Real Return on Investment Real Estate

by Mr. Cheap

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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