From Positive to Negative – Pitbull’s Voodoo Math

A couple weeks ago I was at the physiotherapy clinic undergoing painful dry needling to address an injury I sustained at the gym. The physiotherapist, Lauren (name has been changed), told me that she was planning on purchasing a condo so she can rent out and collect a small income from it.  She said she saw it done on HGTV and it’s something she has been thinking about for some time.  Real-estate investing is a good idea [bet you didn’t expect me to write that line in this blog!].  The only caveat is that the numbers need to make sense.

As the needles went into me, she explained how she can easily rent out the place for more than the monthly mortgage costs. “Always a good start” I thought while enduring excruciating pain.

The conversation then went something like this:

Joey: “What about the maintenance fees for the condo?”

Lauren: “Well, what about them?”

Joey: “How much are they and did you take that into account”

Lauren: “No, they’re not much I don’t think. Doesn’t the tenant pay them anyways?”

Joey: “No, you pay them. Ok, how much is the monthly taxes?”

Lauren: “Maybe $1500? I don’t really remember”

Joey: “How much is the insurance for this rental unit? It’s usually more than a standard homeowner’s policy since tenants are in there”

Lauren: “I thought the condo board pays that?”

Joey: “No, you pay that”

Lauren: “Oh”

Joey: “What percentage are you allocating for when the unit is empty and for costs associated with damage caused by tenants”

Lauren: “Tenants could damage my property?”

Within a few moments, I realized Lauren had not exactly thought this plan through. This was a highly-educated person who was thinking of making one of the biggest financial transactions of her lifetime and she as relying solely on information she obtained from HGTV. She wanted to buy in my current area so I already had a good idea what the missing numbers were.  We calculated it all and concluded that she was going to be losing money every single month. I thought, well at least she figured this out before signing on the dotted line.

Then the bombshell came.

“I already put the deposit down.”

Real-estate investing 101

Investing in real-estate is a great way to build a steady stream of income that could one day replace the current income you generate from your job and then some.  Many financially successful people in the world have real-estate investments in some form or another. I must have read at least a dozen or so books on the topic as I’ve always been fascinated by real-estate investing.

It’s not an overly complicated process and it goes something like this: you put down 15-25% of the purchase price, you make a few repairs or renovate it to maximize rental potential, and then you rent it out to a suitable tenant(s). The key is that the rental income is more than all the associated costs including mortgage payment, insurance, property taxes, reserves for damages and times the unit is vacant and all associated maintenance costs. At the end of each month, there should be a surplus of money known as “cash-flow” which you can use for yourself or to store away for more property acquisitions down the road.

As time goes on, you can leverage the property to buy other properties or you can just sit on it until the mortgage is paid off and collect the rents until you ready to sell it. Or maybe you’ll redevelop the property into something else once you raise enough capital. There, I saved you the time and effort of signing up for a real-estate seminar or reading a book on topic. You’re welcome.

From positive to negative

For the past few years, I’ve been looking at various semi-detached and detached homes in the Toronto area with the intention of doing some renovations and then renting it out. Every single property I looked out was a losing proposition. The only way to make money was to put down 30-40% plus another $50-90k for renovations, which was an obscene amount of capital and would have put my entire net worth into one single asset. It’s the equivalent of putting all your money into one stock, a very high risk and ill-advised strategy.  I’ve been burned before betting everything on one horse and I was not going to repeat history again.  But, maybe it was just me and others were making money?

What I’m about to tell you may seem shocking to some, even those who attended the Real-Estate Wealth Expo in Toronto recently and were told real-estate investing is a viable way to make money in Toronto and to do whatever it takes to buy real-estate.

Most “investors” who entered the market in the last 2-4 years are losing big money every month. I don’t know about you, but investing is about making money every month, not losing money. When you buy shares in a company, bonds, preferred shares, ETFs, mutual funds, REITs or any other financial asset, there is an expectation that your investment will grow via dividends, distributions, interest and, hopefully, a capital gain. But, would you buy a financial asset and pay several hundred bucks or even a thousand dollars a month to hold it? Heck no! What sane, rational investor would do that?

While gyrating expert Pitbull may have given an inspirational speech on going from negative to positive at the Real-Estate Wealth Expo in Toronto a couple months ago, he would have done a better service explaining to the audience how in reality real-estate investing went from positive to negative. I now welcome you to the world of Pitbull Voodoo Math. 

 

Minority Report

John Pasalis is a real-estate agent and president of Realosophy Realty in Toronto.  Mr. Pasalis recently wrote an extensive report analysing the Toronto and GTA real-estate markets to ascertain why prices have exploded in the last few years.  As you may not know, real-estate data in Toronto is a closed system. You and I cannot find out the selling price of a home and what it sold for the last 5 times, only a realtor with access to the MLS system can (in case you’re wondering, most other places in the world have an open system).

Mr. Pasalis wrote an extensive report analyzing all the data and he reached a startling conclusion: 95% of all real-estate investors who bought properties with a whopping 35% down payment lost money every single month in 2016. 

Now, earlier in this post I indicated that real-estate investing usually involves putting a down payment of 15-25%, which, therefore, means anyone who put down less than 35% was almost 100% assured of losing money. There are few things in life that are sure bets – the two big ones being death and taxes. Should we add Toronto real-estate investing = losing money to that list?

