Long, long before Duddy Kravitz’s (The Apprenticeship of Duddy Kravitz by Mordechai Richler) father told him, “A man without land is nobody,” investing in real estate was one of the best games in town. You bought property, rented it out, collected monthly checks, and watched your wealth grow. Historically, price appreciation was a bonus since the primary objective of most property investors was to generate income.
Today, investing in real estate remains a heckuva game.
[Chewy Bit: this post is limited to discussing investing in residential real estate, such as a condo].
And though income potential may be appealing, during the past decade or two many markets in North America, and the West in general, have seen property values increasing at a far higher rate than the historical average of about three to six per cent.
Sounds enticing, yes? Then why doesn’t every investor diversify their portfolio outside of ETFs, stocks, bonds, and find themselves a bricks and mortar investment? Well, the thing is … while property investing has strong potential upside, making money at it is by no means a slam dunk.
Lord Of The Land Material?
Sure, there’s something emotionally appealing about owning land, about being able to stand tall, chest puffed out, arms held wide open, proudly announcing, ‘Welcome to my Land!’
But I’m here to tell you not to buy into that silly ego nonsense. Being a landlord is not a simple role and its not for everyone. Rather, it’s more like a part-time job: dealing with tenants, property maintenance, unexpected costs, and guaranteed headaches now and then.
And like any investment, before you dive in, you have to do your research and figure out not only whether a particular property is suitable but, as importantly, whether you are suited to real estate investing.
Things To Be On The Lookout For
Most definitely, rental property may provide you with a stable source of income. But like any investment, you need to fully and completely and absolutely understand what you are getting into before you sign on the dotted line.
And you really, really, really, have to think hard about a bunch of issues (see below) that must be factored into purchase deliberations before you get all antsy in the pants and rush out to buy:
- Financial Might. As a potential buyer, you should be financially secure. If your job security is in question or the purchase might compromise financial goals that are higher on your list of priorities, then you shouldn’t be considering the purchase of investment property.
- To Mortgage or Not To Mortgage. If you’re not paying all cash for the property purchase, then you’ll be arranging financing. Which means, naturally, that much thought must be given to the issue of whether or not to take on debt.
It’s not that all debt is BAAAADDDD. It’s not. Especially when you’re borrowing for the purpose of earning income, and that income will be sufficient to cover financing payments, property taxes, monthly condo fees and repairs. And every time you make a mortgage payment, you’re increasing your equity stake in the property. Bonus!
But Debt still equals Risk. And if you already have a mortgage on your home, or your financing a car, or the kids are off to university soon, or you otherwise carry large debts or expect to incur large expenses in the near future, you have to run the numbers and objectively consider whether it’s wise to take on more debt, i.e., more risk.
- Interest Rates. We live in a wildly low interest rate world but that’s going to change, sooner rather than later (so says BuddhaMoney’s crystal ball). As interest rates go up, so will your cost of borrowing. In turn, higher financing costs will reduce your net return unless you’re able to raise rent.
- When To Buy. All investment markets are cyclical. And just like buying stocks, you want to buy real estate when prices are low, when the market is weak. Because buying low increases the odds that the principal value of your property will appreciate in price over the long haul.
- Property Taxes. This is just one of many costs of ownership. Before you purchase, find out how much in property taxes are to be paid during the year in which you buy. Then take a look at property taxes for the five preceding years, to see if there is a trend or a typical percentage increase.
Sure, this information will better inform you of overall costs, but you still won’t know with any certainty how much, if any, property taxes will increase next year or any year thereafter afterward. So do the wise thing: to minimize the odds of there being any financial surprises, and ensuring the property is affordable, plan for taxes increasing at a percentage rate higher than the past typical increase.
- Wear and Tear, Grin and Bear. In the usual course of owing a residential property, maintenance and repairs are needed. Whether you need the washer or fridge repaired, walls freshened up with paint, or the hot water heater replaced, you will incur maintenance and repair costs. And if you’re not the kind of gal/guy who cares to get your hands dirty and callused by undertaking repairs your self, then repairs will cost you that much more.
- It’s the Tenant Calling … Again! Okay, what do you think of this scenario: tenant calls you at two in the morning. Apparently, the toilet overflowed and there’s now a rising lake inside the condo.
Or … tenant is late with their rent. Then simply stops paying rent. And you’re not familiar with local laws so you higher a lawyer (i.e., money out of your pocket) and pop Tylenol for the next thirty days because you haven’t off-loaded property management to someone else because that would eat into net return.
