popularity of many of these
towns along the Silicon Valley also surged thereby making the housing markets in these areas
very attractive. 

Second, we have the established neighbourhood. Real estate investments of this type usually do
not entail huge capital appreciation, but what is important about these neighbourhoods is that
properties located here can have a strong and stable income stream when there are already people
living in the area, when there are already business establishments as well as a lot of amenities.

Next, we want to consider the right property type for your real estate investment. This is kind of
like dating. For example, in San Francisco many of the workers who work for tech firms like
Google are young singles or couples. Hence, there is relatively less demand for large houses in
the neighbourhoods where these firms are located. It makes more sense to invest in an apartment
and loft in this case.

Lastly, the property itself of course matters. You need to find a good property, but what is
considered good? First, the price has to be right for the size of the property you pay for. You
want to invest in properties that are not too old as old buildings tend to have huge maintenance
needs.

Alternatively, you may want to consider some unique and interesting projects. The value of these
projects tends to stay stronger because they’re one of a kind and unique.

Module 7: The Realities of Real Estate, Part 2

As we know, real estate has been making up a substantial portion of the economy. And that’s
why we all need to know some of the essentials of real estate. For example, can you afford to
buy a house at this moment? And also, if you’re ready to buy a house, what kind of locations
would you want?

Chapter 3: Housing Affordability & Rent vs Buy Decision

So, you find a real estate investment opportunity in the city and neighbourhood you like, but can
you even afford it? Here we have the concept of housing affordability and it usually refers to the
relationship of housing expenditure with your household income.   In this case the usual rule of
thumb is 28% to 36%. So, what it means is that if you have been spending more than 36% of
your income on housing, then your housing investment is already too high and over your comfort
zone.
Despite the fact that there are many and more complicated measures of housing affordability, the
simplest benchmark measure is to look at the ratio of median-house-price-to-household-income. 

Let’s conduct a simple calculation to examine the housing affordability of the major Canadian
cities in recent years.

This chart shows you the average house prices of different major cities.
And this shows you the average median income.

If we calculate the house-price-to-median-income ratios, and the rent-to-median-income ratios

and compare among Toronto, Vancouver, Montreal and Calgary, the four largest cities in
Canada, you can see that both ratios are significantly higher for Vancouver and Toronto.

What does that mean? It means housing is getting quite expensive and unaffordable in these
cities. And, not surprisingly, Vancouver has been ranked one of the most expensive cities in the
world for its house prices.

No matter whether a place is affordable or not, one still has to live. And an important life
decision for most people is whether to rent or to buy. We can obtain a big picture by calculating
the price-to-rent ratio.

When the ratio is high, it means house prices are relatively high as compared to rent and it means
it’s more beneficial for us to rent than to own. Most investment firms suggest a rule of thumb of
20.

A detailed analysis of the renting versus owning decision would require other information such
as: other housing expenditures, the amount of down payment you can have, and the time horizon
of your real estate investment.

Chapter 4: Alternative Ways to Invest in Real Estate

Lastly, let’s say owning is currently too pricey for you and you also do not have enough down
payment. Does that mean you have no chance to invest in real estate? No! 

One consideration down the road might be to invest in REITs. What is REITs you might ask?
REITs are real estate investment trusts. They buy and hold real estate properties for rental
income. There are about 300 U.S. REITs and 45 Canadian REITs traded on stock exchanges.
Focusing on different property types such as residential, office, retail, and you can invest in these
REIT securities like you would do for any other stock.

Though it is not guaranteed in the future, REITs have proved to be a very good investment
vehicle in the past.

In this module, we have glimpsed into the world of real estate investing. We first learned the
rationales of real estate investment. Next, we considered the factors that may affect the values of
the real estate investment.
While real estate investment definitively offers many benefits, housing affordability could be a
big concern.

Lastly, even if you do not have the capacity to go into the real estate market, you can still
consider the real estate security market in which REITs, real estate investment trusts, have been
performing quite well in the capital market over the long run.

Thank you for joining this module: The Realities of Real Estate. And best of luck as you
continue forward in your journey towards financial literacy.