Last week, I read Tim Cestnick’s article in the Globe & Mail about freezing assets and one aspect of the article has had me thinking. In the article, Cestnick refers an interesting way of holding real estate:
Paul owns the shares of a corporation that holds rental properties that he’s been accumulating over the years. The value of these properties is about $5-million today (net of any mortgages). He expects these properties to continue to grow in value in the future. Paul doesn’t need the income from these properties to support his lifestyle.
This strikes me as interesting way to overcome a long standing problem with real estate. Even though it does has some promising aspects, I do not think it is a good way to hold a significant portion of one’s assets. Despite its flaws, I think real estate has a valid place in our lives.
Here are the five significant disadvantages I see with real estate investing. For purposes of this analysis, I will focus on residential rental properties specifically:
- Illiquid: how easy is it to sell real estate? Selling a condo unit in Vancouver might not take long but you can’t always count on such a hot market.
- Non-divisable: if you own 1000 shares of a stock (or a mutual fund or an ETF), you can sell part of that holding and retain the rest. Partial selling in real estate is much, much more difficult.
- Transaction costs: one can sell shares and ETF units through a discount broker for a $10 commission. What are the transaction costs to sell a $500,000 property? When you factor in commissions, legal fees and the like, it’s easily 5% of the purchase price. For more background on this, read Toronto real estate lawyer Stanley Clapp comments on some of the hidden costs of buying real estate.
- Risk: If you are running rental properties, you take the risk of evaluating tenants. Tenants also pose the risk of property damage though that can partially mitigated through insurance and a well written lease (and damage deposit).
- Administration: Landlords have significant legal obligations to their tenants, including requirements to repair properties and attend to tenant requests. One could hire a property management firm to handle the administration but such services are not free.
Given all these flaws, why do many people remain interested and committing to rental property as an investment? There’s rental income, there’s some comfort in owning a physical asset and there’s potentially tax advantages (though one has to be very careful on that front). I wonder if the 2008 crisis has caused many people to reevaluate their views on real estate investing. At the very least, I hope that people will consider other ways to get exposure to real estate (e.g. owning units of RioCan or other real estate investment trusts [REITs] which manage a portfolio of properties).