Archive for category Investment Real Estate
The price-to-rent ratio is a simple calculation that one can make to get an idea of whether it makes sense to rent or buy in a particular area. For the real estate investor, it can be used as another tool in your arsenal to determine what areas you should invest in.
How to Calculate Price-to-Rent Ratio
Price-to-rent ratio = price of the house / annual rent
That is, you simply take the price you would have to pay for a property and divide that by the annual rent you would receive for the same property.
Should I rent or buy?
This ratio is often used in discussions about whether it makes sense to rent or buy in your particular area of the country. The thresholds for the ratios are:
- Price-to-rent ratio of 1 to 15 would mean it makes more sense to purchase than to rent.
- Price-to-rent ratio of 16 to 20 would mean its typically better to rent than to buy, but this is the grey area where a lot would depend on the particular market and situation.
- Price-to-rent ratio of 21 or higher means its much better to rent than to buy.
What Price-to-Rent Ratio means to the investor
As a property investor, you can use this ratio as an indicator on what your return on investment (ROI) is going to be for a particular area. The lower the price-to-rent ratio the higher your ROI is going to be.
Unfortunately, if you’re doing these calculations from a major Canadian city at the time of this writing you’re going to find extremely high ratios. According to the International Monetary Fund (IMF) the average ratios for Montreal, Toronto, Calgary, and Vancouver are concerning (full report is here):
- Montreal: 35
- Toronto: 35
- Calgary: 32
- Vancouver: 58
That isn’t to say it would be impossible to find individual properties in those markets with considerably lower ratios, but it would be very tough. As an investor living in any of these major cities this would be an indication, when combined with other analysis like cash flow and cap rate, that it is time to look outside your immediate area for investment opportunities.
As a comparison, the property we recently purchased in London, Ontario has a ratio of 7.66 (175000 / [1905 * 12]).
Significantly more appealing.
This is the third and final installment on how we bought our first income property. You can read the previous posts here:
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.
|Acquisition and Financing Details||Values||Reference|
|Purchase Price||$ 175,000.00||A|
|Down Payment||$ 35,000.00||B|
|Immediate Repairs and Upgrades||$ 6,000.00||C|
|Home Inspection||$ 500.00||D|
|Land Transfer Tax||$ 1,425.00||E|
|Legal Fees (Title Insurance, etc)||$ 600.00||F|
|Total Cash Needed to Close (B + D + E + F)||$ 37,525.00||G|
|Total Investment Required (G + C)||$ 43,525.00||H|
|Unit 1 (Main Level, Front, 1 Bedroom)||$ 6,900.00||$ 575.00|
|Unit 2 (Main Level, Back, 1 Bedroom)||$ 7,620.00||$ 635.00|
|Unit 3 (Upper Level, 2 Bedroom)||$ 8,340.00||$ 695.00|
|Total Income||$ 22,860.00||$ 1,905.00|
|Mortgage||$ 7,536.88||$ 628.07||33%|
|Taxes||$ 3,294.00||$ 274.50||14%|
|Insurance||$ 1,500.00||$ 125.00||7%|
|Repairs and Maintenance||$ 1,750.00||$ 145.83||8%|
|Utilities||$ 1,528.00||$ 127.33||7%|
|Vacancy Allowance (1 month per unit)||$ 1,905.00||$ 158.75||8%|
|Total Recurring Costs||$ 17,513.88||$ 1,459.49||77%|
|Total Cash Flow||$ 5,346.12||$ 445.51|
|Income and Gain Projections||Year 1||Year 2||Year 3||Total – 3 Years|
|Projected Annual Cash Flow||$ 5,346.12||$ 5,346.12||$ 5,346.12||$ 16,038.36|
|Loan Repayment (Principal Portion Only)||$ 3,255.00||$ 3,387.00||$ 3,525.00||$ 10,167.00|
|Renovations Added Value||$ -||$ -||$ -||$ -|
|Capital Appreciation (2% per year)||$ 3,500.00||$ 3,570.00||$ 3,641.40||$ 10,711.40|
|Total Return On Investment||$ 12,101.12||$ 12,303.12||$ 12,512.52||$ 36,916.76|
|Rate of Return||28%||28%||29%||85%|
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.
