An investment banker with one of Canada’s major banks, surveying the devastated state of Home Capital Group, has a question: “I want to know why the OSC (Ontario Securities Commission) perpetrated this thing.” Did Home Capital, whose shares have lost 70 per cent of their value since April 19, “perpetrate a fraud on the market?
I just reviewed the Canadian High Interest Savings Account rates. Not much has changed over the past year, the major banks are still at 0.75%. The only other issue to mention is about being cautious with issuers when your deposit is more than $100,000. Recent events with Home Capital have illustrated the importance of diversification and not chasing returns too aggressively. Even though interest rates are low, this is the reality, and an excessive hunt for yield will lead a reckless investor to losses.
Many people assume someone who owns 3 individual condo apartments in Toronto is getting a free lunch, but the truth is, owning apartments has pros and cons, risks and rewards, just like any other investment. Its difficult to explain how the returns of real estate investing actually work over a conversation at a cocktail party. This post will show real life examples of the returns of 3 individual 1 bedroom apartment condos in Toronto for 2016. I hope this post gives the layperson more knowledge about the actual results of owning condos on Toronto. The rates of return might not be as high as you’d expect!
Below is a table listing the income and expenses of 3 apartments in Toronto. Each of these apartments are located in downtown Toronto. Condo 1 was purchased 10 years ago, Condo 2 was purchased 8 years ago, and Condo 3 was purchased 6 years ago. Condo 1 and Condo 2 are proper 1 bedroom apartments where the bedroom is a separate room from the kitchen and living area. Condo 3 is a bachelor apartment where the living space is contained in a single room with only a separate bathroom. Each building has 24 hour concierge, Condo 1 and Condo 2 have modest rooftop terraces, whereas Condo 3 has extensive amenities including indoor and outdoor pools, a large fitness center, and meeting space. Condo 1 and Condo 2 are rented unfurnished to long term tenants. Condo 3 is rented furnished with term leases. Each unit includes utilities, and Condo 3 also includes unlimited internet. The rent is $1,600 per month for each unit.
|Condo 1||Condo 2||Condo 3|
The additional insurance expense listed is required because although each building has insurance to protect damage caused by common elements, there are gaps in the policies so individual units need to also have insurance for damage caused by the resident or elements exclusive to the unit, such as if there is a flood caused by the resident of the unit causing damage to the building, this risk is covered in the unit specific policy. Also, damage to articles of the resident are also covered under the unit specific policy regardless of fault.
Interest expenses are associated with the mortgages held on each unit. At the time each unit was purchased, a 20% down-payment was invested, and the balance of funding was provided by mortgages.
Condo 2 suffered legal expenses in 2016 because of an error made by the property manager who was subsequently terminated by the condo board. The legal expenses were associated with adjudicating the dispute resulting from the error by management. This impacted the returns of Condo 2 for this particular year.
Maintenance expenses are related to tasks such as appliance repair. The utilities expense on Condo 3 is the cost of providing internet to the resident.
The total annual income provided after expenses for all three units is $16,829 or $1,402 per month.
What is the rate of return these condos produce? This can be determined by dividing the income of each property by an estimate of their market value. I estimate Condo 1 to be worth $450,000, Condo 2 to be worth $425,000, and Condo 3 to be worth $325,000. The estimated rates of return are provided in the table below.
|Condo 1||Condo 2||Condo 3|
|Loan to Value||44.44%||47.06%||38.46%|
|% Return Equity||3.47%||2.55%||3.84%|
|% Return Cash||2.46%||2.53%||3.34%|
As the table illustrates, each property has a bit of financial leverage. Its been a number of years since these condos have been owned as described above, so a portion of the mortgage debt has been paid down, and the properties have appreciated in value, so they carry more equity with a lower leverage rate than when they were each initially purchased.
Readers might be surprised to see the low rates of return. Higher cash yields can be obtained in many other liquid investments such as many blue chip stocks, and some bonds. I’m not going to argue that real estate (in particular condos in Toronto) is the best investment. Many investments are good ones, and from time to time certain asset classes will outperform others. There are many factors to consider when investing in stocks, bonds, and real estate, and its impossible for the individual investor to know which one will be the best. Individual investors can only assume that the market price has accounted for all the relevant factors. I think its more important for the individual investor to maintain a diversified portfolio rather than attempt to dramatically outperform the market. The individual who wants to create wealth should focus their energy on business activities where a financial investment is limited and operational success is far more important. With those thoughts in mind, a low rate of return in the short term should not cause an investor to sell their real estate today.
The % return on equity row describes the rate of return based on the equity invested = profit / (value – mortgage). The % return on cash row describes the rate of return based on the market value of the property = profit / value. The difference between the two rates is the impact of leverage. If the rate of return on the apartment is higher than the interest rate paid, then its profitable to borrow, otherwise, its better to invest without borrowing, or to mortgage the property but use the cash generated to invest in some other higher rate of return. Its also important to note that without the one-time legal expense associated with Condo 2 in the current year, the % rate of return on equity would have been 3.52%.
How does the rate of return on these properties compare to publicly traded REITs? An investor could probably obtain similar rates of return by investing in REITs, without the hassle and risk of managing individual assets. The leverage rates of residential REITs compared to the current leverage of these three apartments is similar. Some REITs have higher leverage, some have lower. The other benefit of owning a REIT, besides the passive nature and less work, is the benefit of liquidity and diversification. Shares of a liquid REIT can be sold at any time with very low transaction costs, whereas individual properties are expensive to sell if a broker is used.
