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The secret to successful real
estate investing over the past decade has been simple: buy property, then sit
back and watch it rocket up in value. With prices shooting skyward at
double-digit rates in many Canadian cities, how could you not make money?
Unfortunately for would-be Donald Trumps, making money over the next decade
may not be quite so straightforward. A recent housing affordability report
from Royal Bank proclaimed “easy money no more,” and warned that prices in
both Calgary
and Edmonton
have “soared well above their fundamentals to unsustainable levels.”
Meanwhile, the latest numbers from the Organization for Economic Co-operation
and Development say that Canadian homes are now more expensive than their U.S.
counterparts, when you measure them in terms of their relationship to incomes
and potential rents. Nobody is yet predicting a U.S.-style real estate
collapse in Canada,
but all the data suggest that the red-hot market of the past few years is
likely to soon come off the boil.
If
the housing market cools, the old way of real estate investing will stop
working, and investors who rely on rising home prices for their profits will
start losing money. Luckily, there’s another way to invest in real estate,
and it works no matter what the market does.
Using this method, Dan Young made his first million by the time he was 34. He
started investing in properties in his home town of Midland, Ont., when he was just 24, and
made most of his money on a four-plex, a six-plex, and a 12-plex.
His secret was nothing more than a systematic method for evaluating potential
investments. Rather than betting on possible gains in real estate prices, he
made sure that the rent he received from a property put cash into his pocket
each and every month, from the very first day he bought a property. “When
things are going well, when interest rates are declining and property values
are going up, then it’s really easy to look like you’re smart,” he says. “But
when things go the other way, it’s really easy to lose money too. That’s why
you need a long-term strategy based on some realistic expectations.”
To be honest, Young’s way of investing isn’t really all that new at all — it
has just fallen out of favour over the past decade. David Southen has been
using it for 24 years. He’s now 48 and he and his partners own 125
residential units in Southern Ontario worth
about $7 million. He can sum up his secret in just three words: positive cash
flow. “You need to be making enough from renting your property out so that
after all of your expenses are paid and your contingencies are allowed for,
you can pay the mortgage and still put a few shekels in your jeans,” says
Southen from his London, Ont., home. “If you’re not, then it’s not a viable
investment.”
If you want to generate a reliable stream of cash from your real estate
investment, rather than just gamble that prices will go up in the future,
Southen says you need to carefully assess each property before you buy it. Your
fate as a landlord will be largely determined at the moment of purchase — pay
too much and your mortgage and expenses will eat up all of your profits.
Southen says there’s a simple three-step way to calculate the right price to
pay for an investment property:
• First, get an honest estimate of the total income you can expect from
renting it out each month
• Second, get an honest estimate of the expenses involved in running the
property
• Third, figure out how much money your property will have to spin off after
expenses to pay the mortgage and provide you with a profit
Once you know those three numbers, evaluating how much to pay for potential
real estate investments is easy. Of course you’ll only get a trustworthy
result if you use trustworthy numbers to begin with, and that’s the catch.
Getting a grip on the true rental income you can expect and the true expenses
associated with a property can be tough — mainly because the seller will
supply you with a long list of bogus numbers. “There’s a well-known saying in
real estate investing,” says Southen. “‘Trust — but verify.’ Getting a handle
on the property taxes and insurance is easy. But people will lie to you about
everything else.”
Sleuth out the real rents
If you want to get past the lies and figure out how much your potential
investment is really worth, start by estimating the total rental income that
the property can generate. Ask the seller for the “rent roll,” which tells
you how much rent is being collected from each unit. Then scan the local
papers to find out the typical rents being charged in your area. As a
double-check, look for the rental market reports published by the Canadian
Mortgage and Housing Corporation (see www.cmhc-schl.gc.ca) and find out the typical rents in
your area. If the rents charged to the tenants in your building are lower
than the local average, that’s good. It means there’s room to raise rents in
the future. “However if the average two-bedroom is renting out for $850, and
the units in your potential investment are renting out for $1,000, watch
out,” says Southen. “They might be filled with the seller’s relatives, who
will leave the second you close on the property. That’s an old favourite.”
Don't forget vacancies
“The vendors will tell you the property is fully rented with a waiting list,
so they don’t have any vacancy or bad debt,” says Southen. “But it’s not
true. Every landlord has vacancy and tenants who skip out without paying.”
When calculating your expected rental income, subtract 5% from the total
income the building will generate at full occupancy to offset your expected
losses from vacancy and bad debt. Then add in any additional income from
laundry or parking. That will give you your “gross effective income.”
Add up the small stuff
The next step is to estimate
expenses. Your first big cost is property management. If you’re buying a
larger property, you’ll probably want to hire a professional property manager
to rent out the units, keep the books, and oversee basic maintenance. If
you’re buying a smaller property, you may want to do all that yourself — but
you should still subtract your time as an expense because you may not want to
do the chores forever. Southen suggests you count on paying 6% of your rental
income for management in larger buildings and more in smaller ones.
Then there are maintenance and repair costs. “That’s where you’ll run into
the biggest fudge factors,” says Southen. “The landlord will tell you: ‘I do
all the repairs myself, so there’s no cost.’” Don’t believe it. You can count
on spending at least $800 a year on maintenance for each apartment or
townhouse. On top of that, you should budget separately for any major capital
expenses, such as replacing the roof or upgrading an elevator. Have the
property professionally inspected and do an environmental audit before buying
to avoid nasty surprises.
