Historical article note: This article was originally published on 2019-01-17. 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.
Many real estate 'investment enthusiasts' in Toronto often raise questions, all related to cash flow and liquidity in real estate investment. The reason they are called 'enthusiasts' is that the number of people 'watching from the outside' far exceeds the 'doers' in real estate investment. I collectively refer to the audience of real estate investment as 'investment enthusiasts.' Those who say that real estate investment has no cash flow or that real estate investment is illiquid, 99.99% of them have never engaged in real estate investment and belong to the group of enthusiastic spectators, not players. These two issues, like a thin layer of window paper, become clear as soon as one invests in a property; there is no need for further explanation.
Let's first look at the issue of cash flow. In North York, Toronto, all the CONDO apartment buildings at subway entrances, according to the current market rental levels, market interest rates, and a 30-year repayment period, will break even in terms of cash flow with a 30% down payment. That is, if the down payment is higher than 30%, there is positive cash flow; if the down payment is lower than 30%, there is negative cash flow. Cash flow = down payment ratio. The lower the down payment ratio, the worse the cash flow; the higher the down payment ratio, the better the cash flow. The statement 'it's hard to find properties with positive cash flow' is logically incorrect, or it is an excuse for outsiders who do not participate. Taking North York CONDO apartment investment as an example, investors with high income and enough labor income to support family expenses would prefer a 20% down payment to maximize leverage, because the lower the down payment, the higher the return on capital. The additional monthly cash is actually just the installment payment of the down payment. If there is a 30% down payment, no additional cash injection is needed; insufficient cash flow is actually just a result of paying less down payment initially, which can be supplemented in installments later. In first-tier cities where real estate investment is worth pursuing, cash flow is usually poor. In remote small towns and second- and third-tier cities, cash flow is better. If a salesperson tells you that real estate investment in a certain city has positive cash flow, you should immediately know that this city is definitely not a first-tier city, and don't expect housing prices to rise. Cities that can consistently ensure net population inflow are only first-tier cities, because the final stage of urbanization is the formation of super metropolitan areas in first-tier cities. In second- and third-tier cities, the cheaper the property, the better the cash flow, but the less you should buy it, because people will move away, and later who will you sell your investment property to? Pursuing cash flow is putting the considerations of real estate investment in the wrong order, and it is an ineffective topic discussed by those with no real estate investment experience. From this perspective, real estate investment is only suitable for families with high labor income who can tolerate poor cash flow. Families hoping to increase income through real estate investment should focus on increasing labor income, rather than looking everywhere for properties with cash flow. The essence of real estate investment is net worth investment, characterized by low current income and high capital gains after long-term investment. Low-income families are not suitable for real estate investment.
Let's talk about liquidity issues. Liquidity = the number of buyers. Liquidity is a market problem, but also a problem of human nature. When panic occurs, all buyers disappear, so 'liquidity' is the most timid thing in the world; it vanishes at the slightest disturbance. There is a real story: when Russian government bonds defaulted back then, the entire bond market was stunned. There was a Long-Term Capital Management fund, composed of Nobel Prize-winning economists and mathematicians, which tried every model but still couldn’t foresee that the bonds of a nuclear power could stop trading. On August 31, 1998, this fund couldn’t find a single buyer all day for all the bonds it wanted to sell. And this was in a market worth trillions; truly, not a single trader could be found to buy. You can’t say the bond market lacked liquidity; you can only say that liquidity itself is fluid and evaporative, able to disappear instantly with people’s fear. Therefore, liquidity has nothing to do with the nature of the asset; it only depends on the number of buyers, and the number of buyers depends on whether they are feeling bullish or terrified. At the same time, for the same property, the number of buyers who both can afford and really like it is not very large, so real estate liquidity is limited. However, the liquidity of real estate can be created and stored. By making good use of the storable function of real estate liquidity, holding real estate can be more stable than holding stocks.
