BUSINESS & INVESTMENTS

Some Simple Safety Tests for Real Estate Bonds

A. W. BLUE December 1 1927
BUSINESS & INVESTMENTS

Some Simple Safety Tests for Real Estate Bonds

A. W. BLUE December 1 1927

Some Simple Safety Tests for Real Estate Bonds

BUSINESS & INVESTMENTS

Hundreds of thousands of dollars are lost annunlly in Canada through careless investment. Fraudulent and worthless securities nro being constantly poured on to the market to entrap the unwary. A gcnernl observance of this simple maxim will assist in the reduction and elimination of this economic waste—

“BEFORE YOU INVEST—INVESTIGATE”

A. W. BLUE

THE average Canadian citizen is more or less familiar with that type of security designated as a first mortgage on real estate. If he is a property owner the chances are a hundred to one that he is struggling to meet interest and principal payments as they fall due at regular intervals. His knowledge of mortgages is thus gained in the rigorous school of experience. Or he may be in the favored position of receiving these pen odic payments on sums loaned out some time before, and if so he can be classed as an investor, with a real estate mortgage his investment.

For many years the real estate mortgage has been a favorite medium for the investment of surplus funds. Especially was this true a generation or more ago. Prior to the opening of the twentieth century the volume of government and corporation securities on the public market was comparatively slight. Canadian corporations were small, and their financial requirements restricted, and indeed both corporations and governments found it advantageous to borrow in outside markets, more especially in Great Britain. Thus the public had little interest in corporation securities, nor had they any special opportunity of becoming familiar with them until the direct and personal appeal made to every individual through the financing of war time, which opened up new channels of investments, and stirred up vast sums of hitherto latent investment funds. In the past fifteen years new and hitherto undreamed of outlets for investments have been created, and to-day, the problem of safely and profitably investing idle funds is a comparatively simple one.

But in the pioneer stage of Canada’s development the mortgage held the premier position in the investment field; especially in the rural sections of the country, where a first mortgage on favorably located farm land even took precedence over government bonds. The real estate mortgage in those days was small enough to be handled by the individual investor, who was usually in a position to appraise the situation and prospects for himself. He obtained first hand knowledge of his investment, and if prudent and conservative, could ensure the maximum of security for his loan. The mortgage has ever been a favored medium of investment with loan companies. Huge organizations have been built up in Canada for the specific purpose of loaning ’ funds on real estate mortgages. These i institutions have always concentrated on mortgage investments, but in later years funds have so accumulated that mort! gages were not always readily available, I and huge reserves have been invested in government bonds and other gilt edged ! securities of similar type.

A Glorified Mortgage Bond

r"PHE real estate mortgage, however, is r coming into its own again, perhaps [ in glorified form. Changing times and

customs have brought new tendencies both in construction and in the financing of building projects. Office buildings, apartment houses, hotels and other corresponding types of construction are now largely financed through the sale of mortgage bonds to the general public. In the old days a single investor could handle the mortgage on an individual piece of property. Not so to-day. With a construction project running into hundreds of thousands or perhaps millions of dollars, it is obvious that no one individual or institution would be able or willing to handle such a project alone. And so the real estate bond, with a new dress, but retaining the old inherent customs and traditions has become a prominent and popular member of the investment security world. These bonds are sold to the general public, usually in one hundred, one thousand or five thousand dollar denominations, and a great many people thus become interested in a single project. The earnings through rentals, leases, etc., take care of interest charges, on the bonds, and sinking fund requirements, as well as provide for maintenance and upkeep.

This form of public financing is comparatively new in Canada. The experience of United States investors with real estate bonds extends back a number of years, and the record of real estate securities has been satisfactory thus far. The potential investor in a farm mortgage was able to appraise the character of his investment with great accuracy. He was acquainted with the locality in which the property was situated. He knew the conditions of the house, the barns and other outbuildings, the fences, the amount of woods, and the different kinds of soil the farm contained. He also knew land values in the neighborhood, and he could set an accurate selling price upon the property in which he was interested.

