Category: Real Estate

Apparently new home owners here in Canada haven’t learned much from their American counterparts because 40 year long term mortgages are getting more and more popular.

According to a TD bank representative about 60% of first-time home buyers are opting for a 40 year mortgage which indicates that they are having a hard time affording the house and need to stretch the payments out in order to make the purchase.

I’ve been aware of these types of amortized mortgages for a while, but I was quite surprised at how popular they are. The optimistic side of me (yes, there is a little one there) likes to think that those 40 year people will make extra payments as time goes on and their income goes up. However, I realize that it’s just as likely that they will indeed take the full 40 years to pay the house off. That’s assuming of course that they don’t take any money out in the form of a home equity loan and of course that they don’t sell the house and “upsize” at some point.

Long term mortgages

I don’t think these mortgages are automatic passages to failure but they are very risky because if the homeowner has a decrease in income then they will have no room to lower their monthly payments by stretching the amortization which is an option that most people have. For example if you have 10 years left on a 20 year mortgage then if you had to, you can call the bank and get them to increase the amortization to say 20 years and that will lower your payments until you regained your income. If you are already on a long term or interest only mortgage then clearly you can’t lower the payments any more.

Another problem is increasing interest rates. Typically in Canada (unlike the US) we only lock in for a maximum of five years and many people like to have floating interest rates which are better in theory, but are too risky if you are maxing out your home payment. If a person or couple buys a house and can only afford a 40 year mortage at 6% then how will they afford a big monthly payment increase if the interest rate is 8% at renewal time?

Conclusion

Personally, I think if you can’t afford a 25 year amortization then you can’t afford the house. 40 year amortization and interest only loans are the same types of new “mortgage products” that recently got some of our American friends in home owning trouble.

Now that we are in the sub-prime era, it has become very fashionable to declare that home owners that bought houses with little or no down payment are a big reason why foreclosures are at record levels. I have to respectfully disagree.

In my opinion, when buying a house, it doesn’t make a big difference how much of a down payment you have. Ideally, if you have 20% or more then you save on fees and interest which is a good thing, but if you are set on buying a house and you have don’t have anywhere near 20% then I wouldn’t worry about it.

The down payment has nothing to do with the affordability of the house

Your ability to make your mortgage payments will determine how well you can afford your house which is completely unrelated to the size of the down payment. In other words, it’s the size of the mortgage that matters. Now you might be thinking that for the same house price, a larger down payment will reduce the mortgage which will reduce the payments. This is true, but unfortunately most house buyers don’t think that way. Typically they will look at how large a mortgage payment they can afford, figure out a maximum mortgage and then add their down payment to the maximum mortgage to give them their maximum house price. This of course will get thrown out the window once they start looking at houses but that is at least, how the initial house price maximum gets calculated.

An example

One house owner, let’s call him “Mike” bought a house for $168,000 with $20,000 down payment. Because he only had 11% down payment he had to pay an extra insurance fee of $3700 which left him with a mortgage of $151,700. With a 30 year amortization mortgage at 6%, his monthly payment is $902.

Another house owner, let’s call her “Sue” bought a house for $268,000 with $53,600 (20%) down payment which left her with a mortgage of $214,400. She avoided any extra fees because she had the 20% down payment and she also qualified for a better mortgage rate of 5.6%. Her monthly payment is $1222, 35% higher than Mike’s payments!

In this case, Mike’s house was more affordable even though he didn’t have as big a down payment as Sue.

Down payment is only one factor

Having a larger down payment is preferable to a smaller down payment, but not having an arbitrary percentage shouldn’t stop you from buying a house. It’s important to look at all the numbers which affect your ability to afford the house – mortgage payments, taxes, utilities, maintenance etc and decide if it make sense to buy a house with a small down payment or wait until you have a larger one.

NOTE: All software linked to in this post is NON-AFFILIATE. We don’t make any money off of any of these, I’m just linking to them because I think they’re interesting. The Reflexive games allow one hour of free play before purchase.

A few months ago I posted some ideas for a real estate video game I’d like to play. I’ve since come across a couple of games that are much better at presenting more realistic real estate concepts than Mansion Impossible is.

Build-a-lot is a game where you play a developer. You buy materials, hire workers and buy and sell land and buildings. The properties never increase in value (unless you build improvements on them), so the only ways to make money are to build properties and sell them, or collect rent from the properties you own.

