“Success is a lousy teacher. It seduces smart people into thinking they can’t lose.” – Bill Gates
If you had a stressful 2023 financially, you’re not alone. We had an incredible bull run from 2009 to 2021 and, quite frankly, it seduced a lot of people into thinking that was normal. For many of you, a twelve-year run is all you’ve ever known, so why would you think it could be any different? And if things didn’t get challenging, why would you think it wouldn’t be temporary? After all, leading economists in early 2022 were telling us that inflation was transitory. Even the Bank of Canada (BoC) was telling us that high interest rates would be temporary.
You’re smart. But when nearly all your experience is within that bull run, and nearly every expert around you is telling you that you should have faith in the process, why would you question your success?
Now you are doubting yourself when in fact you just need perspective. You weren’t wrong in your approach; you just lacked the perspective and tools to protect yourself.
You are smart. Smart people assess the situation, regroup, and activate their next steps.
Embracing Uncertainty
So why did I do well in 2023? It really isn’t because I am an oracle with special powers; I am not. I did have concerns coming into 2022, but I chalk that up to considerable experience and an intuition derived from my passion in the real estate investment sector.
I am older than most of you, so I have the benefit of having experienced things that you may have not. I didn’t personally experience the intense inflation in the 1970s. I’m not that old! But I did witness the stress my parents had with the resulting high interest rates. I even remember my mother mentioning how lucky one of our neighbours was for having locked in a long-term rate of 6%. I don’t know why that conversation stuck, but it did.
Through most of the 1990s when I was buying my personal houses, interest rates were relatively high. We were all used to it. It was normal. In 2005, I bought my first investment property. In my first podcast with Erwin Szeto in 2019, Erwin asked me what interest rates were like then. They were around 5% for a 5-year fixed and perhaps 4% for a variable rate. In 2019, that would have sounded ridiculous. Today, that sounds about right; maybe even favourable!
Buying that first investment property (a purpose built 4-plex), was a scary thing. It was necessary as I had no pension and I needed to find ways to prepare for eventual retirement. It was scary because we were a single income family where, quite frankly, we were spending as fast as the money came in and maybe more than that. I had no experience as a landlord, and I understood nothing about real estate investing. However, I was good at math and I had fear on my side.
Why was fear good? Because it made me think about “what if” scenarios. I knew I had to invest to secure my future, so saying no to a purchase didn’t feel like an option really. Instead, I channeled my fear into considering my risks and my contingency plans. When I understood my contingency plans, I had the confidence to move forward.
Risk Management
There are of course lots of risks of which some you cannot manage. But one I could manage was my mortgage interest rates. I opted for a fixed rate even though it was more expensive. Why? Because I could put a plan in place to deleverage and increase my cash flow when the five-year term was up for renewal. By doing so, it was literally one less thing I had to worry about, and it significantly limited my overall risk. It turned out to be a good decision. Interest rates climbed in the next three years, but then fell in years 4 and 5. I learned from this.
Risk management is a cornerstone of my investment business. It is not a tool to say why you should not do something (though it can), but it is a tool to help you manage the exceptions to your plan.
Here are the four crucial plans I create in my business:
Operating Plan
The purpose of an operating plan is to outline the financial details of the real estate business for the upcoming year. Ask yourself – what is our revenue, expense, and debt profile? Consider structuring this as a series of proformas for each building you own all summed together. You can also add components for non-real estate business activity.
- Revenue Profile: Sources of income, such as rent and other revenue streams.
- Expense Profile: Anticipated costs, including property management fees, maintenance, taxes, insurance, and utilities.
- Debt Profile: Details of existing debts, like mortgages, interest rates, and upcoming payments.
Cash Flow Plan
Your cash flow plan is crucial to help you identify the sources of cash inflow and outflow, ensuring the business remains financially stable.
- Income Sources: Rent, additional services, or other revenue streams.
- Expenditure: Operational costs, debt service, and planned renovations or improvements.
- Employee and Contractor expenses: These are sometimes referred to as G&A costs (general and administrative costs). These are costs not already covered in “Expenditures”. For example, my staff (including me) are included here.
- Variances: Anticipate periods with reduced or no income, especially during renovations, and plan for contingencies. While your Operating Plan may already include market vacancy assumptions, you will have other interruptions such as taking a unit offline for 3 months to renovate it. Or you may have extraordinary marketing expenses.
Capital Plan
The purpose of a capital plan is to define how the business will secure funds for property acquisition, renovation, or construction. Where are you getting money to buy, renovate, or build your next asset? Consider having more than enough capital (money) on hand to complete your plans.
- Acquisition: Strategies for funding property purchases, including equity, loans, or partnerships.
