5 Ways to Make (or lose) Money With Investment Properties – Part 1 – Cash Flow

by Mr. Cheap

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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.

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{ 4 comments… read them below or add one }

1

Have you been able to find other opportunities like the condo you own?

I wouldn’t have thought it was possible to buy any kind of house or condo in T.O. that would rent for 1% (or more) of the purchase price. I’m thinking that either you got a great deal or maybe I just don’t know anything about condos (which I don’t).

Mike

2

Wow! That’s in Toronto? I would have never guessed it was possible.

If you decide you’d like to check something out outside of Toronto…we have a student rental house for sale. :) It should be rented for $1250/mth at the beginning of Sept. andwe’ll list it at $119k.

Only a few years ago we were able to get $1900/mth but many home owners in the area converted their homes to rental properties to cash in on the rental income since this market hasn’t seen much in the way of appreciation.

It’s not a bad deal at all but we’re not very good at letting others do the work and we’re starting to get lazy to do it ourselves.

BTW, good for you for renting for less than you collect. Not many would do this but it likely makes a big difference in how much you’re able to save.

3

Interesting post. I have been keeping my eye on a few condos here on the westcoast. We live in a place which is cheaper than Victoria or Vancouver, but the average condo price would be around $120k for a 1 bedroom. Unfortunately though there is no way I could rent it out for over $1000 a month if I could afford to buy one. I would be lucky to get $800. There seems to be this disparity everywhere. In Vancouver it would cost you over $250k to buy a condo, but max rents for that condo would be closer to $1500. In most cases, rent would barely cover (if at all) the mortgage payment unless you put a lot down. I am still keeping my eye open for deals though, even if I am not buying.

4

Mr. Cheap – to be honest, the student housing situation is pretty darn good in that you never have to worry about collecting rent. We generally get post dated cheques for the whole year and in 4 years and 2 houses have only had one bounced cheque I believe. Most of the cheques come from the kids parents so it’s generally really reliable – much more so than families (at least in this area).

We live in Windsor and the problem here is that housing is pretty cheap so there are very few good tenants out there but there are always students. It’s easy to get full 1 year leases out of students and they generally don’t require much as far as luxuries go. I don’t know what the market is like for student rentals in TO but I would suggest looking into it.

The house we’re currently selling and renovating was rented year round for the past 4 years – never a day vacant – so we haven’t had a chance to do any work on it. Now we’re playing catch up basically.

As for our next move – we’re thinking more non-RE. We’ll keep the other rental house we own (and our own). It’s tempting to hold on to because of the cash flow but I guess we’re just ready to try something else.

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