I liked the concepts it presented of buying underused lots, building a higher value building on it, then selling it at a profit. Selling prices decrease if other properties are for sale (that’s the only element that affects the resale market and home prices).

I didn’t like how static everything was. Because you know the EXACT value and cost of every building and improvement in the game, it becomes quite easy to maximize your profit. It would have been interesting if they had included random elements affecting the property values and some concept of leverage (there’s no way to borrow money in the game).

If you like it and want to play for another hour, you can also try Build-a-lot 2.

A more sophisticated game, Real Estate Empire lets you pick a role, ranging for a carpenter (who can repair things more cheaply) to an MBA (who has a high salary and can put together better deals). You’re based in a town and play over 4 years, each turn taking a month, trying to buy and sell real estate for a profit, and selectively improve properties (looking for the best “bang for your buck” for improvements).

I really like the idea of different roles and how you can pursue different strategies (buying trashed houses and repairing them or buying undervalued properties then reselling them). You play against 4 computer opponents (in Build-a-lot there’s no competition). As well, you have a credit rating (which is bad when you start), which affects the financing terms on the various properties (as your credit improves, you can put less money down and pay less interest). The real estate market “fluctuates” in the game, so you can easily overpay for properties if you always offer sellers their asking price. You can also “over spend” on improvements where you fix up a property to the point that you can’t recoup what you put into it. You have to be careful about balancing the cost of renovations with the value they add. The game even offers you multiple options on how to sell your property, from a real estate agent (quick sale for 5% of the price), FSBO (balanced) or a newspaper ad (cheap and ineffective).

The one thing I found was a real weakness in the game is that each property had a “Estimated Value” which is what you can ALMOST ALWAYS sell the property for with a real estate agent. This makes a very straightforward (and effective) strategy simply to only buy properties with an asking price LOWER than their estimated value (still offering them a bit less than their asking price), then immediately resell it with a real estate agent (and the property will immediately resell for the estimated value – for some reason the new buyer didn’t want it the month before when it was a much lower price). If they removed the estimated value number (or made it vary wildly until you developed a better understanding of the market) I think it would improve the game.

My brother has to travel constantly for his job. While he was in North America, he and his girlfriend owned a Mazda3. As they were getting ready to leave North America they wanted to sell their car (instead of paying for it to sit in storage). A bunch of his co-workers were also going to sell their cars, so they invited a used car dealer to come and view them all at once. My brother was offered $8500 for his car, and after refusing, sold it later for $19,000. Apparently the dealer made everyone similarly low offers and no one sold to him. The dealer was following what some people call the “shotgun approach” to investing (which I touched on in a previous post).

Like a shotgun, this approach doesn’t focus on accuracy. You don’t care whether any individual deal goes through or not. Basically you make MANY low ball offers, and the profits from any that are accepted pay for all the legwork for deals that didn’t go through. Real estate agents like to warn about “offending” sellers with low ball offers. There’s a very good chance you’ll offend people with this approach, but you don’t care: it’s volume you’re after.

Those signs you see that say “We buy houses for CA$H” are all people pursuing this strategy. They call it “wholesaling” and they basically try to get a killer deal from people who are desperate to sell.

Some real estate agents claim that people who try to do a “for sale by owner” will get swamped by low ballers. I’ve asked people who tried to sell their own homes and they say that’s not the case. For both FSBO and real estate represented sales, I think going to tons of open houses or visiting listings in the area you’re interested in and making low offers would be a great approach to finding a good deal if you have the time / energy to do it. Many real estate agents won’t work with you as a buyers agent if this is what you’re doing (they’ll give you lots of excuses, but ultimately I’d guess it’s just because they’d be putting SO much work into every purchase). You may have to deal with the selling agent / owner directly.

Obviously you need to be able to properly value something to do this. If someone is selling their place for a crazy high price, and you offer them a low ball based on their asking price, you might still be overpaying. If you pay a low price for a property in bad repair you can get into similar problems. Finally you might get burned if you bought a bunch of properties right as the market was turning, so probably the best approach to this would be “slow and steady” rather than getting a bunch of places at once.

Finally, you need to be able to sell whatever you buy at the proper price. If you get a property cheap, then find you are getting eaten alive by the holding costs, you’ll turn into a desperate seller yourself!

