Fancy being a real estate mogul, do you? Is your New Year's resolution to live like a Kennedy? Has Jennifer Aniston's recent property sleuthing inspired you to do a little buying and selling of your own? How hard could it be to become the Donald - especially if you have the advantage of better hair?
The reality of tycoons
Most of the famous real estate tycoons you've heard of became rich through other means first and then invested their income in real estate to build greater longer-term wealth. Joe Kennedy, for example, started out working in finance and invested in liquour distribution and movie theatres. He used these profits to buy his first office building in Chicago — an investment that would generate millions of dollars in rent and ensure several generations of wealthy Kennedy heirs. Donald Trump got his start thanks to his father's real estate development business.
David Sung and Wayman Crosby of Nicola Wealth Management have suggested that if you're serious about starting an empire, you will need at least "$2 million of available capital as part of a larger investment portfolio" to get started.
Okay, so maybe you don't need a multimillion-dollar real estate portfolio to be happy. Just a little piece of dirt (or sky) and a modest home to call your own. How much do you need to buy that? How much can you afford to invest in real estate?
Most financial advisors will tell you that the most you should spend on housing (including rent or mortgage payments, taxes and upkeep) is 32% of your gross income. This is called your "Gross Debt Service" (GDS) ratio and how gross it is really depends on how much you earn versus how much you spend.
To figure out your GDS, start with your gross monthly income — this includes any income that contributes to your household, including your hubby's and any extra monthly money you may receive. Multiply this total by 0.32 and voilà — this is what is officially "affordable" for you - the highest dollar figure you should rightly have to spend on your real estate each month.
The real test of affordability
However…. if you have big credit card bills, student loans or car lease payments, these other forms of debt can eat away at your ability to afford a 32% GDS. In general, all of your debt payments each month should not add up to more than 40% of your total monthly income — this is called your "Total Debt Service" ratio (TDS).
Do you have room to wiggle?
The crisis in European financial markets is keeping interest rates — and therefore mortgage rates - lower than they would be otherwise. If and when rates start to climb, things will get super stressful for home owners at the edge of their 32% GDS, or with TDS ratios over 40%. Last July, the Finance Minister issued a warning to Canadians to "get your finances in order," and yet personal debt levels continue to rise. (He might have picked a time when we weren't all busy drinking margaritas at the cottage, just sayin').
More recently, the Canadian Association of Accredited Mortgage Professionals (CAAMP) said that if interest rates rise as little as 1%, about 11% of Canadian mortgage holders (650,000 people) would be unable to afford their mortgage payments. Those in the most danger of losing their homes are the highly leveraged 2% (about 75,000 people) who have less than 10% equity in their homes.
The most recent RBC Housing Trends and Affordability report stated, "The share of household budget needed to cover the costs of owning a home at market values generally remains close to historical norm. We thus continue to believe that the majority of local markets are, at worst, just slightly 'unaffordable'." That's comforting, right?
Real estate values always go up…don't they?
The reason real estate is so compelling is twofold. (1) For many people, a house is easier to understand than intangible financial investments; and (2) it is compelling to think that real estate values will only ever increase.
The Economist magazine recently reported that Canadian home prices increased by more than 6% since last year and nearly 22% since 2007. How could you go wrong? It's tempting to think that even if your house gets more expensive for you to keep, its increasing value is making you richer. So is it realistic to count on increasing house values forever?
Keep your eye on rent
In the same report, The Economist stated that Canadian home prices are overvalued by 71% relative to rents and 29% relative to income. According to Ben Rabidoux - financial adviser, real estate expert and author of the website The Economic Analyst - "Canadian real estate is the most overvalued anywhere in the world when compared to rents."
In theory, home prices and rents should increase at a similar rate, as a measure of the desirability of the location. When buying prices escalate faster than rents, it's a sign that artificial forces are work, such as easy access to credit and cultural values that motivate people to be homeowners rather than renters (even if they can't afford it). As Ben points out, "Houses tend to be bought on credit, but rents are paid out of income. When credit is cheap and readily available, it can for a time, push house prices up much faster than rents."
Show me the income
As house prices keep rising, incomes that support those mortgage payments need to keep rising too. If people's incomes were rising, rents would be rising just as fast as house prices, yet as we see from the stats above, that is not happening. According to Stats Canada, median market income for families with two or more people actually fell 3.2% (to $63,000) in 2009.
Keeping it real for times ahead
Here are a few tips to keep your real estate aspirations real:
1) Bring down your debts — Request a lower interest credit card, pay off your loans as quickly as possible and refrain from acquiring any new debts that take you close to your TDS limit.
2) Renegotiate your mortgage — There are many schools of thought on variable rates versus fixed, so if you have the chance to lower the interest you are paying, grab it.
3) Increase your equity — Use any bonuses or income gains to shore up your home investment with more equity. This will give you more stability in case the markets go sideways. Think of it as trying to own more than you owe.
4) Embrace renting — If you're thinking of buying, do your calculations carefully to determine your monthly costs of renting versus buying. You may find it's more lucrative to rent and put money aside in another type of investment until you can afford a heftier down payment.
5) Hold your fire - If and when house prices do eventually fall, you will be in an excellent position if you've been spending this time patiently accumulating savings rather than debt. This is how tycoons really make their fortunes — staying liquid and biding their time for the right opportunity.
The Donald within
Thanks to our European cousins, our interest rates are staying low and if RBC is right, we have a little more time before "slightly unaffordable" becomes "seriously unaffordable." Not a lot of time, but maybe just enough time. By being smart now, you can make sure your dreams of becoming a real estate tycoon don't go down in flames when and if property values do. Instead, you might just find yourself poised to buy up some marked-down assets, like the Donald would do…but with way better hair, of course.
GoldenGirlFinance.ca is a free personal finance and education site for women.
Nothing contained herein is intended to provide personalized financial, legal or tax advice. Before implementing any financial strategy, you should obtain information and advice from your financial, legal and/or tax advisers who are fully aware of your individual circumstances.