The situation is complicated to-day. So many factors are to be considered in the construction of a mammoth office building or apartment house, that the investor is hopelessly at sea when he attempts to apply the same methods of appraisal as he used in the case of the farm mortgage. He must rely largely upon the estimates of professional appraisers, and trust to the integrity and acumen of the sponsors of the project. But there are a number of points that he can investigate and consider for himself, and their intelligent consideration will set up a guard against haphazard investment, and thus tend to minimize the risk element which is inherent in real estate mortgages as it is in the securities of representative business ventures.

Consider the Business Outlook

IN THE first place, it is desirable to consider the business outlook, and the prospects for growth and development of the city in which the projected building will be located. The trend of business will largely determine the demand for office or hotel accommodation. If business

likely to improve, or is the country now riding on the crest of a wave of prosperity, with all indications pointing to a recession of some extent and duration? If business is on the upgrade, will the momentum be sufficient to attract new population to the urban centres and thus set up a new demand for office space. Is the city amply equipped to provide the special accommodation that is required under favorable business conditions, or will the new project fill a definite need?

Building and Location

THE building itself, and its location, are factors worthy of particular study. Is the location favorable? Is the section of the city suited to a building of the type contemplated? Is the district likely to improve, thus enhancing real estate values, or is it on the downgrade? Can a genuine need be foreseen for the building, or is it merely a speculative venture, undertaken in the hope that it will fill a want not now existing, but which will probably develop in the future? The project should be of modern construction and up-to-date in every respect, and the investor should assure himself that the building will far outlive the life of the bonds.

Conservative Solution

FURTHERMORE the investor should assure himself in so far as possible, that the estimated value of the property when completed, is fair, and that the face of the bond issue is conservative as compared with the estimated value of the property. It is obvious that if a bond issue represents one hundred per cent, of the value of the project no provision has been made to compensate for a possible slump in the real estate market. Usually the task of computing values is left to interests who make a specialty of this type of work. The investor can ascertain the reputation of the valuator, for probity and conservatism, and he should see that he is a disinterested party to the deal. Independent estimates are of value as a checkup. Any real estate firm could supply this information. Trust companies are usually the most conservative of all in their land valuations. If a further check is desired it may be secured by an investigation of the proportion of the assessed value for taxation to actual prices at which other pieces of land have recently sold in the neighborhood.

Loan Standards

HAVING computed the aggregate value of land and building, it is the duty of the investor to assure himself that the bond issue represents a conservative proportion of this valuation. No hard and fast rule can be here laid down, but some suggestions are presented as a guide. John Moody, well-known American statistician, presents the view that this proportion may safely run between fifty and sixtysix and two-thirds per cent, in large cities. The Dominion Insurance Act prescribes more conservative standards in the case of mortgage loans which are authorized investments for Canadian life insurance companies, writing under federal charter. This maximum proportion runs about sixty per cent. Loan companies follow this standard in loans upon well established urban property.

Checking Up Estimates

THE investor can check up the promoters’ estimate of earnings through rentals, and this is an important item. The large life insurance companies of New York which carry heavy investments in real estate mortgages in the leading Canadian cities, have adopted a simple rule. They point out that an office building or apartment house should show gross yearly earnings of fourteen per cent, on its total valu?, or ten per cent, net yearly earnings on total value. The net remains after operating exp nses and

allowance for vacancies. This check may be roughly applied as follows: Multiply the estimated gross earnings by seven. The total should not be less than the total valuation of land and building. Multiply the estimated net earnings by ten, and the total should not be less than the total valuation of land and building.

Life of the Issue

THE investor should take cognizance, too, of the maturity date of the bond. There are many instances of bonds or debentures issued on the security of pavements or bridges continuing to live and draw interest long after the bridge or sidewalk has disappeared. The possible life of a large building is an unknown quantity, but it must be borne in mind that styles are changing rapidly, and what is up-to-date to-day may be cast into discard to-morrow. This is especially true when applied to large office buildings, and it is well to see, therefore, that the bonds will mature well in advance of any likely serious decadence of the building or depreciation of its value. A life of twenty years for a real estate bond issue is generally accepted as the standard term.

There are interesting investment opportunities in the real estate mortgage field, but here, as elsewhere, the investor, to attain the highest degree of success and satisfaction, must exercise intelligent discrimination. The serious application of the foregoing tests will render the investor less dependent upon the salesman’s ‘say so’ and tend to direct his activities into conservative channels.