Real Return on Investment Real Estate

by Mr. Cheap

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When I did my condo purchase series I promised to provide an update after I did my tax return and never got around to it.  Better late than never, I’ve completed my 2009 taxes and can provide a summary.

The way most investors (incorrectly) calculate their return is to take the rental income and subtract property taxes, insurance, utilities and mortgage payments.  I actually lucked out this year and that does match my return (if I can consider condo fees as utilities).  In reality, my return also included a risk element (my tenants could have moved out and I would have eaten the vacancy and something could have broken and I would have been on the hook for the maintenance costs).  Just because I got lucky doesn’t mean I can ignore this.  In future years I may lose any profits (and more) on these and other expenses.

Taking John T. Reed’s recommended approach of using my tax return to truthfully calculate my cash flow, I had a net income of about $3,000.  At a monthly rate of $250, I’m pretty happy with this.  Interestingly, this is quite close to the cash flow I projected (which makes sense, since nothing unexpected happened and the tenants remained throughout 2009).  I’ve raised the rent recently (although costs have also risen, so I suspect my return will stay pretty constant).

Return on Investment

Looking at this based on my initial investment of $43,811.68 this gives me a ROI of 6.8% (3000 / 43811.68).  This is nothing to sneeze at, but also not the greatest returns ever made.  There MAY be some appreciation (I think there would be if I sold today),  but I won’t know that portion of the return until I sell (the Toronto real estate market could crash or the building I bought in may develop expensive problems and I may lose money when I sell – the future is unknowable).

I have written in the past about the problems I see with how people think about current value.  Fundamentally, I think there is a problem thinking about investments purely in terms of return on investment.

Return on Equity

Looking at this from, in my opinion, the far more rational return on equity perspective, I currently estimate the property might be worth $160K.  Deducting a 5% transaction cost (in case I sold), and my mortgage which is a sliver above $87K gives me $65K (160*0.95-87) in equity, for a ROE of 4.6%.  This is probably more realistic, and again, is nothing to sneeze at in the current environment, but I’m not convinced it’s totally adequate compensation for the risks associated with the investment.

Tax Benefits

For many real estate investors, depreciation of real estate (and the tax benefits it brings) is a large part of their return.  For me, as a low-income grad student, this wasn’t useful to me (I didn’t take the capital cost allowance).

Moving Forward

I’ve changed my thinking on raising rent and given my steadily rising costs, the tenancy laws in Ontario, and the fact that it seems to be the standard behaviour I’m planning to be a bit more aggressive about raising rent in the future.  Unless there’s a convincing reason not to I intend to raise tenants rents systematically every year after they move in and each year after the previous increase.

I’d certainly be willing to sell if the right opportunity presented itself (if a tenant living there was excited to buy from me for example), but I’m not in any rush either.  I’ve been quite pleased with the (very low) time & effort requirements over the last 3+ years.

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{ 17 comments… read them below or add one }

1 Four Pillars

I agree that calculating return on equity is the best way. You can’t just use the original investment since that amount has changed.

Good call on raising the rent – it’s tough but you have to do it.

It’s really tough to evaluate this kind of investment. The reality is that in Toronto there is an oversupply (to some degree) of rental housing which is keeping rents from rising too much. Great for renters but obviously it makes rental investment tough to do.

As you point out the appreciation factor could end up being the biggest part of your profit but it may not happen and you don’t know when.

What about your time costs? You must spend at least a few hours per year – if you assume a rate for those hours (ie $25/hr) then that will reduce your return a bit.

I love the fact that you even do this calculation – most real estate investors talk about having the tenants pay off the mortgage and the fact that they sold for more than they bought and that is that.

2 Mr. Cheap

Mike: Thanks! :-) The time commitment was crazy low last year (I spent more time depositing the rent checks then anything else), but in my first year I spent TONS of time (fixing issues with the dryer and plumbing and renting out the unit), so there certainly is the RISK of a high time cost (which, as you say, should absolutely be accounted for).

3 Alexandra

The risk of raising the rent each year is that your tenant won’t stay. You can only raise it around 2% (or so, I forget the actual number), so you have to be sure that the raise would be worth you having to list the apartment again, show it to potential tenants, screen them, run credit checks. It may even sit empty for a month or two until you can find another tenant.

For good tenants who pay the rent on time and never cause issues, I am very, very reluctant to raise the rent on them. I would rather keep a good tenant than make an extra $200 over the course of a year. My time is worth more to me than that.

If costs go up (which they have due to garbage taxes, and the new electricity rates) I raise the rent between tenants – i.e. once a tenant leaves, I rent the place at a higher rate.

4 Sampson

Great post Mr Cheap.

I have to admit, when I first got into this game, I was certainly one of those people who was happy with the mortgage being paid and potential for future capital appreciation. Your previous posts really got me doing these calculations also.

I think the main thing I am now struggling with is this ever shifting ROE. Assuming rent increases at a similar pace to your rising costs the income you generate constantly increases (much like rising dividends) as the mortgage gets paid off. So although it may be looking to far forward into the future, it really seems that one has to make projections a few years into the future and the benefits of RE investing come down the road. Maybe I’m just playing mental accounting games again – and making a major assumption that rental rates will move lock-step with costs.

Maybe this comes from all the intangible elements involved in RE investing. Just like projecting growth in Co.’s earnings and revenues, one can try to project growth in return from RE.

5 Ryan Martin

Good post, I just sold my last duplex this year (closes May 1). I owned two duplexes for eight years but never got into the details you’re getting into. A worthwhile exercise for sure.

