Historical article note: This article was originally published on 2019-01-24. Rates, policies, home prices, statistics, product names and qualification standards reflect the environment at that time and may have changed. This archive is for historical record and general education only. It is not mortgage approval, investment, legal or tax advice.
At the invitation of Fangdong.com, I am here to talk about what I consider the most important aspects of real estate investment. The book 'The Most Important Thing in Investing' by Howard Marks provides many constructive and generally applicable insights for investment activities, which are very worth learning from for real estate investors. Based on the actual situation in Canada and general investment principles, I believe that the three most important things in residential real estate investment in Canada are: 1. Planning; 2. Income; 3. Location.
The essence of investing is to complete a plan that converts active income into passive income. If someone thinks this is an easy and pleasant process, they are mistaken. Investing is a bitter journey of postponing immediate gratification to achieve set goals, with no excitement or ease at all. Our reverence for investing is reflected in how we plan the conclusion of our lives: to be poor first or poor later? If you decide to end your life in poverty, you don't need to invest—enjoy life in the moment. Setting goals and steadfastly executing the plan is the entirety of investing. Many Chinese in Canada are desperately searching for investment products that can make them rich quickly, which is a misguided approach, because investing is not about finding investment products. First, set your goals, and then choose investment products during the process of executing the plan; that is the correct approach. Canada is a high welfare country, and a family can successfully transition from active to passive income by achieving the goal of "before retirement, husband and wife each have a $1 million life insurance policy, own a mortgage-free home, and have $2 million in financial assets." In other words, achieving this goal grants financial freedom, allowing one to avoid doing things they do not like. During the process of achieving this goal, one can invest in real estate, start a business, or invest in stocks, depending on which type of investment one is good at. China's GDP annual growth rate is 6%, meaning national wealth doubles every 12 years; young people can easily surpass the wealth of their parents with effort. Canada's GDP annual growth rate is 2%, meaning national wealth doubles every 36 years; without using debt to leverage investments, you can only wait for the next generation to surpass families who immigrated to Canada earlier. Therefore, in a Canadian family investment plan, leveraged investment is the priority. Assets purchased with leverage must generate their own cash flow; otherwise, it is gambling. Based on this reasoning, real estate in big cities is the best investment product.
In real estate investment, the key is leverage. To obtain leverage from banks, it is necessary to understand the bank's mortgage policies and make a plan, implementing and completing the plan step by step. People only realize the importance of a mortgage plan after making a big mistake. A mortgage error can easily destroy a family's investment plan, leaving them poor both before and after. Let's look at an example—a mistake that someone who hasn't read this article could easily make. A couple has an annual income of 150,000 yuan and, after 10 years, finally pays off the mortgage for their own home (House A), with 190,000 yuan in savings. They then borrow 750,000 yuan to buy a new home (House B), and House A is rented out. After moving, they realize that House A has no mortgage — in other words, the investment property has no leverage, and they have no cash for turnover. They then apply to the bank for a mortgage on House A, but get rejected by several banks. The couple then embarks on the long journey of repaying the mortgage for House B with after-tax income. The correct approach would have been to first mortgage House A and use the withdrawn cash as a down payment for House B. Families hurt by this example end up back at the starting point of new immigrants on the investment path, effectively starting over in terms of mortgage repayment. How many decades do people have to squander? A family with an annual income of 150,000, if following a planned, step-by-step approach to changing their home and buying investment properties, could buy 5-10 properties in 15 years. If they make the mistake mentioned above, they will only ever own 2-3 properties in their lifetime. Many people cannot proceed after purchasing a third property, not due to low income, but because of a lack of mortgage planning. A proper mortgage plan is simple: if you want to buy an investment property, you need to accelerate repayment of your primary residence as much as possible; if you want to buy a new primary residence, you should mortgage all existing properties first before purchasing the new home. The secret to buying multiple properties is one thing only — the mortgage amount and monthly payment of the primary residence must always remain at a minimum. At any time, if the remaining mortgage balance and monthly payment of the primary residence reach the borrowing capacity limit, real estate investment will abruptly stop, returning the investor to a new immigrant state.
Without income, it is impossible to invest in real estate because you cannot obtain leverage. Having income but not reporting taxes is also useless because banks use taxable income as the basis. A prominent issue in the Chinese community is that self-employed individuals often have low personal taxable income, making real estate investment difficult. Here we are talking about 'private real estate investment,' applying for a mortgage/residential mortgage, so the bank relies on personal taxable income rather than business or commercial income to support the mortgage. For every additional 4,000 yuan of personal income tax paid, the mortgage can increase by 40,000 yuan. Clearly, borrowing money grows wealth ten times faster than saving it. Regarding the role of rental income in loans, many people overestimate it; rental income plays a very limited role in supporting a loan. If the property is used for short-term rentals, it may be illegal in some cities, and short-term rental income has no contract, so banks will not consider it as sustainable income to support a mortgage application. Banks require the applicant's debt-to-income ratio to be below 44% to approve the next loan, meaning that the monthly payments of existing debt plus the new debt must be less than 44% of monthly income. Therefore, some people mistakenly think that the rental income from each property can offset all debts and that banks will approve the loan. I often receive calls complaining that their friends in similar situations can borrow money to buy a house, but they cannot. The world is large, and survivorship bias indeed exists, but I believe that without income or for low-income groups, it is very difficult to obtain a mortgage. The main job of the bank is to keep households with low income and weak financial ability out of high debt.
