After watching the movie — the Big Short again, it occurred to me that even though Canada’s housing situation is different than the 2007 US housing crisis featured in the movie, the concept to bulletproof your investment real estate portfolio is always worthy of discussion. It’s also timely, as there’s great deal of talk that Canada is the next market due for an economic and housing correction, especially in light of the “out of control” price increases that markets like Vancouver (which has already begun to correct), Toronto and to some degree now Victoria have been experiencing.
Steps to Bulletproof your Investment Real Estate Portfolio
Step 1: Focus on the Fundamentals
Stick to the basics and do your research. This means you need to understand the market in which you are targeting or buying:
- Understand whether that market’s contracting or expanding, remember that small resource towns generally have a boom/bust cycle, while larger urban centres have more balanced market swings,
- Be aware of what’s happening with business growth within the market and how that’s impacting jobs, population growth (including migration) and demographics.
If people can’t afford to buy, but have stable jobs and good job prospects they will rent, which provides a reliable source of tenants for a real estate investor. So, understand if the housing prices being offered in the market you’re considering (at the city, town and/or neighbourhood level) seem reasonable and how they compare to other similar cities, towns, etc.
Another basic consideration is to buy properties that will appeal to both buyers and renters, and to buy in desirable locations, i.e., close to transportation hubs (transit stations), places of work, etc.
Finally, your research should include a look at what’s happening in terms of housing starts, absorption, days on the market, vacancy rate, etc.
Step 2: Look for Markets that can Weather the Market Fluctuations
The only constant is change, and this is why a look at the past history of a market is important for a real estate investor to gain some knowledge of future possibilities:
- What has been the cyclical nature of that market
• What is the overall economic situation – if there’s an issue, is it chronic or acute
• What is happening in terms of government spending and infrastructure improvements: roads, hospitals, schools and universities
• Are there big private business projects, improvements or expansions within the market
• Are there resources and economic activities in place to attract businesses and jobs, and encourage population growth?
Check with the market’s Economic Development Offices at both the regional and local level to discover what’s currently happening or expected to happen in term of major infrastructure projects. A market in a region that has a track record of weathering change well is an attractive prospect.
Step 3: Increase your Buffer Zone
On a personal level, you have control of how you much you invest and what impact that might have on your personal finances. A basic and very wise practice is to shield yourself financially: have financial safeguards in place such as building up your financial contingency reserve. Depending on your situation, this could be in the form of actual cash in an account, or it could also be a line of credit set up and ready for use.
For each property in your real estate investment portfolio, it is prudent to have at least two years’ worth of your cash flow shortfall on reserve. For example, if you are currently carrying a property for $100/month then you would want to have $2,400 set aside, in order to be able to fund that carrying cost for two years. If the property is in a market experiencing some major economic swings you may even wish to double that amount to $4,800 so that if the market goes into a downturn that you have extra buffer.
A conservative approach is to avoid the minimum down payment. In fact, put 25% or more as a down payment if you can, so that you will improve your cash flow and if there is a downturn in the real estate market and the values decrease you have a buffer. Remember the many people who found that their mortgages were “underwater” during the US housing crash.
Step 4: Pay Attention to your Mortgages
In these times of low mortgage interest rates, it is easy to forget that interest rates have been traditionally much higher. A wise approach is to stress test your current portfolio: consider what would happen if mortgage interest rates rose by 2, 3, or 5% or more? Could you accommodate that increase in your mortgage payments and what impact would paying such increase have on your cash flow and overall investment portfolio? Here is a link to calculate mortgage payments where you can determine what the change in rates would mean to your mortgage payments. Don’t have all your mortgages coming due at the same time. By staggering the renewal dates you’ll have some time to accommodate changes, especially increases in mortgage rates and payments.
We don’t really know when interest rates are going to increase, so it’s best to be prepared. In these days of incredibly low interest rates, a wise strategy could be to put as much money toward reducing your loans as possible. If interest rates are lower at time of renewal of your mortgages, don’t go for the lower payment option, but keep the payments the same as you’re currently paying, so that the extra amount helps pay off your mortgages quicker. If you can increase the monthly (or biweekly) payment, or make an annual lump sum payment on the anniversary — do so, as this, once again, will help you pay off your mortgage quicker. Ensure that you have access to funds to assist you when it comes to make extra payments – you could use the positive cash flow that you’ve built up to make extra payments.
Variable rate mortgages are great, but can catch you off guard when rates increase, especially as interest rates generally increase at a faster pace than the rate at which interest rates decrease. And don’t forget about the length of a mortgage term — the longer the term the more stable or predictable your largest expense in your portfolio can be, and this enables you to do better planning. In certain rare situations where you know for sure that you won’t sell the property within the next 10 years, depending on the rates, it may be worthwhile to lock in a mortgage for even a 10-year term.
