*To start at the beginning – please see part 1 of this series.*

As detailed in the previous posts of this series, I bought a condo in late 2006, fixed it up (new floors, new electrical sockets and a heavy paint job) and found tenants. All the gurus and real estate TV shows use funny math to show how “you can’t lose at real estate”, so here I’d like to lay out, as close to the penny as possible, what my investment has looked like over the last 6 months.

In retrospect I wish I’d kept a journal of how much time I spent, as that’s obviously a consideration. I’d give a rough estimate that I’ve put 40-80 hours of work into finding the condo, supervising the contractors, showing it to tenants and doing repairs. This is a VERY rough guess. The hours weren’t in discrete blocks (1.5 hours here, 3 hours there), so don’t consider it work “equivalent to a work week or two”.

I purchased the condo for $126,000. I made a down-payment of $34,160.57 which includes a 25% down-payment, and closing costs, which were $2,308.19 (legal fees mostly). $34,160.57 is more then 25% down plus the legal fees, which I’m not 100% where the extra $352.38 went (maybe mortgage fees, I’m not 100% sure right now – I know I got a small check back from the lawyer, the SOB made me pre-pay his fees, but it was certainly less than $352.38). Renovations (including labour, materials, condo fees during rehab and mortgage interest) were $10,551.41. As percentages, closing costs were 1.66% of the total purchase, and rehab costs were 7.6%. Ignoring the cost of selling (5% agent commission plus legal fees), my break even sale price would have been $138,859.60. Given that comparable units have been ASKING for $155-165K over the last few months (the rule of thumb supposedly is that condos in Toronto sell for 96% of asking), I’m quite pleased with the cost of purchasing/fixing this unit.

In case you’re wondering how I got such a deal, the place looked REALLY bad when I first saw it. There wasn’t any floor (bare concrete), the walls were an electric blue colour, and had gashes in them. The seller took the perspective “why put more money into something I’m trying to sell”. While I understand that perspective, the condo had sat on the market for over 6 months (and he’d moved, so he was losing $500 / month in condo fees), and everyone who looked at it just viewed it as buying a problem they’d have to fix. He had to drop the price far more then repairs would have cost in order to sell it to me, and he shelled out quite a bit of money over the time period when it wasn’t selling. I’m not a “flipper” at all (I’ll probably post more about this in the future, but I basically think its a suckers game where people convince themselves they’re making more then they actually are), but if you can accurately estimate the cost of repairs (not as easy as it sounds unfortunately), there are certainly deals to be had on run-down properties.

I saw another condo recently that was in even WORSE shape, and I put in a low offer, hoping to pick up another “fixer-upper”. The seller kept insisting on wanting market value for the unit (even though it would have cost $15K to get it into “market value” condition), so I obviously walked away from that deal. So the other factor to keep in mind is that not all run down properties are a good deal. You’re a sucker if you pay market price for a property that needs extensive work. You’re a sucker if you pay market rate – cost of repairs for a property that needs work (you’re accepting the risk of repairs being more expensive then expected and doing the supervision of the repair work without compensation).

I tried to rent it at higher amounts, but in the end rented it for $1300 / month. My condo fees, insurance, mortgage **INTEREST** and property taxes come out to $1,042.87 / month, so I have a positive cash flow of $257.13.

When I calculated JUST the down-payment and reno costs, I came up with a cost of $43,811.68 over the first 6 months. Using the $257.13 monthly profit (which already accounts for the mortgage interest, condo fees and other ongoing expenses), this gives me a ROI of 3.51%, which would work out as an annualized ROI of 7.03%. This assumes I was making the $257.13 since purchase, which I obviously wasn’t, and also assumes there will never be any unexpected costs in the future (which is equally absurd).

This may not seem so great, but firstly this was a learning project for me (so part of the costs/benefit is my “tuition”). Secondly, this ROI is JUST based on the monthly cash flow, if I bought at a bargain price (which I believe that I did), I should also get a satisfactory return on the sale price. Thirdly, if real estate appreciates, this will increase the difference between my purchase price and the sale price. Fourthly, there will be positive tax implications (I can depreciate the property in order to defer taxation). Fifthly, inflation should increase rent, which will increase the monthly cash flow (and decrease the cost of my mortgage). And finally, as my mortgage gets paid down, less of each payment goes to interest (which also increases the monthly cash flow).

In case you read the previous paragraph and are planning to run out and buy all the real estate you can find, the risks in this investment include: future vacancies, difficult tenants (damaging the unit or making demands which will cost lots of time/money), legal liability for any problems resulting from the property, a real estate market crash, and high interest rates when my mortgage comes up for renewal (in 4.5 years).

With my current cost of living estimate, I believe that I could cover my living expenses with 4 more similar properties. If it was possible to get a better deal, or to get a similar deal with less cash invested, I might be able to do it with less. Therefore I am potentially $175,246.72 (4 x $43,811.68) away from retirement.

*This concludes the “Getting started with investment real estate series” – feel free to check out the real estate archives for more article on real estate.*

{ 9 comments… read them below or add one }

Have you bought more investment property since then? I’d like to know what area of Toronto you got that deal in…..those numbers are pretty good for Toronto.

