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.