The following article should not be taken as investment advice and is for information purposes only

In this post we discuss some factors to look at when investing in real estate as well as some ways to unlock value and create wealth using real estate (from a finance and capital allocation perspective).

Cap Rates, Interest Rates and the Cap Rate Spread

When cap rates are high, the unlevered return on investment is generally also high.

Accordingly, real estate returns are strong because the rent versus the purchase price of the property is attractive.

However, this does not just “happen”. Usually, real estate yields are high to catch up in attractiveness to other asset classes. If stocks are returning 20% a year, people will likely flood into stocks so real estate will see selling pressure and be bid down.

Alternatively, if interest rates are rising, real estate becomes less attractive of an asset to hold for two reasons.

For one, real estate cash flows are bond-like in nature. Real estate rent offers fixed income (although it does tend to go up by inflation or better in a normal, growing city). As such, if the risk free interest rate (the US Treasury bond) rises, the attractiveness of real estate yields falls. In order to keep the spread between the risky asset (real estate) and the risk free asset the same, the yield must rise to compensate investors for the incremental risk.

Also, rising interest rates makes financing more difficult for real estate investors. As the ability to service debt diminishes because the mortgage interest goes up, the yields (which are driven by rent and purchase price) have to go up.

Ideally, the best environment for real estate investment is with a wider cap rate to interest rate spread because this means that the returns are relatively high but funding is cheap. Cap rates generally move in line with interest rates.

Today, while rates are tepid but rents continue to rise, there is a decent backdrop for real estate investing.

In North America, interest rates have risen from all time lows post financial crisis after a few rate hikes by the Federal Reserve. However, on an absolute level they are still very low with the 10-year UST at 2.7%. In Canada, a soft economy has the 10-year Government of Canada (GoC) at almost a full percent below. An inability to market oil as an export and an otherwise weak economy means that rate should be low and stable for some time to come.

Easy debt or the availability of mortgage credit is also an important consideration for real estate prices. With mortgage rules having tightened since the financial crisis and with new regulation being pushed out to stave off loose lending by banks, this pulls the demand function back for real estate and should temper prices.

Regulation such as foreign buyer taxes can also severely curb the demand function for real estate in desirable cities.

Using Reverse Mortgages and HELOCS to Invest

Now with all of that out of the way and knowing that it is a low interest rate environment, a lot of homeowners are getting Home Equity Lines of Credit or reverse mortgages in order to fund lifestyle or investment.

The way that these debt instruments work is that a lien is placed on the home and the homeowner can borrow a large percentage of the house’s appraised value. Due to the overcollaterized nature of this loan, the interest rate is very low. As a line of credit, there is no amortization for the mortgage – just interest payments.

Retirees have been using this strategy for some time to fund lavish retirement lifestyles from the appreciation of the real estate – with the ultimate plan of selling the property later to cover the debt and then downsizing.

Snowbirds are associated with this erosion of real estate investment gains. They spend most of their time in a sunnier locale during the winter such as Florida or Arizona for golfing, boating and fine dining while not leaving any capital for their children.

Other major users of HELOCs are investors that want to make huge bets. With a HELOC, investors do not have to chose between real estate and stocks. They can do both. It is a lot harder to buy real estate by collateralizing your stocks.

Plenty of people have lost everything that they have by taking a reverse mortgage on their house and betting it on Bitcoin, marijuana stocks or technology stocks. It is a sad but common story. For every one person who bets the farm (literally) on Apple or Tesla, plenty more fall by the wayside with pets.com or Litecoin.

However, the HELOC investment strategy is not necessarily a bad one if the appropriate risk measures are taken. From a treasury perspective, it is important to match assets with liabilities. When the HELOC is tapped into, these assets can be deployed into assets that generate income in excess of the mortgage principal and interest (for a HELOC, just interest).

For example a portfolio of blue chip dividend stocks can service the interest while appreciating in value. In addition, there is tax arbitrage because HELOC interest may be tax deductible if used for investment purposes.

Keep in mind that this is meant to be an extremely safe stock portfolio with no selling – ever. Basically the idea is that Johnson and Johnson, Wells Fargo, and everything else that is a Berkshire Hathaway mainstay with a decent dividend will service the debt (even better if it is an investment property or the house is Airbnb’d out during vacation times and rent also contributes to debt service) – and raise their dividends every year leading to accelerated repayment.

With this strategy, whether stocks rise or fall is less important.

This is also why an investor employing this strategy cannot just look for stocks with the highest dividend yields – generally this means that they are pricing in a dividend cut. Anyone who employs this strategy cannot risk permanent loss of capital.

Canadian bank stocks and telecoms are particularly attractive for this strategy – the high and utility like nature of the dividends matches the fixed income requirement of the mortgage.

This is not the place to put into equities broadly, that is for retirement accounts and personal accounts.

This is a way to unlock extra value from otherwise dead money or dead equity in real estate. Food for thought.