Real estate investment is an investor's confidence in a city; the house purchased is like the city's stock. The returns from real estate investment come from rent and capital appreciation. The cash flow from rental income is a necessary condition for investing with leverage, and its purpose is to hold the property for as long as possible and sell it in the most ideal situation. Due to the existence of leverage, capital gains can be amplified. With a 20% down payment, the leverage multiplier is 5; if the property price rises 10%, the investment return is 50%. Therefore, the characteristic of real estate investment is to maximize capital gains under leverage. You cannot get rich just from rent. The advertisements you see about real estate investments with good cash flow are actually avoiding discussing capital gains. The cities suitable for real estate investment are only first-tier international cities, and within first-tier cities, the apartments/condos suitable for investment can only be in the most densely populated areas. Investing in properties with good cash flow in suburban or remote second- and third-tier cities is putting the cart before the horse, losing the watermelon while picking up the sesame seeds, and in the end, due to taxes and other frictional costs, even the sesame seeds may not be recovered. Many Chinese have a deep misunderstanding of cash flow; some have been searching for years for properties with positive cash flow but to no avail. In fact, cash flow is just the leverage ratio: with a higher down payment, the leverage is lower, and cash flow becomes positive; with a lower down payment, the leverage is higher, and cash flow becomes negative. Take a condo in North York as an example: with a 30% down payment, the cash flow breaks even; with a 20% down payment, the cash flow is negative, which means additional down payment is needed. Excessively pursuing the standard of a 20% down payment with positive cash flow can hardly enable real estate investment in first-tier cities. Being forced to invest in small towns in real estate is certainly a behavior that deviates from the essence of real estate investment, cannot achieve the expected results, and has nothing to do with the goal of financial freedom. One should completely and thoroughly change their prejudice against cash flow.
Finally, let's talk about the insights that the book 'The Most Important Thing in Investing' provides for real estate investment. The author, Howard Marks, gives a very precise definition of 'risk.' He believes that 'risk' is the possibility of losing principal, not the magnitude of volatility. This is very important because many people think that investments with high volatility are risky and therefore have high returns. In practice, however, investments with high risk definitely have the potential for large losses, but the returns are not necessarily high. Volatility merely tests one's capacity to endure; volatility itself is not risk. Only the possibility of losing principal constitutes real risk. For example, investing in syndicated mortgages is essentially a form of crowdfunded real estate loan where the collateral is land, and the mortgage is a second lien. This is an investment with a very high probability of principal loss, and the 8-14% returns do not reflect a risk premium. Many investors do not perceive the risks and blindly enter, and the results are predictable. There is also a fundamental difference between buying a house built by Vanke and buying Vanke stock in terms of risk: selling a Vanke house without a loss means no loss of principal; if Vanke is acquired by an unscrupulous buyer, the market price of Vanke's stock is uncertain, and delisting could lead to a total loss of principal. The author also mentions a 'pendulum theory': the price of any major asset class follows a pendulum-like pattern. No asset price can swing up and remain in the air without falling. One should sell at the highest point and buy at the lowest. Identifying the pendulum characteristics of major asset prices and implementing contrarian investing is a long-term investment strategy. Buying high and selling low is following the crowd and is one of the human weaknesses of investors, and indeed of everyone. Ultimately, investing is a forward-looking activity: if you hope to sell at a high price in the future, you need to buy at a low price now.
Someone once specifically asked Buffett for tips on investing in the stock market. When they came back, they said disappointedly that Buffett is just a rookie in the stock market; the things he cares about are the macroeconomy outside the stock market and the micro activities of companies. Real estate investment actually has little to do with the property market. 99% of the market information, such as how many second-hand houses are sold each month or how much the average house price rises or falls, is unrelated to real estate investment. Checking such information twice a year is enough to understand the trend. As long as investors can identify risks, recognize asset price cycles, make feasible plans, maintain a certain income, and adhere to the principle of only investing in first-tier city properties, achieving financial freedom is not difficult. In 2019, both the Federal Reserve and the Bank of Canada will complete this round of interest rate hikes, and the new B20 stress tests currently implemented by commercial banks will also be reassessed after the interest rate hike cycle ends. The swing of Canadian real estate prices will reach its lowest point in the first half of 2019 and is expected to swing upward in the second half of the year.