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Five ways the wealthy become wealthier with real estate

DIANNE MALEY

Special to The Globe and Mail

Published 

 

For the wealthy, and those who aspire to be, investing in real estate can reduce risk and volatility in a portfolio.

Those with the money have myriad ways to play real estate. Some are easy, some are challenging. Here are a few, and their possible risks.

Individual commercial properties

One of the most basic ways to invest in real estate is to buy a small commercial building. Some business owners and professionals prefer to own their work space and rent out an extra office or apartment upstairs to help cover costs.

When mural artist Katherine Sunita first stepped into the 120-year-old, double storefront on the main drag in St. Catharines, Ont., she just had to have it. It’s the kind of building that brings out the dreamer in people.

In the 2,000-square-foot main floor, with its soaring tin ceiling, big windows and hardwood floors, Ms. Sunita imagined a group of artists painting, teaching classes and displaying their work.

Her contractor husband, Goran Mohar, was taken, too. He saw a place to showcase his environmentally friendly building materials, and a meeting hall where like-minded people could get together to discuss sustainable ways of living.

How long had Ms. Sunita been looking?

“All my life,” she says. They are both in their mid-30s. While they won’t say what they paid for it, Jordan Clark, their real estate agent, says the building – which for 50 years housed a craft and hobby shop – was a steal.

The former hobby shop also charmed teacher Melisa Parkins and her husband Stuart Hillman, so much so that they bought the adjacent storefront. It had been part of the hobby shop but is now a separate property.

Their goal, inspired by a volunteer stint in Guatemala, is to open a shop to showcase local and fair trade arts, crafts and jewellery. More than a year later, they are behind schedule and losing track of the renovation costs, but rental income from two upstairs apartments keeps the project afloat. “Without that, we couldn’t have done it,” Ms. Parkins says.

Burgeoning costs have Mr. Mohar worried, too. In a little over a year, he has spent $150,000 over and above the purchase price, and he’ll need that much or more to complete the renovation. The 1,800-square-foot upstairs has been taken down to the rafters.

As a backstop, he and Ms. Sunita have listed the building for sale. “We really don’t want to sell it,” he says. She agrees. A hopeful sign: The listing is attracting potential lessees – just in case the art space doesn’t work out.

The risks: Falling in love with a property and underestimating the time and money a renovation will take, resulting in a cash-flow squeeze.

Neighbourhood strip malls and apartment buildings

Traditionally, these investments have been low-risk for buyers who like control, are well-capitalized, have a long time horizon and manage them well. They offer an alternative to a registered retirement savings plan (RRSP) or pension fund because income jumps once the mortgage is paid off.

Buying right is key. “As an investor, you have to avoid getting caught up in the frenzy” of a hot real estate market, says Don Campbell, author, analyst and founding partner of the Real Estate Investment Network, or REIN. “Ask yourself, where is my money going to work hardest for me?”

REIN produces what it calls a “property gold-mine scorecard” to help members compare potential investments across the country. Key demographic drivers to check include population growth, low vacancy rates, job growth and improvements to transportation. The key financial drivers are return on investment (rental income over market price), household income and growth in gross domestic product.

Another key number is the capitalization rate. The cap rate is the percentage you would make on your money if you had paid cash for the property. Return on investment, or ROI, is what your return is when you factor in any financing. The higher the risk inherent in the property, the higher the cap rate should be. For a run-down building that needs renovation, you’d want a cap rate of 20 per cent or so, whereas a fully rented one might have a cap rate of 8 per cent.

The risks: Paying too much or failing to set aside enough money each year to keep the building in good repair. If a building becomes shabby, tenants move out and you have difficulty attracting new ones.

Private REITS

Investors are attracted to real estate investment trusts for their yield, but a look at the five-year history of the iShares S&P/TSX Capped REIT Index exchange-traded fund shows how volatile the publicly traded REITs can be.

Wealthy investors have the option of investing in private REITs, which are not traded on the stock market. In doing so, they give up liquidity for stability and safety of capital.

One example is the Centurion Apartment Real Estate Investment Trust, which has a minimum investment of $25,000 and is sold under an offering memorandum to high-net-worth investors.

“With a private REIT, you own what you own, there is no mark-to-market,” says Craig Machel, a portfolio manager at Richardson GMP in Toronto. The value of publicly traded REITs, in contrast, fluctuates with the stock market. When you sell, you get your pro-rata share of the buildings’ value. While private REITs are intended to be long term, the Centurion REIT has a monthly redemption window.

The risk: REITs, which are essentially property funds, will be hurt if property prices fall, or if the income the portfolio generates falls because of a weak economy. In the worst case, the redemption window could slam shut and it could take a long time to get your money back. “You need to be conscious of liquidity risk,” Mr. Machel says.

Private limited partnerships

Limited partnerships have been sprouting like mushrooms, with some being formed to develop a single property, such as a high-rise condominium. These are risky, analysts say, because of their lack of diversification and sometimes less-than-professional management.

“Management is huge in these things,” says Mr. Machel. Management must be experienced and their needs must be aligned with those of their investors, he says. “You like to know the biggest owners are management and that they’re going to stick with the fund.”

For experienced management, broad diversification and potentially high returns, very wealthy investors can turn to private funds offered by Brookfield Property Partners LP, among others. Brookfield Property is a limited partnership that trades in Toronto and New York.

Brookfield Property’s offerings for high-net-worth and institutional investors include its Global Opportunistic Real Estate, U.S. Multifamily Value-Add Real Estate, and U.S. Open-End Core-Plus Real Estate funds.

The publicly traded parent, Brookfield Property Partners, pays distributions quarterly and yields about 5 per cent based on the current unit price. The units can be sold at any time. Its private funds, in contrast, usually have a specified fund life, generally about 10 years, says Matthew Cherry, vice-president, investor relations and communications, at Brookfield Property in New York.

“In the private vehicles, distributions are not as predictable and regular,” he says.

The risks: Because you are an actual partner, you can lose money if something unexpected happens. You are depending entirely on the skill, experience and integrity of the managing partner, so choosing wisely is critical.

Mortgage pools

High-net-worth individuals have the option of participating in mortgage offerings, usually commercial loans, that are not available to smaller investors. The private pools tend to be larger and better diversified because they include institutional investors, who like them because they are more stable than stocks and bonds.

The risks: Returns could fall as low interest rates squeeze lending margins. There is also a liquidity risk: The economy could flop, borrowers could default and your money could be tied up longer than you anticipated.

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