- Purchase Price: pretty self-explanatory – this is the price paid for the property
- Down Payment: minimum required down payment for an income property in Ontario is 20%
- 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.
- 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.
- 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).
- Legal Fees: covers your lawyer fees who takes care of title search, etc. Varies from lawyer to lawyer, but will generally be around $600.
- 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.
- 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?
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.
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:
- 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 (firstname.lastname@example.org | (519) 857-4593). We’ve gone to him for both places we’ve purchased so far and he is fantastic to work with.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
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.
- 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!
- 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.
- 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.
- 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!
- 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.
- 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.
This is the second installment on how we bought our first income property. You can read the other posts here:
Everyone has heard it:
Location, Location, Location…
This holds true, and I would argue even more so, when it comes to income properties. When we first started looking into markets we were still living at Yonge and Sheppard in Toronto. If you’re familiar with Toronto you’re aware that real estate in that area can cost your first born. Even though I’m convinced I will inevitably screw up my first born and would do better on a second attempt, I’m still hesitant to give him/her up for a piece of property… just in case they turn out alright.
So we looked elsewhere. We started looking in Durham Region. I was comfortable with that area having grown up in Whitby for most of my life. Whitby had an established college (Durham College) and a new and growing university (UOIT). Unfortunately, in response to some unhappy homeowners around the campus there were tight restrictions and heavy fees being implemented for student rentals in the area that limited the ability to have a 5th room in a basement or convert a single family dwelling into a duplex. Both of those are key for that area in order to have a cash flowing property.
We turned our attention off the student market and looked elsewhere. The only area we found with half-decent cash flow was in the slum areas of Oshawa which would’ve attracted non-ideal tenants (to put it nicely) and would of had us holding below average property.
We found similar results looking in surrounding Ajax and Pickering. There may of been money to be made, but it was cutting the cash flow too tight for our liking. It was time to move on.
We turned our focus back to student housing and started looking in affordable student neighbourhoods of Kitchener/Waterloo, Guelph, Hamilton, London, and Windsor. We started to see more possibilities. We looked at a few properties in Guelph that had some potential. The cash flow was still a bit tight, but the quality of house was higher. It would of attracted quality tenants and would be easy to sell when we wanted to as many of the properties could easily be single family starter homes (the most liquid homes out there are single family starter homes).
We seriously considered a place in Guelph, but at the end of the day a combination of lack of investment capital and a feeling of not being quite comfortable enough with the area caused us to move on. We were being shown around the Guelph area by a family friend who has kids attending the university there. We learned a lot about the area, but having not spent much time there ourselves it wasn’t enough.
Naturally, we felt much more comfortable in London. We went to school there and knew the neighbourhoods. We once again started out looking at student rentals. Our focus was put there first as student rentals tend to cash flow easier than other rentals because you can charge a slight premium by renting the house out at a per-room rate split between a handful of students rather than a per-house rate covered by a single family.
The student market in London was changing though. The “red brick” style apartments were popping up everywhere. These were newly built, spacious townhouse-style rentals for students that were close to the university and on some great bus routes. Houses that were always fully rented despite the clear lack of maintenance started to go vacant. Students had options in and around the university now and if you wanted your house rented it needed to be more than four walls and a roof on a bus route. We were still fans of student housing around the university but it was important to be picky on the properties.
Around this time I received a job offer in London. We hadn’t really planned on leaving Toronto but both Maggie and I loved London and when the job was mine we decided to take the dive and go for it. Now we were even more confident London would be where we focus our efforts on finding an income property as being in the area makes it exponentially easier (and more affordable) to manage.
Shortly after we moved we continued to learn the London market. We became very familiar with the student market as well as the multi-family market. London has a handful of areas where multi-family homes are available:
- Wortley Village / Old South:Contained by Beachwood on the West, Ridout on the East, Horton on the North, and Baseline on the south this area had a nice diversity of multi-family properties mixed in with single family homes. It is a mix of student and long-term renters with the trendy Wortley Village downtown area just steps away.