I don’t think there’s anything inherently wrong with making low ball offers. You’re not trying to trick them or force them into anything, you’re just saying “This is what I’m willing to pay, if you have a better offer – take it, otherwise give me a call”. That being said, you’d need a pretty thick skin to offer someone $120K on a $200K property and be able to smile and say “give me a call if you change you mind” when they start cursing at you. I don’t do this myself, but am always tempted (I’m too sensitive and would find it hard to keep going when people kept getting angry at me – I wouldn’t be able to do cold-calling sales either).

Algonquin sky

I’ve been reading some “sky is falling” articles lately regarding underwater mortgages or upside down mortgages, where the amount owed by the house owner is greater than the value of the home.  These are often referenced in the same sentence as subprime mortgages.
Maybe I’m missing something, but I just don’t understand the big deal over the fact that some house owners have bigger mortgages than the house is worth. I certainly appreciate that this is not a desirable situation but I don’t see how the “sky is falling” attitude is anywhere near reality.

If your house is worth less than the mortgage, should you walk?

Imagine someone who finances a brand new car with small down payment. That new car owner was probably “underwater” on their car loan about three minutes after they drove it off the lot. Should they bring the car back to the dealership and “hand in the keys”? Should they abandon it in a field or lake somewhere? Probably not – they might just want to keep driving it and unless they had some major financial situation occur like a job loss or medical emergency, then they should just keep going with the payments regardless of what the car is worth.
How did this horrible situation occur? Well probably because they only purchased a small amount of equity in the car when they bought it, which of course disappears very quickly since new cars depreciate quite a bit at the beginning.
If someone buys a house with little or nothing down, then it obviously doesn’t take much of a price drop for them to be underwater on their loan. Is this such a bad thing? Nope. The key is the payments. Since you still have to pay for a roof over your head, as long as you can afford the house payments (within reason of course) then you shouldn’t even worry too much about the house value or consider giving up the house.
Of course there are some situations where an underwater house is a problem – generally if you want to sell it because you are moving to another city or area or because you can’t afford the payments. In that case there is not much you can do – sell the house, assume the loss and add it to your debt and move on. And save the paperwork for the next idiot who thinks that real estate is always a great investment.

What if my real estate investment property or flip is underwater?

Mmmm…tough luck? Even if you end up losing a lot of money you will at least get the satisfaction of learning a hard-earned lesson about risk, leverage and real estate investing.
Bottom line is that it’s easy to look at the raw statistics and draw whatever conclusions you feel like. Equating the number of home owners who are upside down on the their mortgage with home abandonment or a major financial crisis is faulty logic.

Toronto Life had an excellent article some time back on mortgage slaves. The Canadian Capitalist has linked to this article before, and I think its an excellent question: is it worthwhile being house poor?

My ex-girlfriend and I discussed buying a place together a few times, and her feeling was always that to live in the areas she’d want to live in, it would cost so much to pay for housing that her quality of life would dramatically shrink. She felt that renting in a decent area, then having extra cash to enjoy life made sense. Now that the real estate market seems to be changing, her perspective seems to make more and more sense.

In a wild market where property prices keep going up and up, it seems to make a lot of sense to stretch the budget to the breaking point, buy the most expensive house you can find and reap the benefits of appreciation. This strategy requires that the party keep going. If prices plateau (or drop) and you’re having trouble making payments, life gets a lot less pleasant in a hurry.

I’ve been reading Garth Turners “Greater Fool” at Indigo when I have time to kill, and he makes an interesting case that we’re coming to the peak (or just past it) of a real estate bubble. Of course, he’s been saying this since 2006, so I’m not sure *HOW* much credit he should get when we actually hit a crash.

When housing grows away from affordability, its dangerous territory. Consider Japan’s real estate boom and bust. Consider Toronto’s condo crash in the 80’s. Consider the US’s current sub-prime crisis. A money article from 1992 sounds like something people might be asking right now in the US. We’ve been here before, and we’ll be here again. I suspects its a continuous cycle of people viewing their homes primarily as shelter, then over time they increasingly view them as investments, until there’s a crash and the family home becomes viewed as shelter again.

