Ryan Price

This is the third and final installment on how we bought our first income property.  You can read the previous posts here:

How we bought our first income property – Part I (The Preparation)
How we bought our first income property – Part II (Market Research)

We were confident with our knowledge of the London rental market and knew what we were looking for.  It was simply of matter of finding the right house and getting it at the right price.  There were two houses that we looked closely at when the time came.  The first was a four-plex near Argyle mall, but in the end we walked away from that due to concerns around previous water damage and the quality of previous repairs.

The other property – the one we would eventually purchase – was a triplex in Old South and had the strongest cash flow of them all (something I’ll demonstrate shortly).  It was fully rented and being maintained by a professional property management company.  This meant a couple of things in our analysis.  We knew what the rents were going to be for at least the next 6 months or so as all tenants still had time left on their leases.  It also meant that we would have relatively accurate estimates for utility costs and maintenance as professional property management companies keep meticulous records of everything they do.

Below is the template we use for every property we evaluate.  These are the real figures we used for this triplex.

Let’s break this down section by section.

Acquisition and Financing Details

This section covers the one-time costs of the purchase.  I use an excel template I created when putting these together so its easy to play with the numbers to check what happens in a bunch of “what if?” situations.

1. Purchase Price: pretty self-explanatory – this is the price paid for the property
2. Down Payment: minimum required down payment for an income property in Ontario is 20%
3. Immediate Repairs and Upgrades: these are the one-time major renovations or repairs you plan on doing immediately after taking possession.  In this case, the house needed a little TLC and we had a fair bit to take care of with immediate repairs and renovations.
4. Home Inspection: always get a home inspection and do your homework on who to use.  Cost is usually between $350 and $500 and it will be the best money you spend.
5. Land Transfer Tax: this can be calculated by you based on the purchase price.  You can find the rate scale in the “How Much do I Pay” section of the government’s land transfer tax page.  Some municipalities, like Toronto at the time of writing, have additional taxes on land transfer so check with your municipality to be sure (in London, there is nothing additional).
6. Legal Fees: covers your lawyer fees who takes care of title search, etc.  Varies from lawyer to lawyer, but will generally be around $600.
7. Total Cash Needed to Close: this is an important number.  This is the amount of cash you need to have on hand for you to be able to close on the property.
8. Total Investment Required: this is the amount of cash you should have on hand to close.  An extra couple grand as a buffer is never a bad idea either.

So we knew we would need about $45k to be able to move forward on this house.  But would that be $45k well spent?

Income

This section is pretty straight-forward.  You simply list any income you will be receiving from your property.  This will include the obvious income from rent, but should also include any supplemental income you would be receiving from things like coin operated laundry or renting out the garage as storage area.

In our case, it was only the rental incomes:  $1905 / month.

At this point I already had high hopes for the numbers on this property.  Generally, you can count on a property to cash-flow easily if the income is 1% of the purchase price ($1750 in our case).  This property was at a very comfortable 1.09%.  Depending on the property, you can be as low as 0.7% and still have a feasible property on your hands.  Any lower then that and you’ll have a hard time getting the property to pay for itself.

Expenses

It is so important to ensure you have accounted for all expected expenses in a given year.  Missing just one item, such as condo fees (if they apply), can end up ruining your cash flow.  So take the time and make sure you’ve covered everything.  Having the records from the previous owner will help with this.  For us, the expenses were as follows:

1. Mortgage: Your monthly mortgage amount.  I always use a value a little higher than the current interest rates to be safe.  In our case, I went with a 4% interest rate amortized over 25 years even though the interest rate we ended up getting was below 3%.  Amortizing over 30 years instead of 25 will also lower your mortgage payment.  Even if you decide to go that route, make sure your estimates are on the safe side with a 25 year amortization and a higher interest rate.If you’re in the London area and need a good mortgage broker I’d highly recommend Clint Stroop (clint.stroop@bemortgagewise.ca | (519) 857-4593).  We’ve gone to him for both places we’ve purchased so far and he is fantastic to work with.
2. Taxes: These are the property taxes.  Barring any major increase from your municipal government, its usually safe to assume the previous year’s property taxes as they won’t change significantly.
3. Insurance: This can be tougher to estimate, but again you want to be safe.  Even if you own a similar house and pay $1100 for insurance, do some asking around and see what you would be paying on a rental.  There are fewer companies to choose from to insure rental properties and the rates are generally a little higher.  For us, we were looking at around $1500/year.
4. Repairs and Maintenance:  I generally use 1% of the purchase price for repairs and maintenance unless I have reason to believe it will be more.  Generally, it will be less than 1% of purchase price but having this set out lets you accumulate funds for major items that come every handful of years like replacing shingles or windows.
5. Utilities: This can be hard to estimate, but do your best and again be cautious in your estimates.  In our case, we had the detailed records from the previous management company and knew it would be similar to the past year.
6. Vacancy Allowance: It is important to account for times when your units might be vacant.  In general, one month of vacancy per unit (or 8% vacancy) is high, but again I like to be cautious in any estimates.  I want the numbers to work in non-ideal scenarios so I know we’re covered.
7. Total Recurring Costs: Unlike the “Acquisition and Financing Details” section, this total represents the amount you can reasonably expect to spend on the property each year.