Or … something innocuous like tenant calling at nine in the evening asking you to drop by to change a light bulb that they cannot unscrew despite their two university degrees.
Hey, that’s reality folks. You may be Lord of the Manor but that doesn’t mean you’re always walking in the rose garden. From minor annoyances to major inconveniences, there is a price to pay and time to give. So don’t underestimate the amount of work involved in dealing with your tenant.
- Evil Renter Person. You may have heard a story or two about renter’s doing serious damage to a condo. Though I tend to believe that most renters act honestly and respectfully, there remains the possibility that your condo is leased to Evil Renter Person. And when damage happens, guess who’s going to pay for repairs?
If Evil Renter Person escapes from your clutches, never to be seen or heard from again, then you, Property Lord, are responsible for paying repair costs.
Or … you may get lucky and Evil Renter Person may accept responsibility and reimburse you for repair costs.
Or … your insurance may cover the damage.
Or … the security deposit may be sufficient to cover repair costs.
However it works out, dealing with renter caused property damage is a headache of varying pain thresholds.
To best protect yourself: (1) before agreeing to lease, meet with prospective tenant at least once if not two or three times to get a feel for who will be living in your property; (2) before agreeing to lease, thoroughly review all information concerning prospective tenant; (3) retain a lawyer to review the lease agreement, ensuring the agreement covers damage caused by the renter and; (4) require a security deposit, minimum one month’s rent, two is even better.
Ya, Ya … So There’s Risk … How Much Money Will I Make?
You’re in the property investing game to earn money. And with rental properties, income is earned via rent payments. Once you’ve assessed applicable risks, and decided they are manageable, you’ll need to calculate how much income this baby’s going to drop into your account each month.
Here’s a straightforward example:
- If property cost is $400,000;
- And the property rents for $2000 / month;
- Then you receive $24,000 annually (i.e., $2000 x 12 months = $24,000), which works out to 6% gross return
[Chewy Bit: gross return means we have not yet calculated expenses].
That said, you should know that rent payments are not guaranteed from the day you purchase the property.
What I mean is that there may be times when the property sits empty earning bubkus! Such as (1) if the rental opportunity is typically seasonal, not year-round; (2) those times you’re searching for a new tenant; or (3) Evil Renter Person refuses to pay rent and you have to jump through legal hoops before evicting tenant.
Spend Money To Make Money
That $24,000 I mentioned above, that’s also known as the property’s cash flow.
Deduct all expenses from cash flow and, voila, you figure out how much money gravitates to your pocket, i.e., net return.
What kind of expenses are we talking about?
- First, you have Fixed Expenses. Meaning, expenses you’ll incur every year, i.e., property taxes, insurance, and common maintenance and repairs.
- Second, there’s your Surprise!-wasn’t-planning-for-this-expenses, like replacing the roof or air conditioner, or a pet shredded the carpet.
Now, as an example, if expenses run you $5,000/ year, this leaves you with a net return of $19,000 ($24,000-$5,000) or a 4.75% return. When considering whether the investment is worthwhile, you’ll want to calculate the approximate net return.
And when you’re doing so, be sure not to underestimate expenses. Because it’s no fun if you go into this investment thinking you’ll make money and then you don’t.
[Chewy Bit: most common mistake among novice real estate investors is to inaccurately minimize costs of renovation and ongoing maintenance].
Streams and Streams of Cash
The thinking goes that rental properties provide a stable income stream that is separate from all of your other investment and retirement accounts and not necessarily subject to the same risks. And if you understand the risks involved, can afford to make the purchase, and are willing and able to wear the Landlord hat, then odds are you’ll have one solid investment supplementing your income each month, building equity, and contributing to a financially secure retirement.
But you know what? For me, I’m thinking: is it worth the effort to buy an investment property? I mean, there’s a simpler way to gain exposure to the real estate sector if that’s what I’m looking for.
I pay my discount broker $9.99 and buy a Real Estate Investment Trust (REIT) that pays me a monthly income of anywhere between six and nine per cent.
Sure, REIT units may go down in price, just like real estate value may decrease. But if I’m holding for the long run, I’m quite comfortable taking the risk that the REITs principal value will not decrease, and in fact will likely increase. In the meantime, I’m earning my six to nine per cent every month with the added pleasure of not having to take on any of the risks involved with purchasing an investment property such as managing a tenant, financing a property, learning home repairs, or tying up a boatload of capital in the property.
Bottom line: If you want a piece of real estate, then it comes down to deciding not only which investment will provide the better return, or which investment will save you money on Tylenol, but as importantly, which one is a better fit for you: REITs or bricks and mortar.