I was predicting to anyone who would listen that the Toronto market was going to die once the property transfer tax went into effect. My rationale was that it would heat up demand in the end of 2007 to beat the tax, everyone thinking of buying would buy, then 2008 would be an immediate slump. I’ve been apologizing to people I made this prediction to, as the the media kept reporting that the market was still doing well in 2008.

Then they said there wasn’t as much sales volume in Toronto real estate because of bad weather (riiggghhht). Since then they’re saying that high end properties are dropping in price, and sales volume is going down, but prices are still high (which, supposedly, dropping sales volume is the first step of a real estate decline). When I’m out walking around these days, there seem to be A LOT of properties for sale.

Anyone shopping for Toronto real estate right now, I’d strongly recommend holding off for a couple of months. I have a feeling prices will be dropping soon.

If you watch late-night infomercials, or attend the “free real estate investing” seminars, a popular element of the sales pitch is grinning people talking about buying property with “built-in equity”. They talk about getting a property, pulling $100K of equity out and going on a trip to Hawaii.

I’d like to get $100K and a trip to Hawaii!

The question rational people will ask is, why would properties with a bunch of money in them be sitting around for the taking like that? Why wouldn’t the gurus just hire a bunch of employees, buy up the properties themselves, and make lots of money instead of telling other people how to do it? These are great questions, but lets talk first about where the $100K is coming from.

Basically all the various techniques boil down to buying a property for more than its worth, paying what its actually worth, and getting the extra cash from the larger mortgage. Say you buy a $300K house, get a $400K mortgage, you give the seller his $300K, and pocket the other $100K. Yes, this probably involves fraud. Yes, this is “free money” in the same sense that a credit card with a $5000 limit is “free money”; i.e. its not free money, its debt. All you’ve managed to do is qualify for a loan you probably shouldn’t have qualified for.

So you go to Hawaii, spend the money, and expect to pay back the debt by selling the property after it appreciates or through income it produces. HOWEVER, in a normal markets, its going to take a long time for a property to appreciate 33% (and you’ll be paying high mortgage payments while it does). AND its very unlikely any income from the property will support such a high price (I recently did a post that (hopefully) showed how hard it can be making money from a property, even when its “reasonably” priced).

Alligators are properties where people have bought them for “investments” but they’re losing money on them every month. They need to sell at an inflated price to pay off the outrageous mortgage, but no buyer is going to overpay as much as is needed to dig the seller out of their hole.  I think the joke is that they’re called alligators because they eat you rather than feed you.

Chain investing is something along the same lines. Instead of pulling the money out and going on vacation, you use it to buy another property (and you can pat yourself on the back for being *SO* “responsible”). Say you had 5% down for a property. You buy a property, and get a 7% cashback mortgage. 2% should cover the legal fees, and gives you back your 5%. You’re now in the “exact same place” (not quite, but we’ll get to that) where you started, except that you have a property in addition to your cash. Rinse and repeat until you have as large of a real estate empire as you want.

The problem with this is that each of your properties is leveraged to the hilt. Any downturn in the market is going to be magnified by the number of properties you own. If values go down, you won’t even have the option of selling some of them to raise quick cash if needed (they’ll all be alligators). With multiple properties, the chance of emergency repairs (like a furnace or roof replacement) obviously goes up.

Luckily lenders SHOULD stop you from doing this, but again the gurus will show you all sorts of techniques (some legal, most not) to get around them. Casey Serin basically tried this approach and put himself 2.2 million in debt before the foreclosures started.

If a property is “worth more” than you paid, pat yourself on the back and enjoy the extra income (or capture it by reselling the property). If there’s no extra income or if you can’t resell it, how can you fool yourself that its worth more? Borrowing against expected future earnings can be as irresponsible as buying consumer goods on credit. Either way, you’re paying a price (the interest rate) to have things in the present that you won’t earn until the future. If there’s any chance the future income won’t support the debt you’re incurring, you’ve gotten yourself into a very precarious position.

It always drives me nuts when people recommend a specific investment, give a bunch of reasons to buy it then finish with “of course, do your own due diligence before buying”. As I’ve written before, it always feels like such a cop-out. Often books which specifically claim to help you learn how to buy stocks or real estate will give the same out. Or they’ll encourage you to talk to an advisor before making any purchase (not a bad idea, but didn’t you buy THEIR book for information, then they just tell you to go talk to someone else).

