The Must Know Strategies for Rental Property Investing
‘Rental property investing’ is often thought of as a singular type of investing and wealth creation strategy. However this couldn’t be further from the truth. Although investing in all kinds of rental properties share some attributes, there are certainly several different ways or strategies that one could pursue. Different strategies will make sense to different individuals, with different plans, preferences and risk tolerances. This section of the Real Rental Wealth guide will teach you the 4 main strategy types, and some ways to help you plan for your purchase once you have identified your preferred rental property investing strategy.
Four Fundamental Rental Property Investment Strategies
Although there are some common, broad based forces in real estate markets that will affect returns in general, there are also a number of differences that can affect your performance. So I have broken down rental property investing strategies in to four different categories of (1) Condos, (2) Single Family Homes, (3) Multi-Family Properties and (4) Light Development. We will look at these strategies through real life examples, of which I have personal ownership in the examples 3, and 4. The first two examples are drawn from an un-named investor that I have been working with.
It is important to note as we go through these strategies, that we are assuming similar property costs, and mortgage amounts. For example the risk and cash flow of a $500,000 condo with a $25,000 mortgage cannot be properly compared to a $500,000 multifamily property with a $400,000 mortgage. The latter would carry less risk due to less mortgage leverage, and would likely produce a higher net cash flow. Instead we should compare similar mortgage amount as purchase prices to one another, from strategy to strategy. For example, comparing a $500,000 condo with a $100,000 mortgage, to a Multi-Family property with these same numbers.
To help summarize and provide focus to what will be discussed regarding these rental property strategies, have a look at the chart below. As you go through these, it’s helpful to note, that the investment features/ attributes of each strategy are not mutually exclusive. It is more of a continuum, and all four of the categories share some aspects of one another. Also, there are some definite exceptions to this – I get it that some condos can be remodeled and re-rented/ refinanced for a profit. The purpose of these examples is to get an idea of the differences out there and for you to get a feel of what direction to go in.
|Lower Cash Flow||Higher Cash Flow|
|More Volatile/ Higher Growth||Condo Purchase||Light Development|
|Less Volatile/ Moderated Growth||Single Family House||Multi Family|
Condo Rental Investment
Due to inter-city intensification efforts and increasing land values, condos have become a very popular form of rental property investing. A condo purchase involves purchasing a single unit within a condo corporation, usually in a building with many other condos. Like other forms of real estate, and depending on the area, prices can range from less than $100,000 to well over $1,000,000 for others.
Condo Purchase Price in 2011: $350,000
Down Payment: $87,500
Initial Mortgage including Closing Costs: $267,500
Mortgage in 2016 (5 YR Fixed term at 3.19%): $229,500
Approximate Condo Value 2016: $500,000
Cash Flow: (-)$200/ month or (-) $12,000 over 5 years.
Net Value Over 5 Years: ($500,000 current value) – ($12,000 negative cash flow) – ($229,500 current mortgage) = $258,500
Given our initial $87,500 down payment (the investment) – this investor has yielded a 294% return on investment over 5 years or 59% per year. The condo market in Toronto has increased by about 7% per year over this same period. However please note that this return may not be representative of future returns.
Potential Condo Investment Benefits:
- Condos are easy to maintain: For many condos, especially if newer, the likelihood of running into costly and annoying maintenance issues is typically lower. This can save you time and money.
- Easier to manage: A condo will typically have one tenant, and given the popularity and ease of condo living, often attracts the ideal kind of tenant. This kind of tenant respects the property, keeps to themselves and pays their rent on time.
- Easier to sell: Condos are typically very easy to appraise, relative to other similar condos, and in a stable real estate market makes are a more marketable and liquid investment. ‘Cashing in’ on a sale in a timely manner can be as, if not more, important than a property purchase itself.
Potential Condo Investment Draw Backs:
- Condos are harder to cash flow: Especially with higher mortgage amounts (like 25% down payment/ 75% loan to value mortgages), condos always carry costly monthly condo fees which can make it very hard to turn an end of month positive cash flow. Owners may need to prepare themselves to break even, or even pay some extra out of pocket towards the investment each month.
- Condos are more volatile: Condos tend to react more sensitively to real estate market changes. Given this, they will likely react more favourably than other forms of real estate investment when markets are increasing. However when real estate markets eventually moderate, then the condo market will be more susceptible to down side risk. In other words, they will likely fall faster in a down market.
- More investor speculation in Condos: Given the ease of investing in condo properties and the heightened sensitivity to upside market movements, there is broad concern that more condos than other forms of real estate are being bought just to ‘ride the wave’ of upward real estate prices, without a solid long term investment plan. Many condos are not lived in OR even rented. This kind of speculation can artificially inflate a market, or subsection of a market (i.e. condos) which can lead to more drastic price moderation. When speculative investors get scared of a downward trend and start to sell, there is a higher likelihood that the rest of the hurd follows.