Utilities, your next expense, can be an opportunity. “If I go into a building
and see that it’s stuffed full of old incandescent light bulbs, then I know
right away that I can peel 10% to 20% a year off the bill just by changing
the bulbs,” Southen says. Similarly, old furnaces and boilers, old toilets
and leaky showerheads offer you the chance to improve your annual income from
the property with a few lost-cost upgrades.
To get a good idea of what you’ll be paying for heating, water and
electricity, ask for at least one year’s worth of bills. “A lot of people
will say they don’t have them,” says Southen, “but utility companies will
provide a summary of the previous year’s charges if the owner asks for it.”
Don’t forget the cost of advertising for new tenants. If you have a lot of
units like Southen has, you can count on paying about $400 a month for
newspaper ads and the like. If you have a single triplex, the expense can be
negligible.
Your final three expenses — property taxes, insurance and bank charges — are
usually straightforward, but Southen offers a couple of tips. With property
taxes, watch out if you’re paying a lot more for the building than it was
last assessed for, because the very act of purchasing it could trigger a new
assessment and higher taxes. With insurance, make sure the building isn’t
underinsured. If it is, be prepared to pay more for a better policy.
By now, you’re probably starting to see why inexperienced real estate
investors would rather just focus on rising house prices. Getting a good grip
on your true income and expenses is a lot of work, and you may feel like
you’re worrying about nickels and dimes when there’s big money to be made
from rising property values. But remember that you want an investment that
doesn’t depend on rising home prices to make you money.
If you diligently tote up all your various costs, you’ll be astonished by
what you find. Almost always, vacancies and expenses eat up a full 50% of
your gross rental income, though many sellers will deny it. “Underestimating
how much it’s going to cost to run a building is the No. 1 mistake made by
inexperienced investors,” says Southen. And it’s the No. 1 reason why
investments that look good on paper can end up costing you tens of thousands
of dollars in the long run.
So what's your return?
You’re now on the home stretch to determining what your building is worth.
Subtracting vacancies and expenses from your rental income will give you
what’s called your “net operating income” for the property. You use that to
determine the return from your property, commonly referred to as your “cap rate.”
The cap rate is simply the cash yield you get from your property, after
accounting for all expenses but before mortgage payments. In other words,
it’s your net operating income divided by the price of the property. It has
to be higher than the interest you’re paying on the mortgage or you won’t
make any money. These days, Southen says he looks for cap rates between 7%
and 8%. “If someone came to me with an honest 8%, I’d buy all day,” he says.
“A 7.5% would be okay, but a 7% … well, I’d have to think long and hard about
it if it were a 7%.”
And
the true market value is…
Now that you have your cap rate, you can calculate what you should pay for
your building. Just subtract the expenses from the annual rental income, then
divide by the cap rate. For instance, if the building has four units renting
for $900 a month each, expenses that eat up 50% of your gross income, and a
cap rate of 7.5%, you can quickly calculate that you should pay about
$290,000 for the building, tops. If you pay more, it’s probably not a good
long-term investment.
We know what you’re thinking: “Where on earth am I going to find a four-plex
that’s going for less than $300,000?” Certainly not in Vancouver, where the average detached house
is now selling for north of half a million. Probably not in Toronto, Calgary or Edmonton either.
But that doesn’t mean the calculations are wrong. What it means is that now
may not be a great time to buy. Your annual return is essentially the spread
between market rent and the cost of buying and owning a property. In many
cities, property prices have been climbing by as much as 10% a year. Rents
have been edging up far less. Thus, the rising prices have squeezed the
profit potential right out of the buildings.
If you’ve read books or attended seminars on buying real estate, this may
surprise you. Many gurus talk up how easy it is to succeed in real estate and
offer up tricks that are guaranteed to make money. They chatter about the
power of leverage, the secrets of bargain basement financing, and how to
identify up-and-coming neighbourhoods. All of those tactics can help you get
more out of a decent investment. But none of them will help you if you pay
too much for your property. It’s almost impossible to turn around a true
money-loser — which is why positive cash flow is king, and all other
considerations are secondary.
David Southen and Dan Young made a killing in years past because they bought
when prices were lower. Southen says that since then, prices have surged too
high. “I’d like to buy right now,” he says. “I’ve got lots of money available
to buy with. But I’ve found that there’s really nothing to buy that’s
reasonable.”
Young largely concurs. His first investment was a four-plex in the Midland area that he bought back in 1998 for just
$135,000. His second investment was a six-plex that he bought in 1999 for
$190,000. He’s not seeing many prices like that today. In fact, he’s been
looking to buy a new property for seven years.
He thinks he may have finally found a prospect. It’s a nine-plex in Midland that he’s had
his eye on for some time, although it wasn’t officially for sale. He liked it
because he knew that the landlord was charging lower-than-market rents, which
meant that Young could raise the rents as the tenants rolled over. Not only
that, but the landlord had been paying for the utilities. Young knew that the
units were separately metered, so he figured he could also download the
utility expense to new tenants, who could pay their utilities directly. On
the off chance he could persuade the owner to sell, Young asked his real
estate agent to inquire. “The owner was interested, so I moved in fast,” he
says. “Really fast.”
Young’s latest adventure shows the challenges of investing in this market. At
first, the price for the property looked too high, but once Young factored in
the artificially low rents and the effect of downloading the utilities, he
found that the building could carry itself at a decent cap rate. “It’s really
hard to find investments that make any sense right now,” he says. “But there
are some. You just have to wait and persevere.”
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