Kicking Financial Ass

by Paul Christopher Dumont

  In general, the same economic factors that increase the stock market impact the performance of REITs. An expanding economy, job growth, and investment in the economy will lead to increased prices for both. A contracting economy, decline in the employment level, and reduced investment will have the opposite effect. Keep in mind that REITs traditionally perform better in low-interest rate environments since most of the properties are leveraged with debt because lower interest rates mean more income distributed out as dividends. If interest rates are increasing, then your returns might not be as high as they have been historically.

  What are the returns like for REITs?81 Between December 31, 1978 and March 31, 2016, total returns for exchange-traded U.S. Equity REITs have averaged 12.87%82 compared to 11.53% for the S&P 500 over the same period.83 Not too shabby. But watch out for the volatility. The magnitude84 of gains and losses with REITs outpaces those of the S&P 500, so they are not for the faint of heart.

  Overall, I recommend keeping it simple and buying the S&P 500 index. However, if you want some real estate exposure without purchasing a property, consider these REIT ETFs, which I discuss for the U.S. and Canada separately, although you can purchase any REIT with your investment accounts.

  U.S. REITs

  Vanguard REIT ETF (VNQ)85

  VNQ is at the top of the list for broad, diversified exposure and a reasonable expense ratio of 0.12%. Its goal is to track the return of the MSCI U.S. REIT Index, a gauge of real estate stocks. Since its inception in 2004, it has on average returned 6.00% annually after taxes.

  Schwab U.S. REIT ETF (SCHH)86

  SCHH invests in REITs from the Dow Jones U.S. Select REIT Index, and its goal is to track that index as closely as possible, before fees and expenses. Since its inception in 2011, it has on average returned 6.39% annually after taxes.

  iShares U.S. Real Estate ETF (IYR)87

  IYR invests mostly in ETFs and attempts to keep 90% of its assets in securities that are in the Dow Jones U.S. Real Estate Index. The emphasis on the fund is on the large-cap players. Since its inception in 2000, it has on average returned 6.98% annually after taxes.

  Canada REITs

  iShares S&P/TSX Capped REIT Index Fund ETF (XRE. TO)88

  XRE aims to generate long-term capital growth by tracking the S&P/TSX Capped REIT Index. XRE provides exposure to 15 different REITs across diversified, retail, residential, and commercial properties. Since its inception in 2002, it has on average returned 9.86% annually.

  BMO Equal Weight REITs Index ETF (ZRE.TO)89

  ZRE aims to generate long-term capital growth by tracking the Solactive Equal Weight Canada REIT. ZRE provides exposure to 18 different REITs across diversified, retail, residential, and commercial properties, with a focus on diversified, residential, and retail. Since its inception in 2010, it has on average returned 10.1% annually.

  Vanguard FTSE Canadian Capped REIT Index ETF (VRE.TO)90

  VRE aims to generate long-term capital growth by tracking the FTSE Canada All Cap Real Estate Capped 25% Index. VRE provides exposure to 19 different REITs across diversified, retail, residential, and commercial properties, with a focus on industrial, office, retail, and residential. Since its inception in 2012, it has on average returned 6.96% annually.

  Should You Buy a REIT ETF?

  REITs are:91

  •Easy to buy and sell, with low costs compared to physical real estate.

  •Tied to long-term contracts (leases) that remain in place regardless of the economy, which keep their earnings resilient.

  •More defensive in a recession since their cash flow is likely to be less affected than stocks.

  However, you are still exposed to interest rate hikes affecting returns with REITs and REIT ETFs. As interest rates increase, the cost of borrowing increases, decreasing the distributions to shareholders. Furthermore, an S&P 500 index fund already provides plenty of diversification, some of which is real estate-related, and you can expect more reliable returns from an index fund. While some REITs have shown to have higher performance than index funds, historical records of the stock market go much further back than the stock market performance of REITs, providing a longer track record.