Single Family House Rental Investment
A single family house is typically found in a neighborhood with other comparable single family houses. Like a condo, this form of investment is typically rented to one person or a family, however this kind of tenant may be looking for a different lifestyle and more square footage.
House Purchase Price in 2011: $300,000
Down Payment: $75,000
Initial Mortgage including Closing Costs: $230,000
Mortgage in 2016 (5 Year Fixed at 3.29%): $197,700
Approximate House Value 2016: $375,000
Cash Flow: Break Even/ $0.
Net Value Over 5 Years: ($375,000 2016 value) – ($197,700 current mortgage balance) = $177,300.
Based on a $75,000 down payment (initial investment), this represents a 236% return over the 5 year period or a 47.2% return on investment per year over the same period. It reflects a 5% per year growth rate within the Kitchener-Waterloo and Cambridge housing market. However please note that this return may not be representative of future returns.
Potential Single Family House Investment Benefits:
- Easier net cash flow: Even with a larger mortgage expense, relative to a condo it is often easier to produce an end of month cash flow from a single family residence. Cash flow is heavily dependent on the location and property, however it is more typical to see an end of month cash flow from a house that can help to reduce risks such as repair costs and higher interest rates.
- Relatively easy to maintain and manage: Especially if newer or newly renovated, a single family home can be easier to maintain when compared to a multi-family property. Also, many tenants can remain longer term, assuming a form of mental ownership within the community and the property itself. For example, children may be attending their local school and have friends in the neighborhood. Adult tenants may be less transient than those just starting out. Tenant pride as well as lower turnover can help save a land lord’s time, reduce expense, and improve property returns over time.
- Marketable properties: A single family home usually will offer more space and ownership of land relative to a condo. This can provide for a more diverse ownership – from the building AND the land – within the property itself. This in turn can mitigate, or reduce price fluctuations and risk. At the same time, single family houses can be seen as more highly marketable if there are other similar properties in the neighborhood that will give a good indication of the value.
Potential Single Family House Investment Draw Backs:
- Larger size means more to fix: There are typically more rooms, more mechanics and just more things overall to fix in a larger, more heavily used home. Furnaces break down. Roofs need replacement. Even if newer, a landlord should prepare themselves for higher ongoing structure related costs.
- Higher maintenance costs: Typically a landlord will pay to have grass cut and snow shoveled, among higher outdoor maintenance costs. Although there are ways to lower these cash expenses, such as tenant contracts, these are still costs that should be considered.
- Resale issues: The long term tenant wear and tear and up keep costs cannot be understated. Families are naturally hard on a property, and if maintenance is not kept up with over time, can have a substantial reduction in resale value of the property given relative neighborhood prices.
Multi Family Property Investment
These types of properties are known as duplexes, tri-plexes, four-plexes and so on. Any multifamily property above a 4 plex is typically considered a commercial residential property, from a mortgage financing perspective. Many landlords have converted previously single family houses into multi-family units, whereas other structures have been built from the ground up for this purpose.
Tri Plex Value in 2011: $275,000
Equity position: $60,000
Mortgage in 2011: $215,000
Mortgage in 2016 (5 Year Fixed at 2.99% average rate): $195,000
Approximate House Value 2016: $385,000
Cash Flow: (+)$500/ month or $30,000 over 5 years.
Net Value Over 5 Years: ($385,000 current value) + ($30,000 cash flow) – ($195,000 current mortgage balance) = $220,000.
Based on an equity position of $60,000 in 2011, this investment grew 367% over 5 years or 73.4% per year over the same period. Of note here is a 35 year amortization mortgage, which is no longer available for rental properties and which has the effect of lowering the monthly mortgage payment. The property is located in the Kitchener Waterloo and Cambridge housing market which grew about 5% per year over the same period. Please note that this return may not be representative of future returns.
Potential Benefits of Multi Family Investment Properties:
- Higher cash flows: Multifamily properties typically have higher rates of monthly net cash flow than single family homes or condos. It is not uncommon to see $500 to over $1000 per month in net, after expense, cash flow from these types properties. Positive cash flow can be used to help cover long term repairs and, importantly, act as a ‘safety net’ or buffer from potentially higher mortgage interest rates.
- Less speculative, more stable over the long term: Multi-family properties are valued as much based on the income they generate, as on the value of the building and land itself. This is a central concept, and represents a big difference from condos and single family properties. Moreover, the diversification in property valuation (comparison and income approach to valuation) approaches can help to stabilize growth over time, meaning less ‘spikes’ in value, but also less potential downside risk.