- Renovation/Construction: Financing plans for renovation or construction projects, considering short-term financing options.
Risk Management Plan
A risk management plan aims to identify and mitigate potential risks that could impact the real estate business. What needs to be put in place to protect your business?
- Insurance: Adequate coverage against risks like natural disasters, liability, and damages.
- Legal Protections: Establishing legal structures for liability protection.
- Market Risks: Analysis of market trends and contingency plans for economic uncertainty.
- Staffing Risks: Ensuring you have your staffing plans and contingency if someone becomes unavailable do to illness, or termination.
- Interest Rate Risks: Put a plan in place in case interest rates do not go the way you expect they will.
- Project Risks: For each project, identify what could go wrong and ensure you have aback up plan (contingency).
- Other: If you can’t sleep at night or you are worried about something, write it down, consider the probability of it happening, the impact it would have on your business, and what your contingency plan will be.
Deleveraging Plan
Use your risk management plan to plan actions to be taken before mortgage renewals to avoid equity top-ups or to take advantage of favorable rates. Ask yourself – what do I need to do before a mortgage renewal to ensure I do not have the lender ask me to top up equity or, if rates are favourable, allow me to do an equity take-out.
- Equity Management: Regularly assessing and increasing equity through property value appreciation or debt reduction. Do not reply on market appreciation. Consider instead what you can do to the property to increase its value.
- Inflation: Inflation reduces the value of your debt relative to the value of your asset. Make modest assumptions about inflation and how it will affect your debt profile before the loan’s maturity.
- Interest Rate Management: Monitoring interest rate trends for potential refinancing opportunities if they are favourable. Consider a ReFi as opportunity in your delverage plan. But the intent is to bring the leverage (amount of debt vs value of the asset) down over the mortgage term.
- Regular Financial Health Check: Regular reviews to strengthen the financial position and prepare for mortgage renewals.
Protecting Your Real Estate Portfolio in 2024 and beyond
It’s critical to implement a proper plan to support your success this year and into the future.
Do this for your business; do this for your family. I refresh my plans annually and monitor them monthly.
Now as we head into 2024, consider the following:
Put Your Five Plans in Place:
Start by implementing the five essential plans – operating, cash flow, capital, risk management, and deleveraging. These plans serve as the backbone of your real estate investment strategy, providing a structured framework to guide your decisions and actions. Work on these plans now and refresh as necessary when you know more.
Consider Purchases on Your Terms
I have been buying properties on my own terms. Take advantage of a buyer’s market by assessing potential purchases on your terms. Fear in the market can limit competition, offering you opportunities to negotiate favorable terms. Be strategic in your acquisitions, considering long-term value and the potential for future growth.
Assess Property Values Based on Current Parameters
Evaluate the value of properties based on current market conditions and interest rates. Steer clear of valuations rooted in the past, focusing on today’s parameters. This approach will ensure that your investment decisions are aligned with the current realities of the real estate market.
Reassess Assets in Your Portfolio
Regularly review the performance of assets in your portfolio. If any property is lagging in Return on Equity (RoE) or adversely impacting your operating and cash flow plans, develop a strategic plan for it. This may involve optimizing its performance, renovating, or considering a sale to reallocate resources effectively.
Restructure Debt for Optimal Cash Flow and Risk Management:
Explore opportunities to restructure debt to enhance cash flow and mitigate risks. This proactive approach allows you to align your financial obligations with your plans, taking advantage of favorable interest rates and optimizing the overall financial health of your real estate portfolio.
Free Up Working Capital for Contingency and Opportunities:
Seek ways to increase working capital, ensuring you have cash reserves for contingencies and seizing buying opportunities. Maintaining liquidity provides flexibility and agility in navigating market fluctuations and unexpected challenges.
Continue Learning for Effective Discipline:
Prioritize ongoing education to stay informed about market trends, regulations, and emerging opportunities. Continuous learning is crucial for establishing effective discipline in your real estate investment strategy. It equips you with the knowledge needed to adapt to changing conditions and make informed decisions, ultimately contributing to the long-term success of your investments.
The Complex Nature of Interest Rate Predictions
Many people are asking about interest rates. I have my theories, and not surprisingly, they are not in line with most pundits. In a future article, I will explain my theory. But let me be clear, I view my predictions to be only slightly better than random chance. The economy is incredibly complicated and subject to things beyond our control. As such, establish your risk management plan for your debt! Whatever you choose to do, what if you guessed wrong? What if the pundits are wrong? What is your contingency plan? If things are better than you hoped, then that is upside!
Remember, you are smart! You can do this. Opportunity presents itself when others are cowering. Just focus on your discipline!
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