  The question then is: Do you want real estate exposure without the costs associated with owning a property? If you do, then a REIT is a low-cost, easy way to have exposure to real estate. If you want to own a home, however, then make sure you do your homework.

  10 FACTORS TO CONSIDER WHEN BUYING A HOME

  This is not to say buying a home is a bad idea. Keep these 10 factors in mind when considering purchasing a home.

  1. Know How Much You Qualify For

  Remember that the rule of thumb is not to spend more than a quarter of your take home pay on housing and less is better. More than that and your finances will be too tight, leaving you financially strained if things go wrong. If you want to retire early, aim for much less than 25%. Of course, this is not always possible, especially for expensive cities. Use mortgage calculators online to see how much your payments will be. It helps to talk to a bank first to get an idea of how much you will qualify for. Be careful because banks will qualify you for the maximum they feel you can afford, but that is a dangerous game. Rising interest rates could leave you with very little buffer in your finances.

  If you want to save the most money while making mortgage payments, aim for a mortgage that is half what the banker or realtor tells you are qualified for, if possible. This depends on how much house you want to own and your personal circumstances. You might need a more expensive home for a large family, for example.

  2. Homes Are Long-Term

  Homes are expensive. Between realtor fees, 3% and 6% when you buy and sell; closing costs, 2% to 5% of the purchase price, which include legal fees, inspections, title insurance, credit checks, and appraisals; and property taxes, chances are that breaking even will take at least five years of owning the property. Furthermore, for the first few years, your mortgage payments are mostly interest. Do not forget the cost of maintaining the property.

  Because of the costs involved with real estate, only buy a house if you are planning to live in the same place long term. I own multiple properties with the intention of holding them for at least 10 years each. The longer you stay in your home, the more you save. Just like owning a car, the real savings happen over time. If you bought a house and find out you cannot live in the same place for that long, then you have the option of renting it out.

  3. Do Not Be House Rich and Cash Poor

  One common reason people do not have enough money to retire is that they become house rich and cash poor, meaning their home is their largest asset without much spare cash. As a result, many:

  •Retire later than originally planned

  •Accept a lower standard of living in retirement

  •Move to a less expensive home and use the extra equity to fund their retirement

  •Borrow against their home equity

  Do not be one of those people. Stocks, over time, have always outperformed the housing market, so while a house is nice to have, do not overextend yourself on the mortgage and save the difference in index funds. Remember, your home is your home, whatever it is, and it is not a speculative investment. Furthermore, it is better to diversify your investments outside of having everything in one basket, i.e., your home.

  Think about it this way. Even if your primary focus is paying your mortgage first, the bank only cares if the most recent payment was made. The moment you stop making payments, you lose credibility, your credit score decreases, and you could potentially lose the house. If you have liquid investments and an emergency fund, these can help in times of need.

  4. Have an Emergency Fund First

  There is a reason why Chapter 4: Build a Small Emergency Fund comes before this chapter. You should have enough saved up in an emergency fund before thinking about taking on a mortgage. Unexpected life events can and will happen, so be prepared before you take on the biggest debt of your life.


  5. Pay Off Other Debts Before Getting a Mortgage

  When you apply for a mortgage, the bank will ask about your other debt obligations. These include car payments, credit cards, lines of credit, student loans, and other real estate you may own. If the amount you want to borrow exceeds 43% of your income,92 you will have a hard time getting a mortgage. Your debt-to-income ratio will be too high.

  What is the debt-to-income ratio (DTI)? Simply add up all your monthly debt payments and divide them by your gross monthly income. Your gross monthly income is generally the amount of money you earn before taxes and other deductions are taken out.

  For example, if you pay $1,200 a month in mortgage payments, another $200 for a car loan, and $400 in other debts, your monthly debt payments are $1,800. If your gross monthly income is $5,000, then your DTI ratio is 36%.