I’d be a little more accepting if they gave a detailed overview of HOW to do your own due diligence, but I’ve seldom come across any writers even willing to give that. By way of example, I thought it might be worth running the numbers on a property currently for sale here in Toronto (this is an exercise I’d usually go through to decide if it was worth going to see a property and digging further into the details about it).

I like to watch real estate listings in one area of North York and another area called Crescent Town (which is near the Victoria Park subway station). I’ve been able to get a feel for prices in these two areas, as well as rents. If I found out another area that supposedly offered good deals, I’d look into it, but would be a lot more skeptical of my calculations (and would spend more time verifying things before making an offer or following through with a purchase).

Crescent Town is great in that its a complex with a bunch of buildings, so there’s a TON of comparables for any details you might want. The cheapest unit available is listed here (link will be dead eventually, I’ll write relevant details here – the asking price is $92,900). As a 1 bedroom unit, a $900 rental price is probably reasonable (that’s what other units in the complex rent for), as long as its in decent shape (which they claim it “Shows Well”).

Income ($900 / month):

• $900 / month (rent)

Expenses ($476.02 / month):

• $370 / month (condo fees)
• $66.02 / month (0.8528434% property tax)
• $40 / month (insurance – this is what I pay on my condo)

This is looking pretty good! $424 / month cash flow positive! Sweet! Perhaps we’ve been reading the Canadian Capitalist too much, and we know he insists on REAL expenses, not just the pretend hypothetical kind where we ignore stuff we don’t want to face (he’s such a stickler for reality!). So lets add on 5% of the monthly rent as a vacancy rate, and 1.5% / year of the purchase price as a maintenance rate (this might be a LITTLE high for a condo, since the corporation handles all outside maintenance, and SOME inside maintenance).

• $75 / month (vacancies)
• $116.13 / month (maintenance)

The maintenance DOES look high, but we’re including in this things that are expensive and only rarely needed (such as replacing the carpeting or getting the unit painted – amortizing them over the length of time we own the unit). $233 / month profit is still pretty nice.

Lets think about transaction costs and financing now. Legal costs will probably be about $2K, Toronto’s new transfer tax will be $1,393.50 (1.5%), if we put 5% down (lets ignore CMHC fees) that’d run us an additional $4,645. So cash down we’re looking at about $8K (we’re assuming NO renovations are needed).

On an INTEREST ONLY mortgage at 5.5%, we’d be looking at paying $404.50 / month in interest (simply the purchase price, minus the down-payment, multiplied by 5.5% and divided by 12).

This puts us at $170 in the hole each month. We’re paying $8K for the honour of losing this money each month. And this is the cheapest unit in the complex. In order to BREAK EVEN every month, we’d need to up the down payment to 20% and for them to accept a purchase price of around $81.5K. To make $50 / month (as recommended by Violent Acres), we’d need a purchase price of $72.6K.

Surprisingly, telling sellers they need to give us a killer deal in order for us to have a cash flow positive property rarely produces good results. As a very low priced unit in the complex, I don’t think the agent or the sellers would take you very seriously if you went in and offered them a low ball offer. However, there’s nothing to lose, so there’d be no real reason not to (and maybe you’d get lucky and they’d need to sell for some reason). Some real estate investors claim the hardest part of getting into it is being willing to burn down the shoe leather looking at places and putting in low offers (trying to find the 1 in a 100 seller who will accept). This unit has been on MLS for a while, so I’m sure they’d entertain offers below asking.

Obviously you can make the numbers work for ALMOST any property by just increasing the down payment (as we did when we upped our down-payment to 20%). You have to be honest with yourself, however, that money has value. If you’re using it for the down-payment, you’re missing the chance to use it for something else (the opportunity cost). Assuming a 10% opportunity cost for the down-payment and transaction fees might be reasonable to include in your calculations (we won’t here, as it’d put us in the hole again).

Condos are notoriously bad money makers for people getting into real estate investing, and the numbers are usually bad. By being able to control the costs that are made up by your condo fees, in properties that you own on your own, you’re usually able to cut costs to turn a profit. The big advantage is that condos are cheaper than single family homes or apartment buildings and let you “try on” the landlord hat without being overwhelmed.

If anyone goes to view this condo (Guinness416 lives in the neighbourhood I believe), please post a comment with how it looks, and if anyone makes an offer, please let us know how it goes!