The Top Reasons to Buy an Investment Property
Statistics show that over 25% of Canadians consider buying an investment property as a sought after way of growing their net worth – and these numbers continue to grow. However not even CLOSE to this number of people have actually moved forward and taken the plunge. So weather you’re one of the undecided first time investment property buyers, or are thinking about ramping up your portfolio, the following will help to answer the big ‘WHY’ involved with any buying decision. In doing so, we will also deconstruct and learn exactly how investment property investing works.
Investment Property: An Age Old Institution
The act of renting out land and property is one of the oldest forms of business known to have ever existed. Queens, Kings, and Lords would own vast territories of land, and charge a fee for individuals to farm on and live there. So it went for thousands of years, high nobility maintained their empires and lifestyles through this form of rental income. Fast forward a few years into the industrial and technological revolutions, property ownership has become more wide spread and more accessible for purchase by the majority class. Yet it remains one of the most time tested and lucrative forms of creating wealth. So real estate markets are long term (like ancient history long term), and generally stable over time.
The notion of ‘long term’ and stability appeals to many investors. At the time of writing, there is much debate about a Canadian ‘real estate bubble’ – and truth be told, there will likely be some sort of moderation in the real estate market at some point. However, for those who take a long term approach to real estate investing, they are likely to benefit from good rates of return as economies and societies continue to flourish over time, and positive economic inflation naturally pushes up property values. People will always need a place to live – and we are not expecting and kind of human transcendence into forms of pure universal energy, at least not any time soon.
Perhaps my favourite reason to invest in rental properties is the concept of leverage. This is the idea that you can use someone else’s money, through a bank/ lender intermediary, to grow your own wealth. So I pose the question: In what other business, can an average middle class Canadian worker, earning $50,000 per year, borrow hundreds of thousands of dollars at an extremely favourable interest rate?
I would be hard pressed to see any comparable way of borrowing so much money, at such a relatively low cost. The basic principle of leverage, or more accurately of a ‘leveraged investment’ is the effect of magnifying or increasing rates of return, on a given invested amount. I would like to, and need to stress to readers –that leverage can also magnify losses if property values decrease. However if we are taking a long term approach to real estate, and we have faith that Canadian and global markets will continue to grow – then we should expect some sort of positive return over time, which will be made even greater through the use of leverage. To help understand, let’s take a look at a couple examples of how leverage works.
Leverage Example 1:
20% down payment on a $100,000 property: $20,000. So $20,000 is also our investment here.
Now if the $100,000 property increases in value by 10% – how much would the property now be worth? The answer is $110,000.
So, given this – What is our rate of return on the original investment of $20,000? Since we just earned $10,000 on the total value of the property, our rate of return is 50%! We still have the $20,000 that we invested PLUS the $10,000 return on the property – so our total equity $30,000 in this case.
The financial tool that makes this investment phenomenon possible is the mortgage loan. Since we invested $20,000, and the property initially cost us $100,000 – we had to come up with an additional $80,000. This $80,000 literally helped us leverage our return in the example from $2,000 (which is a 10% return on $20,000) to $10,000 as we saw. So because $10,000 is 5 times larger than the $2,000 return, this is known as a 5:1 leveraged investment.
Please note that for a rental property – to calculate the rate of return we would have to subtract the COST of the mortgage interest, or the cost of the leverage. However, as we will see, not only is this interest expense tax deductible, it is our goal that the tenant covers this cost with their rent payments.
Leverage Example 2:
Let’s take a look at another quick example. Suppose I made a $500,000 property investment, and use $250,000 for down payment.
Now if this property went up in value by 10%, what would the growth be on the property?
The answer is $50,000: (10% * $500,000 = $50,000)
Given this, what would my % return on initial $250,000 investment be?
It would be 20% – because the $50,000 increase in property value represents a 20% increase on my initial $250,000 investment. So in this case, because half of the property is leveraged, and half of it was purchased with my investment capital, the leverage here is 2:1. In other words, in this example, the leverage permits me to earn twice as much compared to if I invested the $250,000 without the leverage/mortgage.
Please note – that less leverage (or less mortgage) is directly related to less risk. There is less potential for returns, but leverage has a flip side that can equally magnify losses. So in a declining market, less leverage can also mean fewer losses. In our two examples, the first (5:1 leverage) represented a riskier leveraged investment than the second example (2:1 leverage).
Diversification and Other Unique Rental Investment Benefits
Real estate investment can offer highly effective diversification from traditional stocks and bonds portfolios. Due to the extent of which real estate markets and rental cash flows behave or ‘move’ independently of stock and bond portfolios, holding on to real estate can lower what’s known as your ‘risk adjusted rate of return’. In other words, holding real estate may allow you to achieve a higher return, without increasing overall portfolio risk. To analytical investor types, this is a really big deal. To learn more about why this is, try reading up on Efficient Market Theory.