From a tax perspective, the individual properties are probably a better investment. The expense categories that CRA allows for real estate investments are pretty broad, and can include transportation and administrative expenses. The individual property investor can also make CCA deductions to reduce any other current year’s tax owed, but this comes with the caveat that if/when the properties are sold this CCA is clawed back in the form of capital gains tax. With REITs, the distributions are mostly taxed at the holder’s marginal rate in the year they are received. REIT distributions are not dividends, but are considered passive income to CRA. If its possible, try and hold REITs and bonds inside registered accounts (RSPs, TFSAs, RESPs, RDSPs, etc) and hold dividend paying stocks in non-registered accounts since the tax rate on eligible dividends is relatively low.
Another element that should be considered when analyzing the rate of return of condos in Toronto is the potential for their value to appreciate. This is one of the main drivers behind many real estate investments, the idea that the property will become more valuable over time, regardless of the annual yield %. This has certainly been the case in Toronto throughout its history, but who knows what the future will bring. If we consider urbanization will continue, major cities around the world will to grow and the added population will continue putting pressure on real estate prices. With leverage, the returns from appreciating real estate prices are magnified.
So who’d want to buy Home Capital Group and why? Before considering who, let’s first consider why. What would the buyer of Home Capital get and how might this transaction be structured? First, could a big bank wring value from HCG? Probably not, the big banks such as BNS, RY, CM, TD, BMO can source better quality mortgages on their own terms without needing a portfolio of mortgages from HCG. What about competitors such as EQB and FN? They have a similar business model, and they could probably clean up HCG’s mortgage book and further leverage relationships in the mortgage channel? The problem with this logic is EQB and FN are about the same size as HCG, and if the quality of HCG’s mortgage portfolio is less than expected, it would drag down the buyer, possibly also causing a larger bankruptcy. Its pretty risky for EQB and FN to buy HCG, and there is limited upside. A better strategy for EQB and FN, and its the one that EQB has taken, is to play defense and arrange for liquidity to get by the near term GIC redemptions.
What about a larger firm such as Brookfield? I guess its possible, but not likely. This would be a departure for Brookfield, but it does have some logic. If Brookfield could fund $10 to $15 billion in the short term, it could satisfy GIC redemptions and put the mortgages into a MIC, even offering this MIC to the secondary market (as a private equity or public listing). It would take some time to do the re-organization, but Brookfield has the capacity for this and could certainly find financial partners. Once the MIC was setup, it could be re-capitalized further diversified. This type of strategy would preserve the HCG mortgage and deposit brokerage relationships.
All of this is armchair speculation. I think the most likely next step now is to find further information from the OSC on their claims and settlement process. Also, I think investors need to know more details on the quality of the HCG mortgage book, is it indeed full of holes or could it stand up on its own?
By now most Canadians have likely seen the Home Capital Group Inc. stock graph, a Rocky Mountain plunge that began April 19 at $22 before hitting bottom a few days later at $6, wiping more than $1 billion off the value of one of Canada’s most successful non-bank mortgage lending enterprises.
Home Capital Group announced it has secured a $2 billion line of credit that will carry an interest rate of 10% and a 2.5% standby fee. They also announced their HISA deposits have fallen y more than $500 million in the past few weeks to $1.4 billion.
April 26, 2017 /CNW/ – Home Capital Group Inc. (“The Company” TSX: HCG) announces that its subsidiary, Home Trust, has reached a non-binding agreement in principle with a major institutional investor for a credit line in the amount of $2 billion. It is expected that a firm commitment will be agreed to later today.
I remember when Home Capital was a darling of Bay Street, when it was gaining customers by focusing on segments of the mortgage market that were disregarded by the big banks. I remember HCG was issuing
New rent-control rules are “the exact opposite” of what is needed to deal with housing affordability problems in Toronto, Canadian Imperial Bank of Commerce economist Benjamin Tal says.
The case of the Dole Foods class action payout has created headaches for share depositories and brokers. Short sellers arn’t too blame, or are the current bookeeping methods (although distributed ledgers would help). The problem is public courts inserting themselves into private contracts because of overbroad securities laws.
In 2013, tropical-fruit tycoon David Murdock, who was the chairman, chief executive officer and biggest shareholder of Dole Food Co., took it private for $13.50 a share. A lot of shareholders felt that that price was way too low, and that Murdock had sandbagged the shareholders by driving down the value of the company so he could buy it cheaply for himself.
Consider an underlying price of 918. You are presented with the choice of buying or selling a European binary call option with 1 day till expiration and a strike price of 918 (i.e. at the money). The 30 day historical volatility of the underlying, as measured by standard deviation, is 5%, and the risk free rate is 1.50%.
Since this is a binary option, the bet is about whether the underlying price is going up or down tomorrow. So how should this option be priced? If the price of the underlying is more than 918 in a day, the binary pays off 1, if the price is lower than 918 in a day, the binary pays off 0. Is this a 50/50 bet? An amateur would say the option should be worth 0.50 since there is an equal chance of each event happening. But the price of this binary call is actually worth slightly more than 0.50. How so?
To value the option scenario described above, we need to consider the (1) time value of money and (2) the volatility of the underlying. If we use a black-scholes model, with the variables listed above, we come up with a call price of 0.506.
Using the same variables, but changing the time to expiration, comes up with the following values.
|Days till Expiration||Binary Call Price|