Compared to stocks, real estate has an opponent willing to trade with investors as a "buyer" every day, and that all-weather "buyer" is the bank. Banks are not affected by market panic: as long as the borrower applies and the bank approves, the loan can be redone, commonly known as "refinancing," allowing investors to take cash out of home equity for future mortgage payments. After buying a piece of real estate, the mortgage must be repaid with both principal and interest on time every month. Over time, the loan principal inevitably decreases, and refinancing can restore leverage, enabling the withdrawn principal to be reclaimed. For investors using debt and leverage, liquidity also means that loans must not be interrupted. If mortgage payments are not made on time, it will constitute a breach of the loan contract, and the investor will become a "forced seller," having to sell the property to repay debt regardless of market conditions. The cash withdrawn through refinancing is meant to maintain long-term payments, not to be forced into becoming a "forced seller" due to economic downturns or borrower emergencies. Both real estate and stock investments need to avoid becoming "forced sellers." Those buying stocks on margin are leveraging their investment just like with real estate; when they receive a margin call, they must either replenish the position or become a "forced seller" selling at a loss. The storable liquidity of real estate helps investors hold property long-term, avoiding the awkward situation of buying stocks on margin. Whether real estate liquidity can be stored depends on two factors: 1. Real estate investors must maintain a good long-term income level and always have the ability to refinance; 2. Never borrow money when you need it, but borrow when you are most capable of doing so. Using the example of the sudden massive loss of the Long-Term Capital Management (LTCM) fund, we can illustrate the universal principle of "never borrow money when short of funds." When you lack funds, everyone worries about your repayment ability; when you don't, banks or investors believe you can repay. At the end of 1997, LTCM, having achieved a 400% investment return where 1 dollar invested became 4, decided to return all external investor funds and only keep internal investors, meaning only insiders benefit. From August to the end of September 1998, 45 billion in principal quickly suffered losses: the 1 dollar principal that had grown to 4 dollars dropped to 0.23 dollars. At that time, if the fund tried to seek external investors, as you can imagine, not a cent could be borrowed, and eventually, the fund was taken over by 14 concerned investment banks and commercial banks. Any investment, whether by families or businesses, cannot have interrupted cash flow; otherwise, it will lead to bankruptcy.
Overemphasizing liquidity is meaningless; frequent buying and selling increases investors' transaction costs, turning investing into a negative-sum game. In the 1980s, Americans held a stock for an average of four years, but now that period has shortened to eight months. Investors frequently trade stocks because of their high liquidity, paying substantial transaction fees, yet they cannot find a market or investment with long-term risk-free arbitrage. The stock market is essentially zero-sum: I sell a stock to you, you sell a stock to me, the loss you incur is my gain. After accounting for transaction fees, it is actually a negative-sum game. Arbitrage in real estate investment is even less likely; profit made from speculating on nine houses can be lost in a single deal on the tenth. Overall, real estate investment loses less than stock investment because there are fewer speculators in property than in stocks, and more people hold property long-term than holding stocks long-term.
Readers can observe those who say 'cash is king,' 'cash flow is the most important,' and 'leverage should be used within limits'; none of them dare to invest. The poorest people have the most liquid assets, all in cash. If one person has 5 million in cash, and another has property worth 15 million with a mortgage of 10 million, who do you think has better assets? Prosperity has always been sought amidst risks; avoiding risk is avoiding wealth. There is no need to wake someone who is pretending to sleep; it is best to let the world remain in a state where 2% of people hold 98% of the wealth. In the Jinmahui area, with more than 7.4 million people, only 120,000 own multiple residential properties, less than 2%. 98% of people are looking for properties with positive cash flow, or in other words, looking for excuses for not daring to invest in real estate. The vast majority around us, 98%, are full of negative energy when it comes to real estate investment, spending all their effort finding excuses rather than methods. I will debunk these two common excuses at once, helping readers recognize and stay away from negative friends in their vicinity, and seek those lighthouse-level beneficial friends whose wealth is more than five times yours.