Mr. Pasalis also noticed something different happening with the market, people were coming into his office eager to purchase money losing properties because they wanted to flip them a short time later. These buyers were willing to take out line of credits and even use their credit cards to pay the monthly difference. Here is the kicker – in Toronto the average “investor” was losing a monstrous $1,121.00 every single month. Welcome to peak insanity ladies and gentlemen!

It takes a lot of chutzpah to write a thorough, well-researched, methodologically sound report that directly debunks the narrative that some of your peers preach and will likely ostracize yourself (send me an email if you want a copy). I would imagine Mr. Pasalis will be cut off the Christmas card list from many of his colleagues this year because he called a spade a spade.

What does the industry say about this report?

I inquired with various industry players on their thoughts on your behalf. As expected, no one replied to my inquiries. This wasn’t a great shock; if I was a real-estate agent I would probably have better things to do with my time then to respond to some shmuck’s questions about a less than favourable report. 

So, I did what most Torontonians do on a Saturday afternoon in the spring, I went to a whole bunch of open houses.

Hitting the pavement

I attended some open houses in the Mt. Pleasant and Eglinton area which is one the hottest areas in the city right now when it comes to real-estate. Houses here, as I was told, do not sit for more than 5 days before they are scooped up.  

As you and I have read in multiple newspapers, magazines and blogs over the past few months, open houses are apparently mini-circuses where hundreds of people come in droves to check out the place before making a hasty offer above asking price.  Well, the open houses I attended were pretty much empty. These were sub $1 million homes – the most desired and lusted for digs. This was spring time in Toronto, the proclaimed hottest real-estate market in the world, on a Saturday with beautiful weather and it was just me and one couple touring the open houses. I say one couple because we followed each other to the other nearby open houses. At one house, we gave each other awkward looks when we simultaneously noticed that the upstairs floors were wobbly; it was a true Kodak moment, I wish you were all there to see it.   

I spoke to the realtors who were managing these open houses. All were very nice and knowledgeable individuals. After asking them some basic questions about the property and developing a good rapport, I casually brought up Mr. Pasalis’ report. The mood instantly went from joyful and friendly to apprehensive and vigilant. Apparently, they all read it! They all downplayed it and stated I shouldn’t take anything from it as it was “wrong”. Most realtors declined to answer any more questions on the topic.  As a lawyer who deposes people on a weekly basis, failing to answer questions means something was amiss.

One took the bait, however. “The assumptions made in the report were faulty,” she stated. I asked if she could explain that and I received a nonsensical answer. I pushed a little more, “was the math done wrong?”  She replied, “well, that I don’t know, but our office puts little weight on it”. After receiving this politician answer, I asked the big question, “listen, I understand you don’t agree with it, give me something, anything, to dispute the findings written here”.  I was met with deafening silence. She then changed the topic to the new appliances put into the home, which were quite attractive and sparkly I must say.

In life, when someone doesn’t give you an answer to an important question, it’s usually because the answer isn’t pretty. For example: if you ask your significant other “did you cheat on me?” and your partner is silent, odds are high the answer is not great.  Even for the mundane things in life such as asking a server at a restaurant if a dish is good and the server is silent, odds are high it’s a crappy dish.

It was at this very moment that this realtor knew that I knew, and all you reading this blog now knows, that real-estate investing in Toronto died. It died a painful death a long time ago. What remains is the high-risk game of speculation and Pitbull Voodoo Math – losing money every month.

*** 

When I initially wrote this blog post, I referred to this wonky math as “Hood Rat Math”. “Hood Rat” is a pejorative term used to describe inner city persons engaging in scandalous activities, usually illegal.  After eating a large bowl of Reese Peanut Butter Puffs, and careful reflection, I decided to go with Pitbull Voodoo Math because it would have been insulting to inner city drug dealers who have a clear understanding if they are making or losing money at the end of every month.

All joking aside, there are now countless people like my physiotherapist, Lauren, who are losing obscene amounts of money every month on so called real-estate “investments”. Most are too afraid to admit it for fear of feeling like a failure and others are adamant that they will time the market perfectly and make out like bandits. This is the problem when Pitbull’s Voodoo Math has infected the masses. How long this game of taking out cash advances on credit cards to pay the monthly losses on these properties is anyone’s guess.  All I can say is that it’s a very toxic, high risk endeavour.

Stats are hard to come by, but some condo developers have stated that 1 in 2 units are now going to investors.  The Minister of Finance in Ontario recently stated on TV that some people are buying dozens of pre-build houses with the sole purpose of flipping them. We have seen this exact behaviour before all over the world and even in this city just 30 years ago. We know the results.

The Greater Fool Theory

The greater fool theory is probably the simplest concept that will be discussed in this blog. “I may be a fool by paying X dollars for this object, but I know there is a greater fool out there who will pay me more for it”. The object can be anything: tulip bulbs, Nortel stock, beanie babies, oil, gold, Miami condos, artwork, and even Toronto real-estate. The only thing that matters is that there is someone out there who is stupider and will pay more for something than what it’s really worth.

This game of hot potato or musical chairs, whichever analogy you prefer, works just fine if there are enough irrational market participants with access to greater and greater amounts of cheap money. People participating in this game are only playing to quickly make a buck, not because they believe the object is worth anywhere close to the price they paid. It’s the definition of Russian roulette because the last one holding the bag is the true greater fool. He or she is the one who ends up paying the most for that object that quickly depreciates back to its true intrinsic value.

Will you be the greater fool?