Author: Mr. Cheap

Go the first post in the 5 ways to make money with investment properties series.

Inflation

In most investments inflation causes you problems. With real estate investing its your friend in a major way.

Inflation is measured by taking an imaginary basket of goods, and figuring out what they’d cost at different points in time. If the purchases would cost more then they would have in the past, the difference is the inflation rate (if it costs less, the difference would be the deflation rate). How much inflation affects you depends on what you typically buy and in what amount. If you don’t drive, clearly the gasoline component of the “basket” wouldn’t affect you as much as it would affect drivers (it will still affect you as increased gasoline costs will get passed along to consumers in the price of any items that requires gasoline for production or distribution – e.g. anything you buy that’s made in China or if you buy a bus tickets to go to Calgary).

House prices (or at least housing costs generally) make up a large part of the inflation measurement. Therefore, house prices and inflation are strongly correlated (some could argue that increasing property values is one of the driving forces of inflation and that house appreciation and inflation are basically the same thing).

Say we buy a house for $100K, get an interest-only mortgage and inflation is 3% over the next year. How much do we expect our house to be worth? In “real” terms (inflation adjusted) we’d expect it to still be worth $100K in todays dollars. In terms of future dollars though, it will actually be worth $103K.

So we now see that without doing any work, our real return on the property purchase is roughly the inflation rate (3%, or a real return of 0%). Since GICs give a real return of 1%, this isn’t too shabby!

It gets better though.

Since we have an interest-only mortgage and have been paying the interest (part of our cost of living, for simplicity’s sake lets say the interest, utilities, maintenance and taxes are equivalent to what we’d pay for rent and ignore them). After a year the mortgage is still $100K (since we’re paying interest only), however, after that’s adjusted for inflation, the $100K mortgage is only actually worth $97K to the bank (money in the future is worth less then money today).

Once we remove the speculation element from real estate pricing, we can clearly see that part of our return from the property is:

Or, in the case of a 100% interest-only mortgage, double the inflation rate times the property value.

Not too shabby at all!

Most of our methods to make money with real estate can backfire and cost you money. Clearly the speculative element of price appreciation is totally beyond your control (or ability to predict), however this is one of the nicest returns, because as long as we have inflation (I don’t think its going anywhere soon), you can pretty well count on this portion of your return Extended deflation would be the negative risk of this portion of the returns – however, again, I can’t imagine a situation where that would happen here in Canada. If it did we’d have worse problems then poor real estate investment returns.

See the next post Taxation.

Go the first post in the 5 ways to make money with investment properties series.

Benefits and dangers of leverage with investment properties.

Whenever people get talking too much about O.P.M. (other people’s money) keep your hand on your wallet and start moving towards the door because they’re about to pitch a get rich-quick-scheme to you. On the other hand, leverage is a valid and powerful way to magnify you returns (good or bad) on an investment.

Say you’re opening a store, and you have the money to afford a small 800 sq. ft. shop. In such a space you feel you could earn a 20% annual return on your initial investment, working there full time. If you considered borrowing money at 7%, getting a larger shops (say 2000 sq ft), selling a wider range of merchandise, etc, etc and earn a projected return of 14% on your money invested and the money borrowed. All other things being equal, it would probably be well worth considering borrowing the money. Your time investment (1 year) is the same either way, but a 14% return on your investment, plus a 7% return (14%-7%) on the borrowed capital would give you a higher return if they were equal amounts (21%), and increasingly large returns the more money you borrowed after that.

The obvious downside is the larger venture will have a high risk (volatility). If you start a business with your own money and it goes bust, you lose that money. If you start a business with borrowed money and it goes bust, your creditors will do whatever they can to make your life unpleasant.

With real estate, a commonly used example is buying a house for $100K. If you buy the house outright (with your own money) and it appreciates 3% (so its now worth $103K), you’ve earned a 3% return on investment (ROI). If you buy the house for $100K, with 10% down ($10K), and it appreciates 3% you’ve earned a 30% ROI!

Clearly in such a situation the interest, maintenance and closing costs to buy and sell the property would be far more then 3%. However if you rented the house out to cover all these costs, clearly its nicer to earn $3000 from a $10K investment instead of $100K investment. Even then its not a totally fair comparison, as your costs would have been lower if you hadn’t borrowed the money, so therefore your return would have been higher (more then 3% – probably more like 10% if you had avoided a 7% mortgage). We’ll ignore this for now, although I do acknowledge the omission.

My consideration with leverage is to look at the ROI of the investment, add a margin of error and make sure that I expect to be earning more then I’m paying for using OPM. At 5.05% (what I got on my last mortgage), it isn’t too hard to get better returns then this. I would be very reluctant to borrow money at 20-30% (like you sometimes hear about people doing to pursue “sweet deals”).