- The Hamilton Road Stretch:Stretching from Adelaide to Clarke road, the strip along Hamilton contains many multi-family properties at affordable prices. A few blocks north and south in either direction also have their fair share of multi-family properties. This area is a bit more rough and while the cash flows can be quite strong its important to be picky. Tenants aren’t always ideal in this area and it seems that previous owners with properties in areas like this don’t always seem to keep up on maintenance. There are some gems in the area, but a lot of duds. More suitable for someone with the cash to both purchase and do major renovations.
- Richmond Row:Richmond and Oxford area stretching down to Richmond and Dundas. From the river on the Wast to Colborne/William on the East. This is a desirable area of London, and where I lived for three of my years at Western. Historic properties, great access to amenities, always easy to rent. The tradeoff is that this area is significantly more expensive and most properties here just don’t cashflow out of the gate without a significant investment.
- Dundas and Adelaide Strips:Running from Richmond along Dundas Street and North up Adelaide you’ll find a variety of multifamily properties. While there are always exceptions for certain pockets, these areas are not overly desirable by the type of tenants we prefer. They are worth looking at, and the city is pouring a lot of money into the Dundas strip trying to revitalize that area. So far we haven’t found anything along those two strips that appealed to us.
I did not cover all the areas, and within the areas I did mention there can be differences block to block – but you get the idea. These are the areas we chose to keep a close eye on. I check the listing feeds daily for new postings in these areas and monitor the sales of specific properties.
We were quickly becoming area experts and when the right property popped up its head, we were ready…
This is the second installment on how we bought our first income property. You can read the other posts here:
The process of buying any type of property can be daunting. Buying investment property adds a little more complexity. Buying the property we ended up choosing resulted in more obstacles to overcome along the way.
At the time of writing, we are about three weeks from closing on the property that we have been working on since early June.
In the next few posts I’ll take you through our process and give you a look at how we prepared, why we chose this property, and the obstacles we encountered along the way.
Setting up the Company
We plan on building a portfolio of investment properties over time. For a variety of reasons ranging from liability to tax benefits it made sense to incorporate a company to hold the houses rather than hold it under our own names. The incorporation process wasn’t difficult but we decided to hire someone to take care of all the paper work. This ran us about $600 and took care of all the filing with the government and the set up of all the initial documents (articles of incorporation) that specify name of the company, director roles, ownership percentages, purpose of the company, company charter, etc.
Once we had our articles of incorporation and our corporation number (you get this from the government after everything is processed) we were ready to open the business bank account. We went with the small business account at RBC. They charge $6/month for minimal transaction volumes which suited our needs nicely.
The next piece of the puzzle was some documentation to get us started outlining the terms of the Joint Venture deals we were planning on using. We didn’t want to pay a lawyer to write the legalese from scratch so we had been looking elsewhere.
In fact, in the months leading up to this we were doing a whole lot more than looking. I started taking the necessary courses to become a Realtor in Ontario. At the same time we were absorbing as much experience as we could from others who had walked the walk. One of the best resources we found was Julie and Dave over at RevNYou. They are seasoned real estate investors based out of BC that have a great starter package for JV partnerships. We ordered the package, and used many of the templates they provided as the starting point for our own documents. We also joined their mentoring program which provided a wealth of information through calls with experts and the simple act of sharing past experiences.
The company was incorporated, the bank accounts established, and our contracts prepared. We were theoretically ready to purchase. All we needed was a quality income property and the funds to buy it. Minor details, right?
TD has released its annual First Time Home Buyers report and if you were thinking about buying a duplex or a place with a basement apartment you’re not alone. One-third (33%) of first time home buyers said they have or plan to buy a home with a rental unit. Of those, 70% said they would use the extra income to help pay down the mortgage faster.
The majority of those surveyed expected to receive between $500 and $1000 per month for their units. This was a national survey, but that is pretty on target with what you can expect from a typical duplex in London too.