  Monthly debts= $1,800

  $1,200 (mortgage) + $200 (car) + $400 (other expenses)

  Gross monthly income= $5,000

  DTI ratio= $1,800 / $5,000= 36%

  It is important not to be anywhere close to a 43% debt-to-income ratio when qualifying for a mortgage. Many people think if they can qualify at or close to 43%, then they should take on the mortgage. This is the wrong way of thinking. Have your debts under control first, and preferably be debt-free, before taking on a mortgage. And, reduce that ratio. As previously mentioned, most experts say mortgage payments should not exceed 25% of your gross income. I say you should try to get this under 20%.

  Another ratio lenders look at is your PITI ratio: your Principal, Interest, property Taxes, and Insurance to gross monthly income. This ratio should not exceed 28%. For example, if your gross monthly income is $5,000, your PITI should not exceed $1,400.

  6. The Bigger the Down Payment, the Better

  The average down payment size is $20,000 or 7.6% of the median sales price of $263,000. What is sad is that this is one of the highest average down payments since the year 2000.

  This is not good enough. I recommend putting down at least 20% for your down payment.

  Why? The more money you put down, the lower your monthly mortgage payment, and the less interest you pay over time. Suppose, for example, you have a mortgage of $100,000, and you are paying it back over 30 years. If you pay 5% interest rates, you must pay back the lender $100,000 and nearly the equivalent amount again in interest! If you put down a higher down payment, you will also likely qualify for a lower interest rate, which will save you money in the long run.

  Another reason to put at least 20% down is that if you put pay any less, you need private mortgage insurance (PMI) in the U.S. or mortgage default insurance (CMHC) in Canada, which is very expensive. In the U.S., the annual cost ranges from 0.38% to 1.03% of your home’s value or more than $1,250 on a $250,000 home depending on the loan to value, borrower’s credit score, and debt-to-income ratio. In Canada, the premium can be a total that is between and 2.8% and 4.0%. What is worse, in Canada, is that this is tacked onto the price of your home, so you will be paying interest on that amount over time, increasing the amount you owe even more. The worst part? The insurance does not protect you. Instead, it protects the lender and is a total waste of money.

  In the U.S., a mortgage with PMI looks like this:93

  *Most common loan type in the U.S.

  **Any down payment that is less than 5% will have a 1.03% PMI rate.

  In Canada, a mortgage with CMHC looks like this:

  Note that in Canada, the mortgage default insurance is not available on homes purchased for more than $1,000,000. This means that a down payment of 20% is required on these homes. Also note, that the maximum amortization for insured mortgages is 25 years in Canada.

  Why does the bank require you to have insurance if you have less than 20% of a down payment? It is because lenders believe that people who put down less than 20% are more likely to default.

  7. Location, Location, Location

  If you commute to work, put a dollar value on how much your free time is worth and do the math to see how much your commute time costs you. It has been proven that if you live close to work, you will be happier and healthier.94 Americans on average spend more than 100 hours per year commuting to work, which is more than the two weeks of vacation that most workers take annually! People with the longest commutes have the lowest overall satisfaction in life. This is because time is limited and spending it on a commute makes us feel stressed. In fact, the daily commute is the number two activity people hate most on a day-to-day basis. The number one is housework. Cutting out a one-hour commute produces the happiness equivalent of a $40,000 raise. This is not to say that no commute is the best commute. Studies show that about a 15-minute commute is the ideal length, with walking being the best form of transportation.

  For example, if you commute an hour to and from work each day and your hourly rate at work is $25 an hour, you spend the equivalent of $1,000 a month of time or losing $12,000 a year in traffic.

  Not only will living closer to work make you happier, but it also costs less to maintain a car, and smaller homes closer to downtown tend to appreciate faster than larger homes farther away from the city.95

  8. Buy a Primary Residence Before an Investment Property

  Popular advice is to buy an investment property first to get your foot in the door, and then use the equity to buy your first family home in five years. This is terrible advice. Due to the upfront and ongoing costs of owning a home, buying an investment property first will eat into your savings and delay you getting into your own home.