Consider setting up a line of credit on those properties that have a larger equity position (50% or more), so that if you absolutely needed to access funds to potentially expand your portfolio when the timing is right and the right property opportunity comes along, you could do so.
Step 5: Buy Wisely
There are times to sit and wait, and there are times to step up and buy. Is it a buyers’ market or a sellers’ market? There are opportunities in both types of market depending on your desired outcome i.e., flipping real estate vs. buying for cash flow, or whether you’re looking for a short term vs. a long-term investment.
Not all markets are going to experience significant drops at the same time. Even in the US during the “housing crash” not all markets experienced drops in housing values. We have seen some markets increase in value while others decreased. As markets shift there will be opportunities both currently and, in the future, so don’t be fooled by all the negative talk in the media.
The key to buying wisely is to identify and focus on those markets that are set for sustainable growth and purchase your properties while others believe the media hype and step back.
Step 6: Know When to Sell
For many investors, the goal of building a real estate portfolio is to create wealth and cash flow. We all know that this is not a straight-line situation and that there are ebbs and flows in any real estate market. By reviewing your portfolio’s performance on a regular basis, you are going to know which properties are performing well, which are not performing so well, and whether the poor performance is a chronic or acute issue. Selling a chronically underperforming property may not be ideal, but it might be a real option to consider.
Three Situations Where You Could Consider Selling
Stop the Loss
Sometimes a property’s poor performance becomes chronic for any number of reasons. For example, in a smaller town such as in Tumbler Ridge, BC — if one major employer closes down for a long period or permanently, then this will have a definite and long-lasting negative effect on people’s jobs and their ability to pay rent and remain in the community. In such a case, particularly when there’s no or little sign of improvement in the future, it may be time to cut your losses and sell an investment property, especially if it is draining both financially and emotionally. On the other hand, you may wish to take the short-term loss and “stick out the downturn”, but you should only do this after you’ve weighed the costs of selling such a property and reinvesting those funds elsewhere.
Expand your Portfolio
This situation is where you’ve had good growth in an investment property in a particular market, but now it is stagnating i.e., the market is at the top of the real estate cycle. It is time to take the profits out of that market and move on. This scenario may also include the fact that you are fully invested and don’t have additional funds to invest in other rising markets, or you are maxed out for obtaining more mortgages and you need to sell something in order to have the funds to invest elsewhere and obtain a new mortgage.
Increase Cash Flow
If a property is draining the cash flow from other properties in your portfolio and there seems to be no end in sight, then it might be time to sell that poor performer and enable your other properties to perform and provide you with the full returns from them. You could also take the funds from the sale of the poor performer and redeploy them to reduce the debt on those higher-performing properties, thereby increasing your return (cash flow).
Step 7: Increase the Return
You can always consider improving the financial performance of your property by addressing things that could increase the rental rates you can charge for your property. Typically, this includes a renovation or upgrade to the property such as updating or adding new appliances; painting; upgrading the flooring, counters, cabinets; or upgrading the bathrooms. You do have to spend money upfront, but by knowing which improvements could enable you to boost your rents, and by what amount, you will gain a better understanding of what upgrades are going to be the most beneficial to you in the long run.
With a little internet research on rental properties in the area you can gain a good understanding of what upgrades could net the highest rental return. As an example, if you were to add a dishwasher that costs $600, but it could enable you to conservatively increase your rent by $25/month, it only takes 24 months to have paid off that dishwasher and thereafter that additional $25 goes straight into your cash flow.
Your Investment Needs to be Protected
I have provided a few steps to consider in order to bulletproof your investment real estate portfolio. While no one knows exactly what will happen in the various housing markets across the country in the next few years, taking steps to mitigate risk within one’s real estate portfolio will definitely help you weather changes that occur. If the markets in which you have invested do take an economic downturn, bear in mind there will be fewer buyers and more potential renters.
Also, consider the fact that renters don’t necessarily want to pay more for better accommodations, but will look for the lowest cost for the most acceptable accommodations, in such a downturn. Such renters are mitigating their risks by undertaking such steps — they are lowering their expenses.
As a property investor, if you have followed the seven steps I laid out above, you’ll be a better position and able to respond to a market downturn. And as a property investor, it may serve you best to also consider lowering your expenses anywhere you can. Usually the mortgage payment is your investment property’s greatest monthly expense, and personally speaking, this is the one expense I am focusing on reducing, in order to weather these interesting times.