This was a great and very informative article. Just one little thing though…I believe you’re using the term ‘cash flow’ incorrectly. What you’re calling ‘cash flow’ is probably closer to net income.

Given your numbers, I suspect you’re cash flow is negative as cash flow should include all cash outflows (i.e. mortgage interest AND principal, condo fees, property taxes, etc.) and all inflows (i.e. rent). I think you left out the mortage principal from your calculations.

In the end…as long as you’re showing a positive net income , you’re doing well and building wealth though (assuming property values aren’t depreciating dramatically).

JT: You’re right about the cash flow definition. I always objected to including the principle portion of the payment, since that’s money you get back when you sell. Imagine two mortgages had identical interest rates, and one was interest only, while the other was on an amortization schedule. According to the def’n of cash flow, one would be positive and the other would be negative, which doesn’t make sense to me.

That being said, I certainly shouldn’t use my own definitions of terms without clarifying, thanks for catching me!

THAT being said, I *THINK* I’m still cash flow positive. At the beginning of my investment (when I wrote this), most of my mortgage payments were going to interest. I was paying about $500 / month, 400 going to interest, 100 going to principle, so I’d still be $150 cash flow positive.

To be TOTALLY FAIR, I now agree with the Canadian Capitalist that vacancies and maintenance should be included with the calculations, which would make me about break even.

To be even MORE FAIR, I put a larger than standard down payment. For a cash flow positive property to be at all impressive, it should be purchased with a standard down payment (20%). Anyone can just pour more money into a property until it’s cash flow positive (I did it to get a loan when I was self-employed).

Thanks for a comment on an older post, your kind words and for clarifying cash flow!

Great article(s), Mr. Cheap. I predict rental properties in my future. I have been thinking about implementing a Smith Manoeuvre when I purchase a home for myself and, from my understanding, the HELOC would be tax deductible if invested in rental properties. That got me thinking: could you effectively daisy chain SMs so that as you pay off your primary mortgage, the new HELOC room could be put into a rental property which also has a SM implemented? I believe the equity in the home is 75% purchase price – mortgage principal remaining, so you would need to invest the HELOC elsewhere until you have 20-25% down on the rental property. At that point, get the next mortgage + SM and invest that HELOC until you can get another rental. This system would probably work best if the initial property had a fairly high value and successive rental’s were priced lower and lower as that would mean saving for less time to get the down payment. I haven’t done huge amounts of research into rentals or the SM as I am probably still a year or two away from diving in, but I am trying to get a bit of a jump start by mulling over ideas. Can you see any problems/flaws with my idea?

Ben

Ben: At it’s core, the SM is simply built on the idea that interest paid on debts used to invest is tax deductible, while interest paid on debts NOT used to invest isn’t. This is a core part of Canadian taxation, and doesn’t have anything specifically to do with Fraser Smith, he just uses this concept (along with segregated funds) to turn a non-deductible mortgage into deductible debt.

A similar way to do the same thing would be with a rental property (which is NOT the Smith Maneuver). Say I had a mortgage on my principle residence, and bought an investment property that was breaking even (lets say it cost me $1300 / month and I collected $1300 / month in rent). Let’s say I have a $100,000 4% interest-only mortgage and I’m paying $334 / month on it (the interest) and I can afford to pay this every month.

First I get a HELOC on my principle residence (I could get it on the investment property, but if the expense equals the income it probably doesn’t have the equity, plus it’s easier to get a HELOC on a principle residence). Say the HELOC is 6%.

Each month I pay my principle residence mortgage payment from my income and that’s taken care of. Then I also put down an extra payment of $1300 (from the rental income) of the mortgage on my principle residence. Doing so creates $1300 of extra room in the HELOC. I pay for the $1300 in rental expenses from the HELOC, and the interest on this $1300 debt is now tax deductible, since I borrowed it to pay for investment expenses. (along with any amount on the HELOC which was used to make the down payment on the property and to pay for transactions fees, such as a lawyer, RELATED TO THE PURCHASE OF THAT PROPERTY).

I still have to pay tax on the $1300 in rent (it’s income). I’m also converting a 4% loan into a 6% loan. Even if it’s tax deductible, that doesn’t seem like the smartest idea in the world. Additionally, if my mortgage in fixed rate, I’m trading the certainty of my payments for the variable rate of a HELOC.

Ultimately, once my mortgage on my principle residence is paid off (after 76 months, or 6.5 years if we ignore the increasing interest on the HELOC and the decreasing interest on the principle residence mortgage) I can, of course, get a new, tax deductible mortgage to replace the HELOC. This process would be accelerated if there was more than one investment property (or if the income / expenses of the rental property was higher).

This sounds like a post…

Mike: Half way through I thought “I should have just written a post…”

Well, now all you have to do is copy and paste!!

Thanks for the response. Like I said, I hadn’t put much research into it yet but I had a feeling there was going to be something wrong with that strategy. When I get more serious about implementing a SM and/or getting a rental property I’ll do some real number crunching and see just how bad this “Daisy Smith” Manoeuver may be.