QUOTE (mmacdonald @ Jan 31 2010, 12:47 PM) Hi everyone, I am newbie looking for some help. My husband and I have registered for the upcoming ACRE weekend in TO and are very excited to start investing. My question is this..we have some outstanding debt as well as our mortgage. Would we be better to pay off some debt or start investing in hopes that debt will be paid off at later date through $ made throught properties? Any advice is appreciated
Here is one of the postings I am preparing for my new blog: http://canadiandiversifiedinvestor.blogspot.com/
It is part I and I`ll give you here the pre-view.
Real Estate versus the Stock Market
Many investors are `Either-Or` investors. It is EITHER real estate they invest in OR the stock market, i.e. paper securities. Being a `Hybrid` investor myself who invests in both, let`s review the both. Where to begin:
Real Estate:
Real Estate investing can be done in many different ways: rental properties, rental pools, rent to own(RTO), Agreements For Sale (option to buy), etc. You can also buy in many different types of real estate: bare land, multifamily apartments, single family units, duplexes, fourplexes, shopping malls, recreational properties, properties in your home town or province, properties elsewhere.
Talk about diversification eh?
One of the great wealth creating tools is leverage. Understanding leverage is essential for the real estate investor. Unfortunately it is also a very complex issue and working with a good mortgage broker with whom you are comfortable is just as important as dealing with the `right` Realtor, the `right` property manager, the `right` lawyer and the `right` accountant. What I am saying is that a real estate investor needs to have the `right` team for him or her. You see, a blog like this can be endless in information to cover and here we`re only talking about real estate investments.
I digress (as usual). We were talking about leverage. When dealing with investment real estate, running out of cash is the road to `oblivion` – a city located in one of the nastiest parts of this world. If you run out of cash, sooner or later you will be forced to sell your investment whether you want to or not. So having
positive cash flow is essential. In its most simple form, positive cash flow can be seen as comprising two components:
1. Net Operating Income (NOI)
2. Cost of financing
!--/fonto-->NOI is the operating profit out of which you have to pay your financing costs (mortgage payments). This is your `cash flow`. It must be positive, otherwise you subsidize the property. Capitalization rate (cap rate) is NOI divided by the property`s purchase price and it can be expressed in percentage points. If you can borrow money through a mortgage or a HELOC, and the interest rate is lower than your cap rate you will increase your return on investment (ROI) and your cash flow. If your cap rate is higher than your interest rate your ROI goes down and so does your cash flow – not good. On later posts we may go into more detail. Suffices to say that if leverage increases so does your return on investment which is the cash flow you generate divided by the money you invested in the property (i.e. your down payment plus acquisition costs).
There is a second aspect to leverage that is a bit more speculative. In Calgary, over the last 40 or so years, real estate appreciated (increased in value) at around 6% per year. So that would mean that if your property is worth $100,000 this year then next year (on average) it`s value would have increased to $106,000 and the next year to $112,360 and so on. Suppose you bought with a LTV of 80%, i.e. you had a $20,000 down payment and financing of $80,000. Then in your first year you earned $6,000 on an investment of $20,000 that is a return of 30% and the next your earned $6,360 on your initial $20,000 or 31.8%. Wow!
Ah, Godfried, you forget something, what about the interest payments? My answer: "He Buddy, I am operating at positive cash flow, remember? The interest is paid for out of cash flow." My total profit in fact is my ROI from cash flow plus 30% from appreciation. You see this is kind of like the value increase of your stocks plus your dividends.
There must be a hook. Things cannot be that easy! Of course it is not that easy. First of all, operating at positive cash flow is not easy to achieve it takes a lot of hard work. Secondly, the real estate market does not go straight up. The value may fall for a couple of years or like in the U.S. it may crash! Then you could really be in the sh.t house when having a high LTV mortgage. In Calgary in 2008, property values dropped by nearly 20%. If you bought the year before your $100,000 property and now it is worth $80,000 what do you think the bank might say especially if you didn`t make you mortgage payments because the place was vacant?
Property Value $80,000
Mortgage principal: $80,000
Your equity: $80,000 minus $80,000 equals Zero. Oops, you are down $20,000! If you sold the property you would lose 100% of your initial investment. If the property had fallen $50% to $50,000 you would have lost in a lost sale not only $20,000 you had to come up with an additional $30,000. Your loss would have been 250%. Got it? Leverage increases risk tremendously!
What happened if you had no mortgage? Well, with a 20% market decline your loss would only have been 20% and there would have been no bank forcing you to sell. You could wait for the coming recovery – markets always do recover and over the long haul you made 6% per year plus your positive cash flow which equals your cap rate.
You see, leverage increases risk and higher risk means a higher potential return but also... exaggerated losses. So at what LTV can you sleep at night?
Next posting is about investing in paper securities – stocks and bonds.
