By Stefan Aarnio, author, entrepreneur, coach and award winning real estate investor
Q: Why are the profits so big in Real Estate?
A: All Real Estate is Finance, banks inflate Real Estate by lending.
Real estate is an industry where the profits are disproportional to the effort used to earn them. A realtor can earn thousands of dollars, tens of thousands or hundreds of thousands of dollars to sign a contract and perform a simple transaction. A wholesaler can earn thousands of dollars for assigning a contract to another investor. A landlord can earn hundreds of thousands of dollars per property by simply collecting the rent and keeping his rental house in good upkeep. All of these real estate professionals make large profits because all real estate is finance and when banks will lend for real estate, prices go up.
At the time of writing, in April 2014, the Canadian residential real estate market is estimated to be 60% overvalued when compared to the intrinsic value of land and buildings. The reason why prices are strong and have remained strong for the last 15 years is because the Canada enjoys one of the strongest most conservative banking systems in the world. When the banks are strong and jobs are strong, real estate prices will be strong.
But what would the price of real estate be if there were no banks to lend?
If the banks were unable to lend mortgages to purchase real estate, prices would be dramatically lower. To see this effect illustrated, compare two countries, one with a strong banking system like Canada, and another country with an emerging banking system like Brazil. Canada has had a strong economy with lots of middle class jobs, the jobs provide income, which the banking system finds favorable to underwrite mortgages. Since the Canadian banking system finds it profitable to underwrite mortgages against the labor of the middle class people of Canada, the Canadian real estate market floods with cheap debt and the prices inflate.
If there were no middle class jobs, the banks would have no labor to underwrite, there would be no mortgages and consequently, real estate would be very cheap. Countries like Brazil are starting to build a strong middle class and the banks are starting to offer retail mortgages backed by the labor and wages of the new middle class. Give the Brazilian real estate market a few decades and it too may inflate the way that the Canadian market has.
Every child who throws a ball in the air knows that “what goes up, must come down”. Every skeptic and every cynic will also proclaim that any inflating market is a bubble waiting to pop. One of the most recent significant real estate crashes was the American market in the financial crisis of 2008. Many experts will debate as to what caused the crash or who was to blame, but simply put; 33% of the buyers were eliminated from the market by the banks that no longer qualified them as buyers. Consequently, 33% of the demand was removed from the market. A 33% reduction in demand will create a 33% reduction in value. Most homeowners in the country had over borrowed and the banks had lent out too much cheap money. This created a financial meltdown and chaos in the market that was caused by money that did not exist lent to people who did not have jobs to pay back debt for houses that were not worth the prices being paid. In two words, the entire country had committed mass fraud, but very few people went to jail.
Across the border in Canada at the same time in 2008, the Canadian banks began to slacken their lending policies, but quickly tightened their lending practices back up once they saw the chaos that ensued in the USA. Nearly 7 years later, the American real estate markets are in different stages of stability or chaos and the Canadian markets are buoyant, stable and have seen very little chaos. In my opinion, the stability or chaos of either Canadian or American markets is directly correlated to the stability and lending practices of the banking system in each country. Stable banking creates a stable market and chaotic banking creates a chaotic market. All real estate is finance and that is why the profits are so big.
Two different banking systems, two different markets
In May 2013, under the advice of my mentor and jungle guide, I flew from Winnipeg, Manitoba in Canada to Texas in the USA to explore one of the fastest growing states and potentially set up my real estate investing business there. Coming from one of the most left wing and business unfriendly provinces in Canada to one of the most right wing and business friendly states in the USA was refreshing.
In 5 days I drove through the 5 major cities in Texas collecting statistics on the housing market, making contacts in the industry and physically exploring the houses on the market. Economically, Manitoba and Texas are similar in many ways in that; both markets are value markets. There are two types of markets in real estate 1) Vanity markets where buyers migrate towards because of glamour, great weather, excitement, tourism, retirement etc. and 2) Value markets where buyers migrate towards because of economic gain. Both Texas and Manitoba are generally value markets where the residents choose to move there for jobs and not for glamour.
Both Texas and Manitoba are economically diverse. Both markets are not driven by one commodity or industry and this leads to a stable real estate market that is unlikely to crash if any one industry should fail.
Both Texas and Manitoba have strong positive net migration in that more people are moving into the markets than are moving out and this creates growth over time for both markets.
What was very different about Texas when comparing it to my home market of Winnipeg, Manitoba, was how far a buyer’s dollar went. The average household income in the major cities in Texas was approximately $50,000 per year and this would afford the average family a house valued at $125,000. These families paid less in income tax and had less debt than their Canadian counterparts. In addition, their home was newer, larger and typically came with more land.
The average family in Winnipeg, Manitoba made approximately $70,000 per year and the average home in Winnipeg was $267,000. This family paid more income tax and had more household debt. The home that the Winnipeg family owned was older, smaller and had less land than their Texan counterpart.
What made these two average families different? Both markets have relatively strong economies, both are value markets, both have strong positive net migration. However, the Canadian banking system has remained strong and has allowed buyers to push inferior homes to superior prices. At the time of writing, the Texan banks were much more conservative with their lending and they allowed their housing stock to remain closer to the intrinsic value of the home. Where the Canadian banks have allowed the housing markets to run away from construction values and the “price to build”, the American banks were much more conservative at the time and were lending at prices that were less than the cost of construction.
To further illustrate the difference in lending philosophy between the Canadian and American banks in 2013, the American banks at the time were uninterested in financing “fixer uppers” so the only way to purchase distressed property was privately with 1) cash or 2) hard money at 12% or higher annually. In Canada at the same time, retail buyers could buy distressed fixer uppers for inflated prices and pay interest rates of roughly 3% annually.
Texas and Manitoba are very similar in many ways and the main difference in their real estate markets in 2013 was the banking system and ability to finance. Never forget that finance rules real estate and your financial ability determines your exit strategy. Many investors finance their deals wrong and use the wrong exit strategy which can lead to a crippled investment career in the future.
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Stefan Aarnio, award winning real estate investor, entrepreneur, author and coach was recently inducted into the Rich Dad Hall of Fame. His book, “Money People Deal: The Fastest Way to Real Estate Wealth” is currently available on moneypeopledeal.com. To learn more about Stefan Aarnio please visit StefanAarnio.com