Personally, I think this is a fantastic route to go if you’re comfortable with it. However, the report also indicated that only 76% of first time buyers were getting pre-approved for a mortgage (down from 91% the previous year) which worries me that people are only seeing the shiny side of the coin.
Having a rental unit provide extra income can be wonderful, but it is so vitally important to do your homework first! Make sure having tenants is for you.
- Do your research to understand what type of tenants will be renting in your area. Speaking to a realtor who is familiar with your area will help.
- Keep in mind that having a rental unit means being a landlord and owning up to all the responsibilities that come with it. Read through and understand the Residential Tenancies Act to make sure you’re willing to assume the responsibilities and risks involved.
- Get pre-approved for a mortgage. Nothing will leave a sour taste in your mouth more than finding your dream home and not being able to afford it. Getting pre-approved first allows you to set a budget. A budget lets you narrow down the areas of town you can afford and can help you decide where you are willing to make sacrifices.
Happy hunting first time buyers!
In a previous post I talked about using cap rates to compare investment real estate. Cap rate is a great way to compare potential investments, but when it comes down to selecting a property its all about cash flow!
What is Cash Flow?
Cash flow is actual money coming into (or out of) your pocket each month. Its the cold hard cash you actually have access to. Its the stuff you can hold in your hand, fill up the bathroom tub, and swim in. Cash is king, and in investment real estate cash flow is king.
Cash flow is usually calculated either on an annual or monthly basis. Either way works, and often they are done together. If you’ve ever taken a look at a company’s official financial documents (everyone’s favourite night-time reading) you’ve likely seen a cash flow statement before. Good news for real estate investors: calculating cash flow for income properties is a lot more straight-forward than an entire business.
Cash Flow = Income – Expenses
Jaw-droppingly difficult, I know.
Similar to the cap rate calculations, income is usually straight forward. Its simply the rent you’re collecting each month. The expenses, unlike cap rate calculations, include your mortgage (or other loan) repayment.
Sample Cash Flow Calculation
Lets continue using our imaginary Triplex in London, ON from the previous post. To refresh:
Our example home is a Triplex close to the university with an asking price of $279,000. The units rent for $1,000 (Unit 1), $800 (Unit 2) and $600 (Unit 3) and the tenants pay all utilities. Taxes are $3,200/yr and insurance is $600/yr.
Lets say we ended up agreeing on a price of $265,000. We put the minimum down payment required for an income property (20% = $53,000 in our case) leaving us with a mortgage of $212,000. This boils down to mortgage payments of around $1,200 per month. Your mortgage payment will vary depending on the type of mortgage you choose. In this case, we went with accelerated bi-weekly payments on a 5 year fixed mortgage at 4% amortized over 25 years. You can use the RBC Calculator to play with mortgage payments.
So, we now know our income and expenses:
Rent is $2,400/mnth ($28,800/yr). Factoring in our vacancy allowance of 6% gives us an adjusted income of:
Mortgage: $1200 ($14,400/yr)
Taxes: $267 ($3200/yr)
Insurance: $50 ($600/yr)
Maintenance: $220 ($2650/yr)
Total: $1737 ($20,850/yr)
This gives us a very favourable cash flow of +$519/month ($6,222/yr). From cash flow alone this means an annual return on investment of 11.7%.
It is important to note that this is an ideal scenario and in reality finding a multi-family property with 4 units or less that has this kind of cash flow is very rare. In reality, a property like this might include utilities which would add another $300 per month to your expenses or you may want to allow for a higher vacancy allowance (some investors like to use one month, or 8.33%).
How to Come Up with the Numbers
When we’re doing calculations on a potential investment we like to stay conservative.
- Be slightly pessimistic in what each unit will demand for rent. If you’re planning on charging $1600 for a unit, do your cash flow analysis at $1450 to make sure it still works if you end up having to lower rent to attract a tenant.
- Leave a buffer for variable expenses like utilities. If an increase in utility costs by 10% kills your cash flow you need to be aware.
