Is Money Safe In Real Estate?

Today's real estate market is a far cry from the heady days of the 1980s when property was king and affluence was measured by the square foot. Once-mighty real estate empires such as Olympia & York Developments Ltd. and Bramalea Ltd. have fallen on hard times, sending shivers through financial markets around the globe. Stories abound of high-profile real estate entrepreneurs suddenly forced to liquidate their holdings at fire-sale prices for fear of corporate bankruptcy.

Even normally staid bankers have cast a wary eye on real estate, making sure that only prime properties qualify for that all-important mortgage. Save for a few isolated markets such as Vancouver and south-central British Columbia, real estate markets have, for the most part, taken a direct hit. Closer scrutiny, however, reveals an interesting pattern, and when considered from the perspective of real estate, mutual funds may in fact present some excellent investment opportunities along the way.

Canadian real estate mutual funds, like real estate, generally have suffered lower investment returns as a result of market corrections in the last few years. But unlike your home, condo or local industrial park, real estate funds have protected their investors from excessive market volatility and, in many cases, have provided competitive rates of return. According to The Financial Post Survey of Funds, for the period ending June 30, 1992, the highest five-year average return was 10.6% for Counsel Real Estate Fund and a five- year low of 4.4% for Great West Life Real Estate fund.

Over the last two years, real estate funds have hit highs of 8.1% for Sovereign Save & Prosper fund and lows of -11.3% for Global Strategy International Real Estate fund and -4.2% for Great West Life Real Estate fund. On a two-year ranking, only four of 12 Canadian real estate funds showed negative returns, with only three of these showing figures below -2.6% per year. Not bad when you consider that residential house prices in Toronto, for example, have dropped an average of 7.5% per month from January through August of 1992, compared to the same period in 1991, according to data from the Toronto Real Estate Board.

Aside from comparatively stable returns, real estate mutual funds are particularly attractive because of their relative market stability, long- term inflation protection, income stream and all-important tax deferral.

Real estate mutual funds are on average three times less volatile than Canadian common stock mutuals. That makes for market stability not readily found elsewhere. Compare commercial real estate between January 1, 1985 through December 31, 1991 with the TSE 300 for the same period and you'll find that real estate grew an average 10.7% per year, according to the Russell Real Property Index, compared to 9.2% per year for the Toronto Stock Exchange 300 Index.

Inflation protection, while not an overwhelming concern today, still remains an important feature of real estate mutual funds for the long term. Select real property has a time-tested propensity for market appreciation on its own. Add the reinvestment of the income stream that is generated by properties held by the real estate fund, however, and an automatic compounding effect occurs that far outstrips the eroding effect of inflation. According to Consumer Price Index figures for the years 1985 to 1991, inflation has averaged 4.3% each year; real property, to the contrary, has appreciated an average of 11% per year over the same time period.

As far as the income-stream component is concerned, real estate mutual funds generate significant benefits for nonregistered investments. First, real estate mutual funds earn interest on their cash deposits; this is usually cash that has yet to be invested through the purchase of additional capital properties. In periods of escalating property values and increasing cash flow from individual fund investors, such interest earnings will normally increase. When property prices begin to deflate, these interest earnings in the fund will likewise drop, especially as the mutual fund starts purchasing more attractively priced properties.

Sometimes, a real estate fund will invest part of its cash reserves in real estate stock that will in turn generate stock dividends to the fund. The amount of income generated by real estate stock will vary, depending on the amount and quality of real estate stock held by the fund.

The third type of income produced by a real estate fund is rental income generated through actual commercial properties held by the fund. Additional, though sporadic, income for the fund is generated in the form of capital-gains dividends earned by selling properties that were previously held at a profit. These dividends are distributed to shareholders in amounts directly proportionate to the number of shares held by each individual investor.

A significant, yet hardly promoted benefit of real estate mutual funds is their ability to shelter real estate income from excessive tax. This tax- sheltering ability is known as Capital Cost Allowance (CCA). A fund can claim CCA on the properties it owns, meaning simply that taxes normally applied to the fund's combined income can be deferred by claiming specific amounts of depreciation against properties held in the fund. This same tax deferral is passed along to fund investors in the form of a T3 for tax purposes and can amount to significant deferral as long as the fund investor retains his shares of the fund. Once shares of the real estate fund are sold, the proportionate amount of CCA is recaptured for tax purposes.

As long as you keep your shares of your real estate fund intact, however, you'll be able to either spend or reinvest your real estate income at very attractive tax rates. Canadian real estate mutual funds are one of very few investments that offer such significant tax-deferral opportunities.

People are reluctant to invest during periods of depressed property values. Some may feel safer putting their cash into treasury bills, mortgages and bonds. However, it is the job of the mutual-fund management team to be aware of and take advantage of the typical up-and-down real estate cycle-to buy low and sell high.

If you think back to the last Canadian real estate boom, you'll find that its earliest beginnings can be traced to the end of the 1981/82 recession. At that time, there was little construction, and rental income had all but stabilized in major urban centres. With increased business activity at the end of 1982 came an increased demand for retail, commercial and industrial property. As this demand increased, so did corresponding rental income, which, in turn, served to increase the value of real estate generally.

The boom market of 1986 to 1989 was typified by rapid construction of residential, commercial and industrial developments. Its subsequent bust was typified by rising inflation, interest rates, and declining business activity. With this came a decreasing demand for real property, rent reduction, and deflating property values due to saturated real estate markets. With reduced real estate income came reduced availability of funds for construction and maintenance. And this is where we sit today. Should you invest in real estate? The answer, of course, depends on your personal investment goals and circumstances. But real estate mutual funds are at least worth a critical look. Good funds base their investments on regular, high-income streams, coupled with quality properties showing good long-term capital-growth potential. Consider carefully where we are in the real estate cycle today. And then consider the old investment adage-buy low, sell high.