This post is a bit long and complex but it may well be the secret you’ve been waiting for. Study it carefully if you want the real opportunity to create wealth.
I get several enquiries each week from people who want to buy a condo that they can rent out short term as an investment. Honestly? That is a lousy investment. Out of the revenue you generate, you have to pay 50% or more off the top for property management fees, cleaning and such. Then, you may also be footing the bill for utilities. With what is left, you are paying the condo fees, taxes, association dues, insurance and, well, you are unlikely to generate any cash flow and more importantly, you may have difficulty in financing your purchase if the property carries a commercial component such as those at the Village at Blue. There is a better way.
Properties that rent out annually generally will save you the costs of property management (you can do it yourself once a year or less), utilities (as the resident pays), cleaning fees and association dues. The property is residential, it may be much easier to finance at conventional mortgage rates and with a low vacancy rate such as we have in Collingwood, the risk is low if you screen your tenants well. That’s another topic for another day.
Maximizing the return on investment, or ROI on every rental property you purchase, is the way to building wealth as a real estate investor. Let’s look at how ROI is calculated. The formula is:
Return divided by amount paid out of pocket + ROI
The first and easiest is to look at a cash purchase. Let’s say you are buying a house for $220,000. Your closing costs for land transfer tax and lawyers fees as well as a little extra for improvements, rental costs, etc could be $5,000 for a total out of pocket investment of $225,000. If the tenants pay 1400 a month in rent or, $16,800 a year but I have expenses of $3000 a year for taxes and insurance, the net return is $13,800 a year.
The ROI can then be calculated as: $13,800 divided by $225,000 = 6.1% return.
That’s not bad. But it could be better.
How does financing a purchase affect the return? The answer is that it affects it quite a bit as you are leveraging the rent to pay down the debt. Let’s take a look.
Let’s say you bought the same $220,000 house with the same $5,000 in closing costs for a total investment of $225,000. You decide though to buy the property with 20% down: $$220,000 x 20% = $44,000 for a down payment. Now, your out of pocket expenses are no longer $225,000 but they are actually about $49,000. ($44,000 down payment plus $5,000 carrying costs). You have added to your $3,000 annual costs because you now have a mortgage payment. Since you bought the house for $220,000 and put down 20%, the remainder of $176,000 will need to be financed.
Let’s say you take out a loan for 30 years at 2.7%. The monthly carrying costs would be $806.00 or, $9672.00 a year. Add your $3,000 for taxes and insurance and you are paying out about $12,700 a year giving you a NET cash flow of just $4100.00. BUT, you didn’t pay out $225,000 as you did with a cash purchase, you only spent $49,000.
$4100 divided by $49,000=8.36% return.
That’s right, by financing, you have actually increased your return.
Now here is the GOLDEN GEM. After just one year in this scenario, you will have paid down $5,009 of your mortgage principal without a single extra dollar invested. Let’s add that $5,000 to your $4100 and see what happens to your return:
$9100 divided by $49,000 =18.57% return!
What if you did the exact same thing but put the mortgage over 20 years instead? The annual carrying costs would now be about $14,400 leaving a cash flow at the end of just $2400 BUT, the one year pay down on the mortgage will have increased to $6740 for a total annual return in the first year of $9740.00.
$9740 divided by $49,000 = 19.87% return!
We have not even considered property appreciation which may add another 2-4% a year over time to your return. There may also be tax benefits when you write off costs and depreciation against other income. Even if you sold the property 20 years from now for exactly what you paid, you could still be generating returns far greater than any other investment vehicle. It takes guts and the willingness to do what it takes to learn how to be a great investor and landlord but the rewards are worth every cent.
Marg Scheben-Edey is a Broker with RE/MAX four seasons realty limited, Brokerage in beautiful Collingwood, ON. With three decades of experience, Marg is a leader in the local real estate marketplace and is ready to help guide both Buyers and Sellers in achieving their real estate goals. Email Marg