Why you should factor in your real estate when you make all investment decisions

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Seventy per cent of Canadian households own their own home. Some also have vacation homes and income properties. Despite this, real estate is rarely considered when determining an investor’s mix of financial assets. GICs, bonds, stocks and pensions are included, but real estate is kept separate.

At our firm, we generally split out the primary home and treat it as a safety cushion that can, if necessary, fund the cost of a retirement home later in life. This is a reasonable approach in most situations, but if you’re living in a city where multi-million dollar houses are common and home equity is the bulk of your wealth, it may be time to start factoring your properties into investment decisions. This means adjusting bond and stock holdings to complement your dominant asset.

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From people I’ve talked to, however, there’s no consensus on how to factor in large property holdings. And certainly, every situation is different. My goal here is to give real-estate-heavy investors some things to think about.

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Economic drivers

To start, you should know the investment characteristics of your real estate. For instance, the price of your home is tightly linked to the regional economy, specifically the growth, diversity and demographics of the job market. I say regional because Calgary is different than Windsor is different than Montreal. Some markets are heavily influenced by a particular industry, and others by unique factors such as immigration and foreign buyers.

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Real estate is highly sensitive to interest rates. Since the 1980s, house prices have benefited from steadily declining mortgage rates. This year, near-zero rates are helping support prices in the face of job losses, rising debt loads and an uncertain economic future.

To understand how important rates are, it’s useful to look at commercial real estate. In this world, prices are put in terms of capitalization or cap rates, which is the annual income earned (after costs) as a percentage of price. A $5-million building that produces $250,000 of income has a cap rate of five per cent. The lower the rate, the higher the valuation.

The sensitivity is revealed when you make a small change to the cap rate. In the example above, if income stays the same but potential buyers demand a seven per cent return (due to rising interest rates), the property value falls to $3.6 million. A rate increase of two percentage points translates into a 28 per cent price drop.

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Your real estate

What you own, and how you own it, are also important considerations. For instance, the amount of debt against a property influences how you factor it in. A house or condo with no mortgage is more stable than one that has a large loan attached (as a percentage of the value). In the latter case, the home equity can double or disappear in a heartbeat.

How you categorize an income property depends on whether it produces a positive annual return (after expenses, depreciation, and taxes) or has only a modest (or negative) cash flow. The former can be slotted in with your stable income securities. The latter is a speculation on higher prices and belongs in your higher-risk bucket.

No hard-and-fast rules

A typical Canadian income portfolio that is heavily invested in utilities, banks, telecommunications and REITs is fuelled by the same forces as your real estate, namely the domestic economy and interest rates. You might consider holding fewer of these types of stocks (I know, this is sacrilege in Canada) and instead owning a higher proportion of foreign stocks. This will improve your overall diversification by giving you exposure to different countries and currencies, as well as industries like technology and health care, which are not well represented in the Canadian market.

Life insurance stocks are good income alternatives, as are reset preferreds. Both tend to do well when interest rates are rising, making them an offset to your real estate.

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On the fixed-income side, you also want to avoid adding to your rate sensitivity. GICs and short-term bonds, which are immune to rate changes, are better choices than long-term bonds that move dramatically on the slightest change.

When real estate is a large part of your net worth, you’ve got a high-class problem. You’ve done well but are now heavily reliant on one type of asset that is cyclical and illiquid. It may be time to give some consideration to the size and type of your properties, and how they’re financed, when constructing your investment portfolio.

Tom Bradley ischair and chief investment officerat Steadyhand Investment Funds, a company that offers individual investors low-fee investment funds and clear-cut advice. He can be reached at tbradley@steadyhand.com.