One of my favourite lines about leverage is that its a power tool. It lets a craftsman do a much better and faster job, but you can injure yourself more easily and much worse.

In part 3 I’ll talk about inflation.

Its been a while since I wrote about real estate investing. One of the common comments from people who have considered investing in real estate (and decided against it) is that the returns are too low for the labour invested. This is fair, however, like any investment, its worthwhile to estimate, as exactly as possible, WHAT the returns will be, THEN decide whether its worth putting the time into it or not. For me, I can get a $40 / hour contract fairly easily for full time work, and my real expected stock returns is around 6% or so (with dividend aristocrats or indexing), so I want my ROI to be at least 6% of money invested + $40 / hour. My experience has been that this is quite easy to achieve, and in this series I’ll detail how.

For each post, I’ll try to detail how you can make money (or lose it) using that concept so that you can hopefully appreciate the risk/reward trade-off a little better.

For a property that you’re considering purchasing, you’ll want to make sure that it has a “positive cash flow” (which simply means that it makes money every month). Some people count on the other ways to make money (to be detailed in later posts) and ignore cashflow (the property costs them money every month). This is a very bad idea (especially early on in your real estate investing career).

Very roughly, a property price should be at most 100 times the monthly rent (Gross Rent Multiplier – GRM).

To start, estimate the market rent for the property you’re considering. Newspaper classifieds and craigslist are probably your best method of doing this (although the management office of the building, if you buy a condo, can give you a good idea of the average rent). Try to be realistic with this, and not just assume people will pay top dollar because its your property (if its a run down property, err on the low side of the range). Renters as a whole are quite savvy about what market rent is (even if they can’t articulate it, they’ll feel like a place is “reasonable” or “expensive” after seeing it).

This is your income. Next, add up the property taxes, utilities (if you pay them), condo fees, insurance, and management fees (if you’re hiring a property manager or management company). Add on 5% of the rent for vacancies, and 0.17% of the purchase price for maintenance (assuming you’ll spend 2% of the value of the property on maintenance each year – you could drop this for a condo since you condo fees include the external maintenance).

If your expenses are more then 45% of the income, you should probably keep looking.

E.g.: I bought my condo for ~$130,000, and rent it for $1300 (I had hoped to get a higher rent, but in the end got just about exactly 1/100th of the purchase price). Condo fees are ~$500, property taxes are ~$100, insurance is ~$40. Vacancies would be another $65, and maintenance (at ~0.8% of purchase price) would be about $100.

805/1300 = 62% (so do as I say, not as I do 🙂 ). This also doesn’t include my labour managing the property (many real estate investors make the mistake of considering their labour as wortheless).

I was willing to pay the 17% premium as my “tuition” for learning more about real estate, but will certainly expect better deals in the future. Condos are notoriously bad investments for a variety of reasons. The condo fees are usually quite an inefficient way to cover expenses (its a tragedy of the commons problem if you’re familiar with the concept), there’s a lot of competition (with many people becoming landlords when they decided to hold on to their condo and let it appreciate – since these are often naive investors, they’ll charge rents that don’t cover their costs and drive investors out of the market, and because its a small unit, you don’t get any of the economics of scale that you would with, say, an apartment building).

Once the 45% of expenses is paid, the remaining 55% of the monthly rent is for servicing debt and your cashflow. The higher down-payment you make, the smaller the debt to be serviced, and the more money in your pocket each month (of course, at a higher cost).

$1300*0.55*12 = $8,580 / year. $8,580 / $130,000 = 6.6% (in an ideal world). Given I’m earning $495 / month after expenses (1300-805, see above): $495*12 = $5,940 / year. $5,940 / $130,000 = 4.6%. Therefore, as long as my mortgage is under 4.6% this property would be cash flow positive with 0% down (with vacancies and maintenance factored in). I made a 25% down payment and got an interest rate of 5.05% so I had enough wiggle room to make it work (and in the end I’m clearing about $250 / month from the property).

PLEASE keep in mind that the 6.6%/4.6% above is JUST the interest. If you’re right at the edge, the property might be covering its own interest but you may have to put in money for the principle portion of the payment. This is less then ideal (but certainly better than having to put in money to cover the principle and part of the interest).

Currently, in order to sleep at night, I like to make sure that I could carry my entire real estate holdings using income from my day job. Obviously this will get more difficult as I expand beyond one property, but the chances of all my properties being vacant (or having tenants in each property refusing to pay rent or leave) will be less likely as well. Once I’ve had the properties operating for a period of time and have a better estimate of the expected risk and returns I’ll probably forget this criteria (however I think its a very good “safety net” for your first year or two).

Given just the cash-flow returns, it would be easy to question why anyone would get into real estate when you can get GICs paying 5% these days and can expect a long-term pre-inflation return of 10% on stocks. In the next post in this series, I’ll discuss leverage.