It is agreed upon by many independent and objective financial advisors and planners, that owning your own home is a cornerstone (although not a necessity) for financial independence. If a mortgage can be paid off prior to the retirement phase of life (55-65) than this would likely leave many years of mortgage and rent free accommodations during the retirement years. So, if this ideal of home ownership is considered one of the financial cornerstones for wealth and independence, than I propose that the better, even stronger cornerstone is to own a property that someone OTHER THAN YOU is paying for.
Integrity is an important aspect of becoming a landlord, and landlords should provide excellent accommodations and service to their tenants delivering superior value. However at the end of the day, landlords will have their properties paid for by those living in them over the years. This point drives home a central point of rental property investing – that the cost of interest (along with most if not all other expenses of the property) is paid for by the tenant. Weather rates are 2.49% or 5% – in our minds, this should be the first cost that a tenant is paying inclusive in their rent. Then come mortgage principle payments, taxes, insurance, utilities, other fees. In this sense, a real estate investor’s investment cost is paid for by the tenant.
But what if interest rates or other costs increase?
To expand on the point we are discussing in a slightly more technical way, if interest rates do increase, this will likely occur alongside increased economic inflation. Inflation, while eroding the value of our dollar – and therefore the value of the mortgage – has the effect of increasing the value of property. With inflation, property values, like the cost of other goods, literally ‘inflate’. So the two economic forces, (1) Higher interest costs and (2) Higher property values may offset each other. No one mentions that during the interest rate bubble in the 1980s – while mortgage interest rates were sky high, so was inflation, and property values were increasing rapidly for a period. Those who were able to hold on did quite well over time.
What brings advantage to the land lords situation is that rents are typically allowed to increase alongside the Consumer Price Index, or in other words with the rate of inflation. So from this we can see an interesting correlation: As (1) interest rates increase, (2) so too should inflation, and (3) increased inflation lowers the relative value of the mortgage and (4) increases the dollar value of the property, and finally, (5) allows for an increase in the rents received to compensate for the higher costs of owning the rental property. Ultimately this paints a pretty good story for the real estate investor to hold a property over the long term, and in different kinds of markets.
But we’re not quite done here yet…
Finally, to add another layer of benefit for owning a real estate investment property, is the Canadian Tax rule that allows for mortgage interest costs (however not the mortgage principle) to be deducted from rental income as a business expense. This is important because this reduces tax rates and helps make rental property investing a tax favoured investment.
In fact ALL expenses, including property tax, insurance and any maintenance or property management fees can be deducted for income tax purposes.
For example, if I receive $2,000 in a month for rents, and my mortgage interest and other expense for that month are $1,000, this means that I am only taxed on $1,000 of income in that month – not the entire $2,000 amount. Tax accounting ties closely with income property management, and a tax specialist should be consulted for optimal strategies.
The point here though, is that the higher taxed investment income can be reduced. The main way of taxing rental property return on investment is through the capital gains tax system. This system is based on the growth or increase in dollar value that is realized upon the sale of the property. In other words Capital Gains is: What you Sold the property for minus (–) What you Paid for the property. Capital gains is taxed at lower rate than investment income (such as GIC interest received) or even dividend income, and is widely considered as the most tax advantaged way of Canadian investing. There are more details about how capital gains tax works that is beyond the scope of this article.
A very important WHY to consider is that you are providing a great place to live for someone and an essential service within your community. I believe that any land lord who does not take this side of the coin into consideration is missing something from the equation of success.
Owning rental property is far from becoming a charity, but a good land lord should go to lengths to respect the tenant who is their customer, offer more value for the tenant’s money than they may expect, and ultimately provide the best accommodations possible. Landlords who feel a sense of pride from providing this higher level of service are also likely to become the most successful in business over the long term. Just think of the kind of service you have come to appreciate from a good hotel, or any other service for that matter. What was that experience like compared to moderate to poor service? Which hotel do you think fares better? Treat your tenant accordingly.
The rest of this article will go over step by step, how to move forward with buying a rental property. Starting with 4 different investment strategies, you’ll get to consider different options, and most importantly become aware of what’s involved with moving forward. It’s not all easy, but for those who get excited by the prospects, the rewards can be fantastic and life changing.
Altrua Mortgages provides Mortgage Broker services across Canada, with a special focus on Kitchener-Waterloo, Cambridge, Guelph, Milton, Hamilton, Toronto, Ottawa, London, and Windsor. Do not hesitate to contact us anytime for a personalized conversation on how you can succeed in the rental property investment market.