Before You Invest In Real Estate, Read This!

James Schofield - May 17, 2023
Real estate investments can feel safe due to to the physical nature of its products, but is it really that simple? Here we walk you through it's pros and cons.

Many real estate investors like the fact that unlike market investments, a property is tangible, unlike a stock which can gain or lose value, the physical aspect of real estate makes real estate feel valuable regardless of the listing price. Like market investments, real estate has unique risk/return characteristics, which should always be rigorously analyzed.

The pros of real estate investing:

Not Disreputable: It is the closest you can get to something unlikely to be disrupted. Different than technology, which is continuously changing, a company like Blackberry can go from #1 to basically out of the smartphone business within ten years. With real estate, people will always need a place to live, and with a growing population and a fixed amount of space, the value of this land should continue to rise long term.

Cheap Leverage: Typically, you can acquire a property using only 20% of your own money, borrowing the other 80%. Because the lender knows they would take ownership of the property if you default on your debt (secured debt), they see the risk as being lower, and as such, the cost to borrow is lower than if you were borrowing to invest in stocks. Leverage has the potential to increase the rate of return on your down payment. For example, If you buy a rental property worth $500 K with $100 K as a down payment, and it earns $10 K of net rental income, it is a 2% return on the value of the property, but 10% on your investment. The 10% is called a cash-on-cash return. The 2% is called a capitalization rate, or Cap-Rate.

Tax Favored: Real estate has attractive tax features, when used for investment purposes. The first is that all costs, including interest on a real estate loan, can be deducted. The second is depreciation deductions or capital cost allowance. Depreciation is essentially the recognition that significant upkeep projects or "capital costs" are required to maintain a property. The CRA allows real estate investors to deduct a percentage of the cost of the structure at a predetermined rate, usually between 5-10%, whether the improvements happen in a given year or not. This theoretical depreciation has the effect of lowering an owner's tax bill. For example, you could have a property worth $1,000,000, and your net rental income is $50,000/yr, which is taxable income. However, you may be able to depreciate 5% of the property's value per year. In this case, 5% is $50,000 of deductions, which completely erases your net rental income from a tax perspective; this concept is called Capital Cost Allowance. It is essential to understand that any CCA claimed is only deferring income recognition. For example, for a rental property purchased for $500 K, assuming the owner uses $200 K of depreciation but later sells for $1,000,000, they would pay capital gains tax on the difference between $500 K and $1 million. The $200 K of depreciation is recaptured and taxed as ordinary income. While the tax is still realized eventually, depreciation effectively allows the recognition to be pushed into the future, allowing more assets to grow.

The cons of real estate Investing:

Time also has a cost: Typically, real estate investing is more hands-on than equity investing. The saying goes, "your diversified portfolio of stocks will never call at 10 PM on a Sunday asking you to fix the toilet." Although a lot of real estate investors disregard the PITB pain in the (butt) element of real estate, it is a fundamental part of the experience. If you hire people to do the work for you, you must put in the time for proper due diligence to research contractors, whether they are painting or adding a basement suite. Changes to the structure require permits, and then there is, of course, vetting tenants. Any landlord will tell you that rental laws in Ontario favour tenants as opposed to landlords, so you do not want to end up trying to evict a bad tenant. If you are the one spending multiple hours to paint or help with the demolition, how much is your time worth, $200, $300, maybe $700 an hour? You should track your time if you want to evaluate whether a piece of real estate is a good investment.

Long term Returns lag equities: Maybe it is recency bias at work or investors' preference for hard assets, but many investors cling to an irrational belief that real estate only goes up in value. Indeed, a few specific Canadian metropolitan areas have had a fantastic run-up in value over the last 10-20 years, but real estate markets can also crash or go through corrections. Covid-19 may bring some change to the North American real estate; As companies shift to working remotely, many employees who previously bought homes in Silicon Valley may move to more affordable cities. This mass exodus from expensive markets could have a ripple effect on real estate markets. The same effect may even happen in Toronto, though likely to a lesser extent. The point is that real estate does not always go up. Investment properties tend to be good investments because of the cash-flow landlords receive from renters and significant, lower-cost leveraging. It is dangerous to purchase real estate for short term appreciation.

The opposite side of the tax benefits: If you're a landlord, rental income is considered regular income and is 100% taxable. In contrast, with other investments such as corporate class mutual funds, distributions often take the form of capital gains or Canadian dividends, which receive preferential tax treatment in Canada. An investor in the 50% tax bracket would need to earn 6% in interest income to equal the same after-tax return as in investor who makes 4% in capital gains distributions

Bottom Line:

Being a successful real estate investor takes hard work and skill. If you are going to buy a property, you should be able to conduct a full analysis of all the costs involved, including maintenance, capital costs, assumed vacancy loss, debt service, and miscellaneous costs like accounting and legal. You also must be honest when projecting the income that the property will generate. If the projected rental income does not cover your expenses, you should be prepared to make up the difference from your own cash-flow, and if it does cover your costs, you should know the cash-on-cash return and cap-rate. The best real estate investors are those who can see the value of severing a property, submetering utilities, or repurposing an industrial building into luxury condos. In many cases, being a successful real estate investor is a lot like being a good entrepreneur.


Source for comparisons for rates of return between real estate and equities was provided by Investopedia