My experience as a landlord has taught me it’s all about cashflow; never miss an opportunity to raise rents. I’ve kicked myself for not taking rent increases seriously. And I guess my method for ROE was getting a couple RE agents in once a year to give me appraisals; they’d provide a list of recent sales in my area. After the appraisal I do a worst case / best case selling price for my place and decide if it was worth selling. At that point it’s still only guesswork until it’s actually sold.

Mr. Cheap, judging by your last paragraph, it sounds like you want to sell. I suggest you be proactive instead of waiting for the opportunity to present itself. Real Estate can be stressful if you let a decision like that drag on.

6 Financial Cents

Great post! We used to have a condo, but sold it last year. We made a great gain on it and took advantage of lower markets to purchase some stocks. I’m glad we did. Although ROI on the condo was good, being a landlord was much more of a headache than watching dividends grow :)

7 jesse

It’s a good point about taking into account all costs (or potential costs) when calculating return. This includes transaction costs, depreciation, major repairs, and operations management. Look at what type of return the professionals require and we know what ROE is acceptable.

I believe it’s important to take a step back and understand why properties have capital appreciation at all: it’s because rents increase over time, not because of some abstraction. From that POV, it’s worth asking what capital appreciation will be going forward.

A good tenant will demand a discount on rent. You can certainly raise the rent but at some point you run the risk of getting hit with a bad tenant if your rent is too aggressive. After a tenant is proven to be of utmost quality, as long as their rent is reasonable and slightly below market (as it should be if they are high quality) there should be no issue raising rents with inflation.

Where I am, in Vancouver, there is significant competition amongst landlords. Vacancy rates, published at around 1-2%, are actually around 6%+ according to professional property managers. With that sort of competition, it is hard to make rent increases stick across the board. The market won’t care if costs increase if there is enough vendor competition.

8 Sampson

>understand why properties have capital appreciation at all: its because rents increase over time, not because of some abstraction.

I don’t agree with this at all.

Immigration into a city can really boost demand and hence RE prices (Vancouver is a perfect example) – cities can redevelop neighborhoods and make them more attractive/desirable for buyers, entire city blocks/regions can be rezoned, and ought out for commercial development. These are just a few ‘concrete’ reasons for capital appreciation in RE.

9 jesse

Sampson, in some areas this is true but a property’s value is nothing more than the present value of future rents minus maintenance, administration, and construction costs. If a neighbourhood becomes more desirable it’s because the rents are increasing as well. A premium for future density increases is justified but it is NOT justified for condos, which are fully densified already.

10 Sampson

>If a neighbourhood becomes more desirable its because the rents are increasing as well

I don’t understand this at all. You are suggesting a neighborhood becomes more desirable BECAUSE the rent is increasing, or is it it the other way around?

11 Mr. ToughMoneyLove

If know many landlords who manage their own rental property. If you manage yours, I believe that your ROI or ROE calculations should also take into account the value of the time that you spend managing the property, because that is an opportunity cost. For example, one of my partners owns multiple rental properties. His wife spends most of her days managing them – no salary. That time could have been spent working for a real paycheck. Instead, she works for nothing. That is a real cost of ownership. That’s why being a landlord in my book is not worth the risk.

12 Ryan Martin

Mr. ToughMoneyLove, I agree with you about factoring time into the equation regarding real estate investing. But, I strongly disagree with your rationale with the example you provided. Yes, your partners wife has no “salary”, but she has income, rental income. I’m sure your partner will tell you the cheques he deposits each month are quite real.
Furthermore, you say that her time is better spent working for a “real” paycheck; I can only assume you’re suggesting she spend her time as an employee instead of being a business owner (landlord is a business). As a former landlord and former employee, I saw way more security, time, and financial benefit from the fake paycheck that is rental income. I would much rather clean gutters at my investment property twice a year over the weekly two hour status meeting (in the real world). Good for your partner’s wife for not needing a real paycheck.

13 Mike

Ryan, I suspect that Tough Money Love’s point is that the income from the rental properties is not worth the time spent on them.

The same logic has to be applied to any kind of investment. If you are a stock picker/trader and spend 2 hours per week analyzing data then that time should be factored into your return.

14 Ryan Martin

Mike, I understood Tough Money Love’s point quite clear. Why the logic fails is that it puts a monetary value on ones time.

Most business owners don’t factor their time in their ROI because they enjoy what they do. It’s the employee (with the real paycheck) who sits all day wondering if they’re spending their time effectively. That’s why you don’t find many business owners (landlords included) contemplating whether they should go back to the real paycheck.

If you believe this logic (time is money), you wouldn’t spend time with family or take a vacation, you’d be off to job #2.

Time is time, you have to spend it doing something; and some people enjoy spending it reading annual statements, others doing renovations. You shouldn’t need to put a monetary value on it.

I hope this is a clearer response to the example Tough Money Love put out there.

15 Mike

Ryan, I don’t think that putting a monetary value on one’s time is illogical. Yes, some businesses are part hobby/part business (like this blog for example) but I just can’t see too many owners of rental properties valuing their time at zero.

The other thing is that you have to eat. If you are running a business full time then you have to make at least enough to pay the bills. That alone means you have to assign a value to your time.

16 Mr. ToughMoneyLove

If you do not consider the opportunity cost of your management time, then owning and managing rental property is a job compensated by net rent income, not a passive investment, which is the way many prospective landlords think of it. In that case, you need to compare your net landlord income per hour spent with other jobs you could have. Comparing ROI or ROE from an owner-managed rental property with other true passive investments is not a fair comparison.

17 David

I agree with the other comments, raising rent on a good tenant is not worth the risk. The real way to calc ROI is;
ROI = [(Payback - Investment)/Investment)]*100

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