Owning an investment property can be a wise investment that not only lets you grow your asset wealth over time, but also can provide you with positive cash flow today. However, property investment isn’t as easy as buying a property and waiting for the cash to start rolling in. It is important to choose your property wisely, and to employ a well-researched strategy. The deal is in the buy.
Here are some tips on how to choose a suitable and potentially profitable property for investment.
Do you have a Financial Buffer?
In addition to having the necessary down payment on hand to purchase a rental property, is the rental property in need repairs or renovations before it is rentable? Do you have the money to accomplish these jobs and pay the mortgage before you’ve got it rented out?
In addition to the 20% down payment needed for a conventional mortgage, don’t forget to also account for closing costs (about 2% of purchase price) when you are setting your house hunting budget. An additional contingency buffer is also key, so that you can give yourself 30 – 60 days to get the house ready for the rental market.
Look at Neighbourhood Vacancy Rate
While the overall vacancy rate in Toronto an incredibly low .08%, there are still pockets in the GTA with higher than average vacancy rates. Are there lots rental/sales listings? Is the vacancy rate high in the neighbourhood you are thinking about? Profitability all comes down to supply and demand. If vacancy rates are high, and there is a lot of competition in among properties in the market to attract tenants, you can’t charge premium rents. This phenomenon is sometimes evident in condominium development projects with high investor ownership. Increasing vacancy rates can also signal a more balanced rental market as evidenced in my the recent article about the Toronto Rental Report.
Buy Near Amenities
You have likely heard the real estate mantra, “location, location, location”? What this means in simple terms is that in order to preserve (and grow) your property’s asset value, you are well-advised to purchase something in close proximity to lifestyle enhancing amenities like shopping, schools, green space and public transit.
Proximity to these amenities will not only help to grow your property’s asset value, it will also allow you to charge higher rents, as tenants are willing to pay premiums for these kinds of conveniences with access to public transit at the very top of most renter’s wish lists.
Another feature that is coveted by potential renters is a good walkscore. Walkscore lets renters assess different homes in terms of how conveniently (and close) a prospective home is to their required amenities. The pedestrian lifestyle is desired by many, particularly for urbanites in a city like Toronto.
Employment & Demographics
Something else you should consider is the local job market in the areas that you are considering purchasing, as this will figure heavily into your likely pipeline of potential renters. Toronto is economically robust at the moment, drawing employees from around the globe as corporations continue to expand their presence in the Toronto area.
This means that there is an infrastructure in place to fuel demand.
Similarly, consider the demographics in the area that you are thinking about buying an investment property. What age, life stage and income brackets comprise most of the neighbourhood residents? Not only will this help you to determine if a particular investment property is a smart buy, this information can also help you to tailor your property to your target market.
What type of home are you thinking of? It’s quite common for first time property investors to purchase a condominium for their investment property, because of some of the turnkey benefits that come along with condominium ownership. However, another viable options, especially in the City of Toronto with the available housing stock, are triplexes and duplexes.
One of the benefits of this kind of property investment is that you could live in one portion while renting out the other spaces, helping you pay the mortgage (which, given the sky-high housing prices in Toronto, is something that more and more homeowners are doing). Or, you could rent out all units- which is a good approach in trying to be cash flow positive.
When searching for duplexes and triplexes, a real estate agent will seek out listings with at least two kitchens. This is the key indicator in determining the readiness for turning a property into a multi-home investment. I have found that 2 ½ storey homes make ideal investment properties and achieving maximum rent. This home type allows for a 2-floor apartment on the 2nd and 3rd floor, a one-bedroom apartment on the main floor and a studio apartment in the basement. It’s important to seek a property with a dry basement and high-enough ceilings to create a viable apartment, if one doesn’t already exist.
The Nitty-Gritty. Determining Financial Viability
When you are purchasing your own residential home, you tend to build a wish list of features and locations. The same approach is used when looking for an investment property, but you also need to consider the financial viability of your investment (i.e. what you can reasonably set your rents for, what your likely expenses would be, and what your likely return on investment would be).
For property investment, there are four important calculations that can help figure whether or not a property is a worthwhile investment; Cap Rate, Cash Flow, Return on Investment and Leverage. Each calculation on its own may give you a small glimpse into a property’s viability, but taken all together these tools can offer you a powerful insight when evaluating an investment.