Potential Draw Backs of Multi Family Investment Properties:
- Exceedingly more repairs and maintenance: Depending on the condition of repair at a given time, landlords should expect to prepare a substantial yearly budget to cover for repairs. Having 2+ families occupy a property naturally leads to 2 times or more the rate of wear, and replacement costs for appliances and other fixtures. These properties are also more work for a landlord, who should expect to devote a minimum of a few hours a month to management of this type of property. If the landlord decides to have a property professionally managed, these costs can reduce cash flow and the control over the property.
- Tenant management: Tenants living in very close proximity to each other can easily start having issues with one another. Often tenants will approach the landlord with these complaints, and so the landlord needs to be prepared to be firm and diplomatic in some situations. With more tenants, there is also increased risk that there will be an issue in collecting rent. Tenant selection is a critical part of becoming a successful real estate investor, and there is an entire section of this article devoted to this – however the law of having more tenants will always increase the risk of a missed rent payment.
Light development refers to purchasing a property in order to modify it and gain value from this modification. Modifications include minor improvements to interior and exterior aesthetics, such as flooring and paint, all the way to turning a single family residence in to a multifamily residence in a complete structure transformation. This is typically thought of as more advanced real estate investing, and requires specialized knowledge and a higher tolerance for risk.
Owner Occupied Triplex House Purchase Price in 2011: $320,000
Down Payment: $32,000
Initial Mortgage including Improvement costs, Closing Costs and CMHC fees: $330,000
Mortgage in 2016 (5 Year Fixed at 3.19%): $308,800
Approximate Triplex Value 2016: $500,000
Cash Flow: (+) $200/ month or $12,000 over 5 years.
Net Value Over 5 Years: ($500,000 approximate 2016 value) + ($12,000 cash flow) – ($308,800 current mortgage balance) = $215,200.
This tri plex property was purchased owner occupied, with 10% down payment and involved a ‘purchase plus improvement’ mortgage addition of $30,000. The additional mortgage funds were used to upgrade the units to a high standard. After the upgrades were completed, the property was re-appraised with a value of $450,000, and then re-mortgaged as a full rental property at this higher valuation. The result of the refinance was that the entire down payment/ investment was returned in cash at the time of refinance. Given this repayment of the down payment cost, the entire $215,200 net value of the property is free of any related ‘ initial investment’.It is therefore not possible to calculate a rate of return as a %, however the net worth has increased by $215,200.
This property represents a unique situation in my rental portfolio, and achieving the result took additional calculated risk. However it does highlight the potential of improvement and light development strategies. Also, please note that this return may not be representative of future returns, and requires specialized construction, housing market and financing knowledge to successfully complete.
Potential Benefits of Light Development Investment:
- Substantial profits can be had if improvement costs are kept low relative to the value realized on the improvements.
- For some investors, minor aesthetic or beautification improvements can be an easy way to improve the rent amounts received, quality of tenant applications and overall cash flow from the property.
- Legal Multi-Family properties that are receiving higher rents will be valued more highly, based on the ‘income approach’ to appraisal valuation. Given this, there is good potential to substantially improve the value of a multi-family rental property by making relatively lower cost, non-structural aesthetic improvements.
Potential Draw Backs:
- Improving a property involves additional expense and effectively controlling several other variables in order to be successful. Some of these variables include the cost of the improvement materials, labour costs, project management and time to complete construction. The larger the scale of construction or improvements, the bigger the risk. Risk in this area can become extremely high, and there are many landlords who have run into unexpected issues and costs during construction that have led to their downfall in the business.
- An individual considering this should have adequate additional to capital to protect themselves from higher costs, and to ensure continued financing from banks and other mortgage lenders. Sometimes individuals will partner with another investor to lower their individual risk on larger property renovations and developments.
A Brief Discussion on Investment Property Strategy
The investment examples mentioned above are meant to highlight ideas surrounding various strategies, and provide some points to consider. The examples are realistic for the housing market during 2011-2016 and have been mirrored by many other prudent Canadian real estate investors. Drawing the conclusion from a few examples, that you will be successful at rental property investing is not the point here – however if the controllable variables available to you are properly managed, and given long term housing market appreciation in an ever expanding global economy, you should expect excellent results.
How to protect yourself from a downturn in the market
Any rental property investor who expects the market to go on a continuous upward trend indefinitely probably should not be investing in this area. Although at the time of writing the Canadian real estate market seems impenetrable, make no mistake, there will be market moderation or potentially down turns over time of which investors should prepare themselves for. Such preparation involves making larger down payments, ensuring manageable mortgage payments should the tenant miss a few payments, and if possible, positive cash flow from the property. If possible, make pre-payments on the mortgage which will help you to become mortgage free years sooner. Pre-payments will also act as an interest rate buffer. If rates go up, then you simply reduce pre-payment and break even on the payment.
The rest of this article takes a step-by-step approach and goes over some areas, notably Financial Planning and Mortgage Financing, that will help you improve profits in the short term, protect you against risk over the long term, to ultimately help ensure your success as a rental property investor.