Cash Flow

The simplest, but most important calculation on this analysis.  Simply take your income and subtract the expenses.  It is so important to us that this number be positive.  Preferably over $100 to provide a bit of a buffer for us (see, I’m being conservative again!).  In our case, its a comfortable $445/month on the positive side.  That is good news!

Income and Gain Projections

This is something nice to do even if you’re the only one investing in the property.  In our case, we had investors putting up capital and this is the section that will hit home for them as it outlines what they can reasonably expect to make over the next 3 years.

1. Projected Annual Cash Flow:  This is taken directly from the cash flow section.  Even though rents are likely to be raised over this time, and thus cash flow improved even more, we again take the conservative route and leave it flat across all three years.  Starting to see a trend yet?  Be conservative with your estimates!
2. Loan Repayment (Principal Portion Only):  This is the amount of the mortgage payment that will be going towards principal.  That is, its the amount of equity you’ve gained in the house thanks to your tenants paying down the mortgage.  You can calculate this using any of the mortgage calculators.  I usually choose RBC’s as it breaks down nicely what the balance will be over the entire amortization period.  As the mortgage is paid down, more of the payment goes to principal so this number only gets better over time.
3. Renovations Added Value: I have this column in here, but unless a really major renovation is planned I usually am conservative and leave it blank.  Of course the improvements you make over time will add value, but let that be a bonus and not something relied on for return on your investment.
4. Capital Appreciation:  This is the amount your property has appreciated in value.  This is hard to predict and can be different property to property, but a conservative estimate would be 2% appreciation per year.  The market research we did for London made us confident this house was in a stable neighbourhood.This won’t always be the case.  For instance, I wouldn’t be comfortable buying a condo in Toronto or Vancouver right now.  I feel those properties are in a bubble that is set to burst any day now.  For areas like that, I wouldn’t even consider purchasing in the area until the inflated prices are brought back down.  This type of research is beyond the scope of this series of posts, but suffice it to say that you need to be confident in the area you’re buying in!
5. Total Return on Investment:  The all-important ROI.  This answers the question posed earlier: Is this $45k well spent?  This is the total gain for investors.  We forecast out three years.
6. Rate of Return: Simply the ROI divided by the total investment.  These numbers should look a lot more appealing than the 3% you would earn in the best high-interest savings accounts.

In our case this property had tremendous cash flow.  Obviously people don’t (and shouldn’t) price houses on cash flow alone, but if they did this one is a steal!  From an investment standpoint, we were pleased with this house and moved forward with an offer.

A spreadsheet like this will let you play with a handful of “what-if” situations which is important to do.  Both positive and negative.  Here are some ideas.  What if…

• We have no vacancies in a year?
• The interest rates stay low?
• We have an unexpected large expense?
• The rents went up to X?

At the end of the day, there is inherent risk with real estate investing.  By being as thorough and prudent as possible you are able to limit that risk while giving yourself an opportunity for some fantastic returns.  Understand that a perfect storm of bad scenarios is unlikely, but be comforted by knowing what the financials will look like in a variety of situations.

Offer, Inspection, and Closing Process

I won’t go into detail as this will be different for each and every property, and your real estate team should be there to provide expert advice for how to proceed with an offer on the property you are looking at and in particular how to structure an offer for an income property as there are certain additional clauses that are important.

In our case, we went through the offer-negotiation process and settled on the final purchase price of $175,000.  We had the home inspection which, as all home inspections will do, turned up some problems.  We arranged for the seller to take care of any of our major concerns and decided to “firm up our offer”.

An offer is considered “firm” once all the conditions have been met or waived.  Conditions will typically include at least financing, insurance, and home inspection.  Once the offer is firm, it is passed on to the lawyers to do their thing.  Your mortgage broker, lawyer, and real estate agent will work together to guide you through the closing process and ensure you’re taking care of any items you need to.

Before you know it you’ll be sitting with your lawyer on closing day being handed the keys!

Expect Obstacles Along the Way

Some deals go through smoother than others.  In our case it was a bit of a pain to get this one through as the seller was from out of town, didn’t own a cell phone and didn’t use email.  Plus, they were leaving on a road trip right when our offer was being negotiated.  This made it excruciatingly slow to get through the negotiations and amendments after inspection, but for a good property you’re willing to jump through some hoops.

I hope you enjoyed my series on the purchase of our first income property.  I will expand on some items we only touched on here in other posts, but I’d be happy to hear feedback from you on what topics you would like to see explored deeper.