An RRSP or TFSA should be viewed as a basket of investments. In the basket you can place various eligible investments or financial instruments. Some of these RRSP or TFSA eligible investments can include: stocks, bonds, GICs, mortgages, call-options, cash or mutual funds….but NOT real estate directly.
So, how then can you participate in real estate with your RRSP or TFSA?
For most Canadians, investing in or participating is real estate can be done inside their RRSP or TFSA, however there are some restriction. Either way, inside or outside an RRSP or TFSA, investing in the right real estate can pay excellent long-term dividends – if done well!
Three broad options exist to participate in real estate within your RRSP or TFSA!
Option 1: Mortgages. Most real estate is encumbered by a mortgage. A mortgage is a loan, secured by real estate. It is not real estate! However, a mortgage is a safe way to invest in real estate, but you do not participate in the overall performance of the real estate! Your TFSA or RRSP becomes the lender. You are the bank! You can hold
a) a single mortgage or
b) a share of many mortgages, called a syndicated mortgage, or
c) shares in a MIC, a Mortgage Investment Corporation. A MIC pools many mortgages and allows the individual investor to co-own a share of multiple mortgages in their RRSP or TFSA.
The risk of this investment, namely payment default by the borrower, has to be compared to the fixed return of this investment, from a low of perhaps 4% to usually in the high single digit range to perhaps the lower double digit range for more risky assets. A second consideration is if the mortgage is on a to-be-constructed property or an existing property. As a broad rule of thumb, a to-be-constructed property carries a much higher risk of non-payment, as the property does not yet exist. As such the interest rate on this mortgage should be much higher to compensate for this additional risk.
Consider return OF your capital before you consider return ON your capital when evaluating this first type of RRSP eligible investment option!
A tertiary consideration is the position of your mortgage on the property title. If you are in 1st position, and the mortgage is unpaid, you are first in line to get paid from a foreclosure action. Even then loss of capital is possible, especially in a construction mortgage. If you are in 2nd or in 3rd position, other lenders get paid first. Thus, the risk of non-payment increases with the increase in position on title. Some trustees or MICs don’t allow 2nd or higher position mortgages, but some do. Therefore, before you invest, do your homework on the risk of the loan.. and then gauge is the offered interest rate compensates for this risk!
Option 2: Publicly traded stocks that invest in real estate. On both the US and Canadian stock exchange there are a number of firms that invest in real estate. Some invest in apartment buildings. Some in commercial properties like industrial parks, office buildings or retail malls. Others invest in hotels, campgrounds, trailer parks or recreational properties. Some invest internationally, all over the world, and some only in certain cities. Some hold existing properties, other invest in land projects or construction.
A common sub-class of these publicly traded firms is a REIT, a Real Estate Income Trust. A REIT pays out the majority of its income monthly, and as such can be an excellent vehicle for retirees or those folks seeking monthly income. In a sub-sequent article I will explore some of those REITs or stocks with specific commentary. There is the expensive brother of the real estate stock or REIT, a mutual fund.. or its less expensive diversified sister, the index fund or ETF.
All these publicly traded vehicles provide the benefit of instant liquidity, quarterly reporting and regulatory oversight, but also the severe drawback of stock investing in general, namely market sentiment, wild, unexpected swings because some politician said s.th. or a report came out that was less positive than expected, buy/sell manipulation by insiders or panic selling due to rumours or opinions by market analysts or newspaper articles (that may or may not be accurate).
Option 3: Private firms that invest in real estate. Many people seek an investment vehicle outside the often irrational stock market. People have to live somewhere if the market is rising or falling. People go shopping, albeit less frequently, if the market is down. Trucks need repair facilities owned by someone. Office workers need space. Etc…. REAL estate has been around 1000’s of years.. and will be around a further 1000’s of years. Have you been to Rome? Some buildings were built over 2000 years ago and still exist.. but I digress.
To buy or build real estate much expertise.. and much money is required. Therefore, the idea of coupling expertise with money partners is a perfect marriage. A corporation or partnership is formed. It is not a new concept, though! England, Holland and a number of nations explored the world several hundred years ago by ship. To finance those fairly expensive shipping expeditions partnerships were created. The captain and his crew got a share, as high as 50% of the profits (spices, gold, slaves, land,…) and the ships’ financiers get the rest. Write a cheque for 4,000 pounds, and I name a mountain after you, write a cheque for 10,000 and your name is on a new city and you get 2% of the wares. Or s.th. along these lines.. and the idea of limited partnerships were born.
The idea of a limited partnership is that one party has the expertise, say to prospect, analyse, buy and manage apartment buildings. Others have money to invest, seeking a fair return, but lack the expertise, the time or the desire to prospect, analyse, buy and manage assets. One party invests, the other parties does the work and profits are split according to a pre-determined, and annually inspected, formula. Since this corporation or limited partnership owns real assets, in the real world, with real money changing hands for real assets, the values can be established relatively readily, without the often irrational stock market value swings. It can provide a better alternative to investing in the publicly traded market. the continuum