Financial Planning – The Essential Component
The first step in any real estate venture, whether it be purchasing a home for your own use or buying a rental property should focus on financial planning – at least to some extent. We are working with hundreds of thousands of dollars over long periods of time, and so I believe it is not just important, but crucial that you have a firm grasp of, and develop a reasonable expectation for your investment performance and goals. Not only will this help you succeed as an investor, for most people it provides an easy source for peace of mind.
The financial planning template just below will help guide you through the process of buying a rental property in a step by step manner. Importantly, you do not need to complete it all at once. For some of the sections, it will be helpful to review the rest of the article before deciding on what you’d like to do exactly. Any conclusions may be ‘slept on’ to help ensure the durability of your confidence, and commitment to your ideas. Even with this said, instead of a ‘one time shot’ , your plan can be seen as more of a ‘living document’ that can change over the coming weeks, months, and even years as you manage and track your investment performance. The important thing here is to build an awareness of your goals, and how you are going to get there.
If you find you need some additional assistance answering these questions, a Certified Financial Planner with knowledge of rental property investment strategies can be an ideal partner resource. Altrua financial offers this level of resource to qualified investors at no charge.
The first part of the financial planning process is to define your goals. As cliché and over done as goal setting may sound, it is a very important step. The questions below are fairly common but if considered and answered seriously, should provide for a solid foundation to build off of.
The Big ‘WHY’
The importance of asking yourself ‘WHY’ go through with any investment cannot be understated. You’ll find extra motivation and excitement as you move along and grow in the process.
|For what purpose will you need the investment money?|
|How much money will you need to reach your goal?|
|What yearly rate of return on investment does this represent?|
|How much are you relying on your rental investment to reach your goal?|
|What other Planning measures do you have alongside this strategy?|
|What other areas of your financial life, such as home budgeting (in case of an unknown expense), life insurance and estate planning have you considered alongside your goal?|
Clarifying where and how you would like to invest will help to provide focus as you delve into, or continue learning the rental property business.
|What kind of property would you like to purchase? Condo? Single Family Home? Multi Family? Why does this make the most sense for you?
|What area or City would you like to purchase in and Why? Have you considered more than one area seriously? How would different local economies affect your investment?|
|Do you plan on buying one property, or several over time to reach your goals?
|Do you have a plan for financing the properties(s)?
If you plan on purchasing more than one property – do you know how lenders will attribute/ consider income produced by one property, towards the purchase of the next? Do you have a plan for lowering expenses on one property to maximize profitability on a future investment property?
|What is your source for down payment or access to capital?|
|What is your time horizon?|
|How does rental property ownership fit in to your time horizon? Does it leave room for temporary market setbacks/adjustments?|
|Will you be holding onto the property until the mortgage is repaid? Or is it possible that you would want to sell sooner?|
|Do you have a process for tenant selection? What will you be reviewing to ensure that your tenants are able to pay their rent (and your expenses)?|
All successful landlords have some way to project their cash flow before buying a rental property, track their progress during ownership, discover optimisations and focus on improvement of profitability. A budget is the fundamental tool for this job, and is a cornerstone of your Plan.
|What are your basic costs, including, but not limited to:
Heating/ Natural Gas
Fire Insurance costs
|By how much will the monthly rent cover these costs? What kind of monthly net cash flow are you projecting for your desired purchase if any?|
|What is your cash flow safety net or ‘cash flow buffer’ in case a rent payment is missed, added expenses come up or mortgage rates and payments increase?|
|Do you have a source of emergency savings? How big is it? What could it potentially cover?|
|Do you have a home budget set up and are you running your home finances like a business would run? How might both business and home budgets be related?|
Effective estate planning can save you thousands of dollars in probate fees and income taxes, and ensure the continuity of your investment and success of your family should you pass away.
|How will the ownership of the property be set up? If you are in a relationship, is the property set up in Joint Tenancy with your spouse?|
|How is this asset insured if you were to pass away? How would this affect your business partner or your family?|
|What income taxes would you have to pay on your income property should you pass away? How would this affect your overall estate?|
Did you take the time to seriously consider the questions above? If you did that’s great, even if its just a start. Because if you’re taking questions like this seriously, then it likely means that you’re putting in the thought necessary to become a successful real estate investor. You’re building a momentum and are well on your way to a successful investor.
If you have questions about any of these considerations, contact Altrua Financial for a no cost consultation.
Your Plan IS, and will continuously become your very own step by step guide to rental property wealth generation.
Remember our thinking from the beginning of this article: The better we can understand and control the variables involved with real estate investment, the more successful we will likely become. A few baby steps here will take you miles further once you hit the ground running. Thankfully time is on your side, and you don’t need to make any decisions until you’ve wrapped your head around some other aspects of Landlording, as is discussed in the next section.
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.