A relatively simple way to determine the viability of an investment property is the Capitalization Rate: INCOME / VALUE = RATE and what is considered Income? Put simply, it’s Rent minus Taxes and Maintenance. It’s important to note that Cap Rate, doesn’t account for mortgage payment, interest paid cash outlay. Based on this fact, you can begin to appreciate the method’s limitations.
Calculating Cap Rate:
Purchasing a rental property $950,000 with the above example of expenses yields a respectable 5.84%
$55,500 / $950,000 = 4.26%
Within the Toronto market, aim for a cap rate for 4 % or higher.
Cash Flow is an important consideration when considering an investment. Ideally, it would be great to start off with positive cash flow from the outset. This means money in your pocket each month. Cash flow can be calculated simply as Rent, minus mortgage payment, taxes and utilities.
For Example, a triplex apartment complex purchased or $950,000 could potentially generate the following cash flow:
-$10,800 Maintenance Fees
= $21,900 in Positive Cash Flow
Return on Investment
Return on Investment is a more complex calculation, but goes a very long way when evaluating a property. It factors how much of your money you actually invested against Net Income and also the principal or equity paid down by the renters over a given time period.
ROI Calculation: Positive Cash Flow + Paid Down Principal / Actual Cash Investment = ROI
For the purpose of this calculation, let’s assume that $18,000 of the monthly mortgage payments went toward the principal. Combine this value with the year’s positive cash flow of $21,900, and then divide this value by the initial cash outlay of $340,000* and you’ll get your Return on Investment (ROI) of $11.73% – A very respectable rate of return.
*Actual Cash Investment (Cash down on property, plus closing costs and minor renovations): $340,000
The final tool in our analysis tool kit is Leverage. Leverage measures how hard your borrowed funds are working for you against your own invested money. Nearly all real estate investments involve borrowed funds and has the potential to increase buying power and give you a higher rate of return on a given investment. Leverage can be either Positive or Negative, when it is compared to what is called the “Overall Rate of Return”. Ideally, an investor will want to see a Positive Leverage calculation, which could mean that borrowed money is working hard for the investor. The caveat to this formula is advance knowledge of expenses and cost of borrowing. It’s important to note that Negative Leverage may not mean it’s a bad investment opportunity. But, it does warrant and deeper dive. This is also a great tool to evaluate multiple properties at a time.
Step 1. Calculate the “Overall Rate of Return” (OOR).
Net Operating Income/Purchase Price = Overall Rate of Return
Step 2: Determine cost of borrowing over a one-year period and deduct this value from the Net Operating Income. For example, $40,600 (NOI) – 32,500 (Cost to borrow) = $8100
Step 3: Divide value obtained in Step 2 by the Actual Cash Investment (including all closing and renovations costs.
Step 4: If value exceeds the Overall Rate of Return (OOR), you’ve got Positive Leverage. If the value falls below OOR, you’ve got negative leverage.
Purchase Price: $950,000
Net Operating Income: $40,600
Cost of borrowing in the first year at 5% interest rate: $25,500
Actual Cash Investment: $300,000
Overall Rate of Return (ORR)
$40,600/$950,000 = 4.27%
$8100/$300,000 = 5.03%
Positive leverage results in a higher equity yield compared to O.R
Purchase Price: 1,200,000
Net Operating Income: $47,500
Cost of borrowing in the first year at 5% interest rate: $45,000
Actual Cash Investment: $300,000
Overall Rate of Return (ORR)
NOI: $47,500/$1,2000,000 = 3.95%
$2500/$300,000 = .83%
Negative leverage results in a lower equity yield compared to O.R.R.
What’s Happening in the Market Right Now
It’s now apparent that the government’s measures aimed to tamp down the housing market have indeed run its course and the Toronto market has shown signs of a rebound in October 2019 with a 14% increase in the number of transactions compared to the same period last year. This trend is supported by strong employment growth, low unemployment and a housing supply that doesn’t meet demand.
There are still great investment opportunities, both in the condominium, single family residential market. Your budget, risk tolerance and how much landlord work you’re willing to take will determine where you will start when building your real estate portfolio.