Avoid the Landlord Pinch

If you’re an investor with significant real estate holdings, now may be the time to consider exiting this asset class in favour of brighter shores. The last few years have seen significant turmoil in real estate markets around the world. As of 2007, we have seen declines in the United States, Argentina, Britain, Netherlands, Italy, Australia, New Zealand, Ireland, Spain, Lebanon, France, Poland, South Africa, Israel, Greece, Bulgaria, Croatia, Norway, Singapore, South Korea, Sweden, Baltic states, India, Romania, Russia, Ukraine and China. In The Canadian Moral Hazard Corporation I pointed out that conditions were ripe for a sizeable decline in real estate valuations here in Canada. Since then, the US economy continues to deteriorate and this brings the collapse of our own real estate market closer with every day.

Income-seeking investors are of a different breed than speculators, who are in the game only to make short term gains on capital appreciation. Investors seeking cash-flow aren’t necessarily concerned with the fluctuations in their asset prices in the near-term. So long as their cash flow isn’t endangered they may be less likely to exit an asset class that has so far been very good to them. This may lead such investors to stay in real estate throughout the turmoil because they expect their cash flows to be unaffected. To these investors, an important metric to watch is the mortgage/rent ratio. It is very similar to P/E ratios for stocks in that it shows how the cost of owning an asset is related to the income that asset produces. It helps investors gauge whether a certain investment is “cheap” or “expensive”. In Canada, the cost of investing in housing has seldom been this expensive.

Price/Rent Ratio

When metrics such as these travel so far from their historical means, corrections are inevitable. The correction to the imbalances illustrated above could come in two ways; 1) increased rents or, 2) decreased housing prices. Falling housing prices are a likely short term consequence of the coming economic turmoil but what about the government’s reaction and how will that affect the market? The government is 100% on the hook for all of the CMHC’s obligations and so they’re likely to engage in massive deficits. Due to the enormity of the CMHC’s guarantees relative to the national debt and annual spending these will be on a scale never before seen in the country. With deficit spending comes the threat of inflation and higher interest rates in the future, both of which spell trouble for income-minded investors.

With higher interest rates come higher costs for property owners. Those on variable-rate mortgages are likely to feel the pain first, while fixed-rate mortgage holders will see the higher costs arrive the next time their loans roll-over. These higher costs will erode the cash-flow created by their investments and they could soon find their properties costing them more than they earn.

The other threat is inflation. While inflation will wipe out any debt incurred to buy the properties, it endangers the income stream produced by them. Many provinces have limits on how much rent can be raised, which is nothing more than ‘soft’ rent-controls. A typical response to inflation is for governments to enact outright price controls, which destroys the ability of property owners to obtain any sort of real income from their holdings. Furthermore, with no income coming from the properties, the ability of sell them will become impaired and valuations will further plummet.

Higher interest rates and inflation will also necessarily bring down the value of mortgage-backed securities that have been flooding the market over the last decade. This is why I refer to this scenario as the landlord pinch, because real-estate investors of all types are facing pressures from every direction that threaten to destroy their capital and ability to derive an income from their investments. For the time being, the only way to avoid this appears to be a timely exit from the real-estate market. Income-seekers have many other options available to them that will get them through tough times and at myCFO, we can advise on how to effectively preserve your wealth.

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