Real estate has been known as the ‘stable’ long-term investment, as prices have historically provided positive annual returns over the long term. Real estate is another form of investment to consider for your portfolio.
Investopedia describes Real Estate Investment as Real Estate that generates income or is otherwise intended for investment purposes rather than as a primary residence. Clearly, the purpose of Real Estate Investment is to build wealth, through rental income and price appreciation.
Like any other investments, there are risks associated with real estate investing in the short term. Despite the short-term risks, such as economic downturns, real estate has historically provided a positive return on investment.
Factors of what to look for before purchasing an investment property include, but are not limited to:
- Walk score
- Area review
Walk Score is a service that evaluates the walkability and transportation services of a property. This score takes in consideration of the transportation services in the area, and the walkability of different locations, such as public institutions, and grocery stores.
According to a report by Reconnecting America, a higher Walk Score raises the home value. Don’t overlook the Walk Score when making the purchase. Remember, not all tenants have access to a car, so a higher Walk Score would provide you with a larger market to rent out too.
The last thing you would want to do is purchase a property in an area with high crime rates, lack of public institutions, such as elementary schools, libraries, etc. In other words, investing into undesirable areas would most likely not provide you with a decent Return on Investment, at least in the short term.
Over the long run, undesirable areas can significantly improve. This is the case for some suburbs outside of major cities, where homebuyers move outwards as home prices are cheaper.
If you are purchasing a condo as an investment property, look into what is offered in the monthly maintenance fees, such as the different amenities, whether or not it includes the hydro bill, etc.
Look into what the fees were like for the past 2 years or so, or since opening date (if it’s a newer condo). From this, compare the month-to-month fees, to see if the prices have been somewhat consistent, and there have been no dramatic increases.
A more consistent, lower increases in prices would suggest efficient management. It won’t be reasonable to purchase a condo where the maintenance fee would double in cost; that would significantly depreciate the value of your condo. Skyrocketing maintenance fees can also lead to negative cash flow, as monthly housing costs would exceed the rental income.
Think about it this way, why would someone pay $600 extra in maintenance fees, where they have the opportunity cost of purchasing a property with a $600 extra mortgage payment, or finding another condo with cheaper maintenance fees?
In terms of taxes – this ranges from city to city. Take the taxes into consideration before purchasing the property. Make sure to include this in the monthly housing costs, to determine whether or not the rent would cover costs.
Always get an inspection. Buying a house is a big enough of an expense. The last thing you want to do is spend several grand fixing up the unknown damages, unless you had the intention of purchasing the home and flipping it.
Real Estate Investing Example
Now let’s look into a Real Estate investing case scenario. Let’s say, we are purchasing a townhouse in Ajax, Ontario for $330,000. Ajax is a suburb in the Greater Toronto Area.
- 3 Bedrooms, 2 bathrooms
- Walk Score of 60, somewhat walkable
- Near highway 401, which connects to Toronto
- 3 years old
- Approximate Rental Income: $1850
- Maintenance fees: $255.57 (includes snow removal, and water)
- Approximate taxes: $275/month
Canadian residential home prices grew on average of 5.4% a year during 1980 – 2012 (TD Economics). However, lets be a little more conservative here and estimate an average annual growth of 4% for the next 5 years. Remember, this is only an estimate.
So far, the investment property increases in value 4% per year, and you get approximately $1850 in monthly Rental Income. That would yield to a yearly cash flow of $22,200.
After a 20% down payment of $66,000, the monthly mortgage payment would be $1,211.11, at a 2.7% interest rate. Deducting the monthly mortgage payment, maintenance fees, and taxes, the positive cash flow would be $110.43/month.
Return on Investment (Term: 5 Years)
Return on Investment is the figure that calculates the percentage gain from investment in respect to its costs. Using the 4% annual growth estimate, the property would be about $402,000 by the end of 5 years.
The total Operating Income for this term is $111,000 ($22,200*5). The Net Operating Income is $36,565.91. This is equivalent to an annual Average Net Operating Income of $7,313.18 for the term.
Annual Return of Investment
Now let’s take the numbers into consideration and plug it into the Annual Return of Investment (down payment) formula.
This investment property yields an Annual Return of Investment of 11.08%, and a 21% Gain on Asset Sale. If the property had no maintenance fees, the Annual Return of Investment would have been approximately 15.40%.
Investment properties without maintenance fees tend to have a higher ROI, as there are fewer costs associated with maintaining the property, and a higher price appreciation.
Remember, this is only an example. Some investment properties have the potential to provide a much higher Return on Investment, where as others can provide a negative Return on Investment.
Preparing for the Worst
There are some tenants that cause nightmares for landlords, such as late payments, damages, and the list goes on…
This is every landlord’s nightmare. Have enough cash for 6 months of monthly housing costs, otherwise the home would be foreclosed on if there are no mortgage payments being paid
For the long term, investment properties are an effective investment strategy to grow your wealth. A common strategy is to use home equity to its full advantage. This involves using the equity in one property to purchase another investment property. This strategy can lead to a high accumulation of properties over the long term.
Remember to spend within your means a do not stretch out your budget too much. Be prepared for the worst, by having enough cash saved for 6 months of housing costs. Make sure to set this money aside for emergency purposes only.
For more information on whether or not your investment properties should be under personal or corporate ownership, refer to Rental Property: Personal vs. Corporate Ownership.
Writer: Jelani Smith
Disclaimer: All investing can potentially be risky. Investing or borrowing can lead into financial losses. All content on Bay Street Blog are solely for educational purposes. All other information are obtained from credible and authoritative references. Bay Street Blog is not responsible for any financial losses from the information provided. When investing or borrowing, always consult with an industry professional.