Spot The Speculator #3 – “Their fortune is held up by the present real estate market. It is a thin thread on which to hang their financial lives.”

This anecdote extracted from ‘West coast couple stakes it all on property’, by Andrew Allentuck, Financial Post, 19 Jun 2010

“Reggie, 57, and Barbara, 41, are British Columbia entrepreneurs who have parlayed real estate investments and a few small businesses into a net monthly income of $8,640 from a combination of consulting fees and rent from a dozen investment properties. They have $3.8-million in properties financed with $1.4-million in mortgages and lines of credit. That makes their equity in the properties $2.4-million. They get an average $17,280 per year cash return, which is less than 1% of their equity. Their monthly mortgage payments add to their growing equity in the properties. As well, the properties carry $1.2-million of unrealized gains. But real estate makes up 94% of their net worth. The remainder is a $50,000 business investment, $121,000 in RRSPs, $5,000 in a TFSA and $9,000 in an RESP. They have no employment pensions”

Partially retired, they are raising a school-age child. The couple is facing the reality, however, that they cannot continue to be high-energy business people forever. Barbara, a real estate broker, wants to spend more time with her child. Reggie wants to shift to investments that are less time-consuming than managing real estate. They ask, “Do we have enough money for retirement? We have been big risk-takers for a long time, but we know that we have to change our investment strategy as we move forward.”

Okay, this is about as difficult as spotting a barn at 10 feet, but it does make for a nice anecdote in the series. A couple of Westcoast speculators are up to their eye-balls in RE. Twelve properties. Yes, TWELVE properties. And note the leverage. (There is an error in the article. Real estate doesn’t make up 94% of their net worth, but rather 147%. [Assets: $2.4M + $185K = $2.585M; RE holdings = $3.8M]). If RE prices drop 33%, they’ll lose 50% of their net worth; if prices drop an unthinkable 66%, they’d be a completely wiped out. Nobody can deny that they’ve done well accumulating wealth through the bubble. But they are now being wisely advised to lighten up (see below). Their case remind us of a few points:
Local Speculators Inflated Our Bubble. Note that these are local speculators, the major driving force for the bubble. When you have locals accumulating 12 properties apiece, who needs foreign buyers to fuel the frenzy? How many other households are there in the LML owning 4, 5, 6 and more properties?
Speculators Will Add To Supply. How many properties is this couple now going to sell? Three? Four? To whom? This is ‘speculator supply’. Some speculators will only decide to lighten up once prices start to fall in earnest.
Retirees Are Overdependent On RE. Note this couple’s complete dependence on RE for their retirement.
Yields Are Ridiculously Low, And Don’t Come Close To Supporting Prices. Despite this couple’s relatively low mortgage:price ratio, the yield on their properties is still <1% !!

Things Have Looked Great On Paper. These guys have done very well simply by pyramiding their RE holdings. This works well in a bull-market/bubble, where the wind is at your back, but turns nasty as the market turns. The realization of their paper gains now becomes dependent on buyers stepping in at these elevated prices. It’s a pyramid scheme, and this is the point where the scheme becomes precarious. We run out of the next concentric circle of buyers.  A small percentage of current owner-speculators will be able to cash out near a top, but the vast majority will not. -vreaa

[The pyramid metaphor has been used in a few ways here: firstly, ‘pyramiding’ is a method of investing where one buys more and more of the same asset as the market moves in the direction you desire; secondly, to describe a ponzi or pyramid scheme, and, lastly, the inverted pyramid of the image symbolizes the precariousness of this couple’s situation. -ed.]

Portfolio manager and financial planner Adrian Mastracci, head of KCM Wealth Management Inc. in Vancouver, made the following prudent observations in the article:
If interest rates were to rise from 2.0% to 3.5%, the variable rate mortgages, which now cost them $9,659 to service, would cost them $16,903 per month, effectively wiping out their $17,148 monthly rental income.
A real estate bust might result in the couple having properties worth less than their loans.
Their fortune is held up by the present real estate market. It is a thin thread on which to hang their financial lives.
Reducing leverage is essential if the couple wants a secure retirement.
[He recommended that they sell some of their RE, and we’d agree. -ed.]

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