Category: Real Estate

I’ve posted on the topic before, but I’ve been looking at Toronto area multiplexes and have bumped up against the issue of asking price vs. market rent again.

ICX (like mls but for commercial properties) has some nice little properties listed (this link will expire in the near future, don’t feel bad if its dead). The property linked to is a nice 3-plex in North York which brings in $2,075 / Month ($24,900 / year) and the owner is asking $299,500.

A good “back of the envelope” calculation for real estate investors is the GRM (gross rent multiplier). This is basically the price / rent (so a lower ratio is better than a higher ratio). Its a good way to ballpark if a property is worth looking at more closely or not. Some sources claim you should use the monthly rent, some claim you should use the annual rent (it doesn’t matter which you use, as long as you’re consistent).

Capitalization Rate is far more illuminating (its based on the net profit instead of the gross income), but takes a bit more digging to calculate.

My condo, with a monthly rent of $1300 and a purchase price of around $134K (accepted price + renos – not including legal or anything else) would have a GRM of 103 (134000 / 1300). In comparison, this building has a GRM of 144. Given that multiplexes should be MORE lucrative than condos (not far less), this especially pitiful.

High GRMs also are good at telling us when housing prices are getting far above rental rates (which is a good indication of an overly frothy real estate market).

If we turn our eye north, and have a look at this gem in Thunder Bay (its a 6-plex but we can ignore that for the time being), we see that in the true great white north a rent of $4,100 / month (49,200 / year) can be had for $249,000 (twice the income for a lower price). This gives us a GRM of 61, which is far more like it!

“But Mr. Cheap…” you protest, “Toronto is a big city, OF COURSE property costs more here!” Yes. But shouldn’t rents be higher too? GRM lets us see the relationship between the stream of income from a piece of real estate and the purchase price of that stream. Even if its harder to find tenants or to sell the building in the future, the higher income for lower purchase price certainly makes property outside the GTA look attractive (not even mentioning the upcoming increased transfer tax).

Any other towns in Ontario that you guys think give a better GRM than Toronto (or perhaps to belabor the point, any with worse numbers)? What do the numbers look like in Windsor Telly?

My friend Christine has kindly agreed to write a series of posts on her experiences with buying a home for the first time which will be posted occasionally.

And so the search begins…..

It goes without saying that home ownership is an enormous financial responsibility, and like many other individuals, I agonized over how my husband and I would be able to afford it. What eased our anxiety was coming up with a manageable monthly amount that we would be able to pay towards a mortgage. We created a realistic budget listing all our expenses to evaluate how much we could afford to spend on our first house without stressing out about the big number. The rough amount that we arrived at is one with which we are comfortable based on our lifestyle. I would suggest that this budget take into account unexpected emergencies or financial difficulties. Lenders advise that the ratio of your debt (including housing payments, car payments, credit cards and utilities) to your income should not exceed 40 per cent of your monthly income.

Online mortgage calculators are a useful tool found on the web pages of CHMC, major banks and lending institutions. What was frustrating though was that they work on the premise that you have a house in mind and know what the mortgage, property taxes and heating will cost. To plug in the numbers, I looked at the feature sheets of recently available homes in my desired neighbourhoods that I was able to obtain from the MLS, on the websites of local real estate agents and of course from open house visits. While the results of your qualifying mortgage will not be precise, at least they will be a reasonable estimate of what you can afford.

My next step in arriving at our financial big picture was to get a pre-approved mortgage (PAM) by talking to a couple of banks and mortgage brokers to determine how large a mortgage we could carry and what lending rate we could obtain. A PAM is a financial lender’s guarantee of a particular lending rate for a specified period of time, usually 90 days, based on your income, down payment and existing debts. A note of caution though with pre-approvals. We learned from a realtor that multiple credit checks can be detrimental to your credit rating. If several banks or brokers will be conducting a credit bureau check, do advise each organization about the multiple reference checks. Some lending institutions can also evaluate your mortgage circumstances based on the information you provide without doing a hard credit check.

The standard mortgage discount seems to be 0.9% below prime to 5.35% on a variable mortgage and a 1.5% discount to 5.74% on a fixed rate mortgage. Do shop around though as your assets and liabilities may impact your ability to negotiate a better deal. Incidentally, ING offers the same rates I found upfront without any haggling; they seem to have a very competitive mortgage product.

Rather than approach banks individually, you may consider using a mortgage broker. These are companies which have the ability to negotiate with a large number of different lenders and are often able to offer a lower rate at a bank than the average person. There is no cost for the services of a mortgage broker as it is the lender whose deal you accept which pays the broker. The Financial Services Commission of Ontario has a list of registered mortgage brokers on their website.

My husband and I have decided not to go the mortgage broker route yet as we have a PAM with a reasonable rate. We will be checking with other banks as we also want to determine what rates we can negotiate as we are also thinking of moving over our line of credit and bank accounts. The other thing that we learned is that you may be obliged to use a mortgage broker that does a full PAM and rate comparison for you even if you do eventually find a better rate elsewhere. Not sure about the veracity of this information; however it is something to verify upfront with a mortgage broker. As it could be months before we find a house, we are taking our time about finding a better rate since our PAM is reasonable and will help us be competitive in the case of a bidding war.