  9. Shop for Your Mortgage

  Interest rates make an enormous difference in your monthly payments. Even a 0.25% difference between two rates can mean the difference of $32 a month or $1,920 over a five-year period. In the U.S., look up rates using Bankrate.com, HSH.com, and Zillow.com. In Canada, I recommend RateHub.ca.

  If your mortgage is up for renewal or interest rates have recently dropped, look around for the best rate and negotiate with your bank. The best way to do this is to see if there is a rate that is lower than your current rate. If so, call up your bank, and ask for the “customer retention department,” and use this script:

  “Hello, I’ve been a long-time customer, but I’m thinking of switching my mortgage to another bank, which has this offer. Given our long relationship, I’d rather continue my business with you. So, would you be able to match the offer? If not, please send me the forms so that I can switch.”

  Whether you are actually willing to switch banks does not matter. See what they come back with. If they say that they cannot match the rate, ask to speak with their supervisor and see what deal they can offer. Let’s say you save 0.5% from doing this with a five-year fixed rate, going from 2.99% to 2.49%. That 10-minute phone call would save you $1,412 a year and $7,059 over five years.

  Tax Tips

  In the U.S., you can deduct mortgage interest from your income to reduce your taxes for the year. Note that tax law changes in 2018 put limitations on this. This is an additional bonus whether you use the home as your principal residence or rental property.

  In Canada, you can only deduct mortgage interest if the house is a rental property. This means that you rent it out to a tenant. You cannot deduct mortgage interest from your principal residence to reduce your income.

  Under no circumstance, in the U.S. or Canada, can you use the principal repayments as a tax deduction.

  10. Go with a Fixed Rate Mortgage

  Almost always lock in a fixed rate. A fixed-rate mortgage is a mortgage where the interest rate on the loan remains the same throughout the term of the loan. The most common term is usually either for 25 or 30 years, but you can get less. In Canada, they have 1 to 10-year renewal periods, and in either country, you can refinance your mortgage if rates decrease. It is harder, however, to lock in a lower rate when rates have increased. Getting a fixed rate in these circumstances gives you peace of mind and allows you to budget the rest of your income without needing to worry about increasing int
erest rates.

  The other option is a variable-rate mortgage. In the U.S., it is also referred to as an adjustable-rate mortgage (ARM). The interest rates on a variable-rate mortgage fluctuate depending on what happens to the interest rates in the economy, which is decided by the Federal Reserve or Bank of Canada. When you hear “rate hikes” on the news, it refers to this interest rate. Typically, a variable-rate mortgage has lower rates than a fixed-rate, but whether it remains low is uncertain. And if rates rise when the economy is doing well, which is what usually happens, you will soon wish you locked in your rate at the fixed rate.

  OTHER MORTGAGE CONSIDERATIONS

  Open or Closed Mortgage?96

  Open Mortgages Provide More Flexibility

  With open mortgages, the entire mortgage balance can be paid off at any time without penalty. But open mortgage rates are usually variable rates and are a little higher than closed rates. You will likely pay the prime rate plus a hefty premium.

  Fortunately, open mortgages allow you to move into a fixedrate mortgage at any time if you feel that variable rates are going to go up. The freedom to pay them off or move to another product at any time is a major selling point for open mortgages.

  Closed Mortgages Offer Attractive Interest Rates

  Closed mortgages typically have lower interest rates than open mortgages, but borrowers have limited flexibility. For example, you cannot pay off the loan without incurring a penalty. However, most closed mortgages allow for accelerated payments of some kind. Each lender has its own prepayment terms.

  With a closed mortgage, you agree to keep the loan for the entire term. Borrowers who sell their house early into the term because of relocation or job loss can end up with less money than they anticipated because the high penalties eat into their equity. If this happens to you, I highly recommend trying to rent out your place first until the end of the term.