At these prices, is real estate a good investment?

Ruth Saldanha: Real estate prices in Canada have been rising for almost two decades straight, with some people even seeing their home values double over the past 10-odd years. Over the long-term real estate is considered one of the best investments, but in the immediate term what are the risks involved? At current prices does investing in Canadian real estate even make sense right now? With me to discuss this is John Pasalis, President of Realosophy. John, thanks so much for joining us today.

John Pasalis: Good to be here.

Saldanha: So, to start-off with, is investing in Canadian real estate right now at these current prices, even a good idea?

Pasalis: I think that's a great question. When we think about real estate as an investment, it's important to step back to think about it, you know there are two components that we're looking at. The first, of course, is the cash flow and the return we're getting on it from rents. And then the other side, of course, the capital appreciation. So, when we look at the rents, generally, it's not a great investment. And the reason it's not right now is because house prices are so high and the rents are not high enough to cover the carrying cost of the property. So, even if you have, 30% down payment, you're losing money, investors would need to put 50% to 60% down to at least even break-even.

So, on the cash flow side, it's not the best investment. And people have been putting a lot of money into it just because of the belief that the prices would keep going up. And that was happening for a while, I mean, we did see 10% to 15% growth. But I think most people are thinking that the growth in house prices is going to slow down a lot over the next year, especially as interest rates are going up. So, we're not going to see 10% to 15% – I mean, at least we're not expecting to see that rate of growth in sort of appreciation.

So, overall, it's probably not the best asset class to be holding right now as an investment purely. I mean, if you are looking 15, 20 years down the road, fine, maybe it's good long-term, but short-term I think prices are still too high to be investing in.

Saldanha: Apart from the short-term immediate concerns, what are some of the other risks that are associated with investing in real estate as an asset class?

Pasalis: Canada is in this greater turnaround, in particular, sort of at this late stage of a credit cycle. So, what happened was that lot of people put a lot of money into housing – invested a lot. And there are lot of people that are very over leveraged. And what's happening now with rates going up, we're seeing that a lot of people just can't carry these assets. And how long they are able to hold on to them is something that we're going to have to find out, but a lot of them might have to eventually sell them if they can't keep up with their debt payments because if rates are expected to go up just close to 3% or north of 3% then that's going to be a significant difference from what people paid for three years ago and the rates that they were paying three years ago. So, the risk is what happens if a lot of these investors need to just gradually start unloading their investments because the numbers aren’t making sense anymore.

Saldanha: One thing that we've been hearing a lot is that under-construction condos especially in Downtown Toronto is a good investment bet right now. You have some rather strong opinions about that. So, what do you think about under construction condos in Downtown Toronto right now.

Pasalis: Yeah, I mean, again I don’t know if they are the best investment, again it's a purely speculative bet. The challenge I have with pre-construction condos is that the prices that investors are paying today are anywhere from 20% to 30% more than resale prices. Which means investors are thinking prices are going to go up 10% to 15% per year in order for them to make a profit on that investment. And I guess the concern that I have is that sort of the pre-construction investor world, that mindset is very disconnected from the reality we're seeing in the resale side. On the resale side people can't afford their payments, they are turning to private lenders because they can't afford their cost. They are overburdened sort of debt-wise. So, the resale market sort of cooling down, but the pre-construction still thinks prices are going to go up 10% or 15% a year. And I think that’s kind of a risk if you are investing and I don’t see that rate of growth kind of continuing in the pre-construction condo space.

Saldanha: Finally, the last thing we like to understand is going ahead are there any pockets where you do see some value from an investment standpoint.

Pasalis: I mean if you are investing again if you are investing long term. If you are plan is 15 to 20 years. I mean certainly if you are buying perhaps even smaller multi-unit residential properties whether it's 3 to 6 units or 10 units. I mean those will probably cash a little bit better have more stability and better cap rates. But lot of people started investing in single family homes and sort of those are the properties that are probably not the strongest investments right now.

Saldanha: Great, thank you so much for joining us today.

Pasalis: Thank you.

Saldanha: From Morningstar.ca I am Ruth Saldanha.