Read the next post in this series “Down Payments and Financing“.

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

I haven’t had personal experience with this part of making money with real estate, but everything I read and hear seems to make the case that its typically a significant part of an investor’s return.

Once I read that basically the more “unusual” whatever you’re doing is, the better the taxation. At a certain level this makes sense, the government is best served by getting the biggest chunk of the largest amount of economic activity. Based on this idea, the advice was that the more “typical” an activity (like working a 9-5 job), the heavier the taxation. Real estate investing is hardly new, but not everyone does it, and therefore its given a bit of a tax break. Additionally, its viewed that there’s a positive outcome for society (increased amount of shelter) and its worthwhile on that basis as well for the government to encourage the activity.

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

Anything you spend on your property is typically a deduction (i.e. you don’t pay tax on the money you earn to pay for that). So if you pay $1000 to get your property re-painted, you won’t have to pay taxes on $1000 of rental income (since you spent it on the property instead of putting it in your pocket). SOME people exaggerate their expenses to keep more of their money from being taxed, but I think this is a very bad idea (if you want to pick a fight with someone, don’t go after Revenue Canada!).

The real advantage (which I’m looking forward to) is the ideas that you can “depreciate” your property. Say you had a rental property that had earned you $250 / month ($3000 over the year). Typically if you were in a 40% tax bracket you’d owe $1200 in taxes on this money. What depreciation lets you do is assume that the value of your property declines over time. You get tax savings based on this decline. When you sell your property, you pay capitial gains taxes on the sale price – the purchase price + the depreciation. Thus depreciation lets you defer taxes until you sell the property (which its obviously better to pay the taxes in the future instead of right now). ADDITIONALLY, depreciation lets you not pay taxes on income, and instead pay it later as capital gains (at half-rate) (Please see the comments, I misunderstood this).

Obviously I don’t have the best grasp on this yet (I’m planning to take the H&R block course this fall so that I’ll gain a better understanding), but the basic ideas that real estate investors all seem to agree on is that you pay a lot less taxes on money you make from real estate then money you make from other investments.

Ways that you might abuse this concept to lose money is when you pay for a deduction (e.g. if a real estate deal is a bad deal, doing it for the tax deduction is probably a bad idea). Also, if you get too caught up in this idea and start doing illegal things (again, a very bad idea), you might be trading slight gains for jail time (no fun).

Go to the next post in the series buying at a discount.

I’m a big fan of listening to different people on a subject, considering what they have to say, then making up your own mind. Violent Acres (a really funny, evil blog!) recently posted an article “Formula For Calculating the Profitability of a Rental Property“. Its definitely worth reading over for anyone who’s interested in real estate investing.

I think her approach of working out market rent then working backwards from there in order to determine a “fair price” for a property is great. My gut reaction would be the $50 / month / unit profit is on the low side (it wouldn’t take much to get $50 in unexpected costs or miscalculations), but she seems to acknowledge that there’s actually a potential for profit in some of her other factors (such as assuming 1 month per year vacancy, increasing equity, tax write-offs and increasing rents). Also the $50 profit seems to be “cash in your pocket”, whereas I prefer to consider it “equity + cash in your pocket” (paying down a liability is as good as saving in my book).

Great post, great ideas and definitely something worth reading (and re-reading if any part doesn’t make sense) if you’re thinking about getting into real estate investing.

Canadian Dream originally posted a link to this and helped me re-discover Violent Acres (thanks!).

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.

I read yet another article in the newspaper today about a bidding war in Toronto and how this is supposedly a big problem for people who are trying to buy a new house, especially if it’s their first one.

The article covered a house sale sale where they were asking $1.3 million and got $1.9 million which is pretty amazing when you consider they got almost 50% more than they were asking for. Now I don’t know if this house is worth $1.9 million or not but from the description it sure sounds like a pretty good house in a pretty good area.

Later in the article there were some comments from real estate agents who were saying that a lot of their clients are tired of getting into bidding wars and having houses sell for more than asking. They also mentioned how some clients just refuse to rent because they have been taught (brainwashed?) about the value of house ownership by their boomer parents. I think those house buyers should consider the value of renting according to Financial Jungle. Ok, it’s a different city but the logic still applies.

Know your real estate market

When I was looking for my current house, I made an effort to look at as many houses as possible in order to get a sense of the market value for the type of house we wanted. Normally what I would do is look at a house, and then see what it would sell for. After a while I noticed that there were some houses that sold for over asking (bidding war), some houses that sold for around the asking price (quick sales) and some houses that sold for less than the original asking price, in some cases much less (greedy, delusional sellers).

Asking price is meaningless

What did I learn from this? Mainly that the asking price doesn’t mean anything. It’s up the buyer to know roughly what the house is worth by getting familiar with the market. If you look at a house and think it will be a steal for $450k, then guess what…you won’t be alone, since there will probably be other people who will be thinking the same thing. Don’t complain if the house ends up going for $500k or $550k. If that’s what it’s worth then that’s what it will sell for. The other thing for buyers to consider, especially for their first house is that maybe their dream of owning a detached house on a nice street on their limited budget is a fantasy and they should start looking at different areas, semi-detached houses, townhouses and condos and just work with that they have.