Wednesday, March 31, 2010

Comparing ‘apples and oranges’

So there is an important distinction between investing and 'investing in real estate'. Investing in the strictest sense of my definition means that your money is working for you rather than that you are working for money. 'Real estate investing' often entails the running of a business, i.e. buying a house, renovating it and reselling it - hopefully for a profit. Or buying a property, renting the property and creating positive cash flow plus appreciation. Members of REIN who own properties and operate them are running a real estate business; their proceeds are a combination of investment profits and salary. Their salary is not guaranteed, it is performance based just like the compensation of many senior managers in large corporations.

If you truly invest in real estate and you have a JV partner (finder) or operator-owner run the place, the only thing you do is getting a return on money without being involved in the operations. This is not much different from investing in a REIT, a MIC or mortgage investment corporation or just investing in a loan. Hence, the returns, at first sight, should not be much different and are basically determined based on risk and on the comparison with results from other investments. The key word is 'risk'.

Here is another matter to consider when comparing investing and 'real estate investing': leverage. This is often called the major advantage of real estate investing. But it is again an incorrect perception. In some cases the passive JV investor (true investor) qualifies for the mortgage taken out on the property and provides a personal guarantee to the lender regarding the repayment of such a mortgage. This increases the risk level of his investment considerably and consequently so should the returns increase. Furthermore, in a true partnership, the passive JV investor may not only be liable for the mortgage but also for any liabilities regarding operations and regarding the property's liability in general. This is another reason for higher returns on investment.

If the passive JV investor raises his investment capital by taking out moneys from another property, say through a line-of-credit (LOC), he does exactly the same as an investor investing in the stock market who buys on margin or uses money from a LOC to buy the shares. In fact, the passive JV investor is now over-leveraged to a degree that no stock trading brokerage would normally allow. Some mortgage lenders are now asking explicitly whether moneys obtained for a down payment are borrowed. No wonder because the underlying JV property is basically over-leveraged and improperly insured or not insured at all through CMHC.

To complete the corporate investor analogy, the stock market investor uses leverage exactly the same way except for his personal liability. As mentioned earlier, an investor buying stock on margin is in the same position as the passive JV investor borrowing money for a down payment. But also, his corporate asset, just like the real estate property is also encumbered by loans: corporate debt! That is why stock market investors are concerned about the corporate debt/equity ratio and related numbers. The only difference is that the stock market investor is not liable for the corporate debt.

I think, over the last number of posts, it is now clearly demonstrated that investing in corporations through the stock market and (passive) real estate investing have much in common and also that there are essential differences. Comparison of their investment performance is often presented in an incorrect light. Passive JV investors are often exposed to much higher risks than a typical stock market investor due to over-leverage, mortgage liability and operational as well as building liability. A stock market investor's funds are more liquid – i.e. it is easier to sell while liability is generally limited to the size of his/her investment except when borrowing on margin. When comparing 'real estate return' versus stock market returns, the above issues are usually not considered and on many occasions we are comparing 'apples and oranges'.

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