- The 1% of purchase price rule of thumb for maintenance costs is generally a good one. If the property you’re looking at is going to require significant ongoing maintenance be aware of this and up the number appropriately. This number may seem high month-to-month but its meant to build a reserve over time for major repairs such as re-shingling the roof or replacing a water heater. You likely won’t use your full maintenance budget every month, so put the excess in a reserve fund for major repairs.
- For fixed costs such as mortgage payments or property taxes you should be safe without a buffer for these numbers. Just be aware that property taxes change from year to year. The change is usually insignificant but do your due diligence and be aware if your city is about to make a major hike to property taxes (usually as a result of budget deficits or new political/economic landscapes).
- Make sure you’ve thought of everything. Ask other homeowners in the area about the costs of ownership to ensure you’re not leaving something out (condo fees as an example).
- Don’t include one-time expenses like closing costs or immediate planned renovations. These aren’t on-going expenses so it doesn’t make sense to include them in your cash flow analysis.
Most of all: do your research! The more time you spend getting to know an area and a property the more confident you can be that you’ve covered all expenses and have accurate estimates. Ask your realtor about market rent, vacancy rates, school reputations, etc. Check Kijiji and Craigslist to see what others are offering in the area. Ask for utility bills for the past year or 6 months.
Anything you can do to make your estimates as accurate as possible will lead to less surprises down the road.
Beware of Negative Cash Flow
If a property does not have at least a neutral cash flow you should stay away. A property with negative cash flow means that you’ll be putting your own money into the property. Every month. For as long as you own it. This kills your personal cash flow, causes unnecessary stress, and will likely drive you away from income properties leaving a bitter taste in your mouth.
A neutral or positive cash flow that used conservative numbers is the minimum requirement for a property you should be investing in. A property that is truly an asset will mean that it doesn’t cost you money. If you lose your job the property still pays for itself and, if it has positive cash flow, has a little left over for you.
In investment real estate, cash flow is king!
What is the Cap Rate?
Capitalization rate – more commonly referred to as “Cap Rate” – is a key formula to understand when evaluating real estate from the perspective of an investor looking for income properties. The Cap Rate helps you determine how long it will take for your investment to pay for itself (more on this later).
The formula is as follows:
Where people usually get confused is when they calculate the Net Operating Income (NOI). It is important to note that the net operating income does not include loan (mortgage) repayment! Lets look at an example.
Cap Rate Calculation on a Typical Triplex in London, ON
We are looking at investing in a fairly typical multi-family home in London, Ontario. Our example home is a Triplex close to the university with an asking price of $279,000. The units rent for $1,000 (Unit 1), $800 (Unit 2) and $600 (Unit 3) and the tenants pay all utilities. Taxes are $3,200/yr and insurance is $600/yr.
Net Operating Income is going to be our annual income less operating expenses. In our case:
Rent = ($1,000 + $800 + $600) * 12 = $28,800
Annual Operating Expenses:
Taxes = $3,200
Insurance = $600
Maintenance = $2700 (rule of thumb is about 1% of house value)
Total = $6,500
NOI = $28,800 – $6,500 = $22,300
Assuming we pay full asking price, our cap rate would be:
Cap Rate = NOI / Value of House = $22,300 / $279,000 = 0.08
Our cap rate is therefore 8%
How To Use the Cap Rate
So we know the cap rate is 8% – now what? There are three major uses for the cap rate when looking at income properties.
- Calculate how long it takes for the investment to pay for itself. An 8% cap rate tells us that the investment will pay for itself in 12.5 years (100% / 8%).
- Use it to compare other potential investments in the area. Prices and income can vary. Using cap rate is a good way of leveling the playing field between potential investments. Which one has a better cap rate?
- Use it to determine what the property is worth to you. People can ask whatever they want for a property, but the cap rate can tell you what you’re comfortable paying. Once you know what a reasonable cap rate for an area is, you can use it to determine what price you’ll pay for a house. For example, if you are looking at a property with an NOI of $16,500 and you know that 8% cap rate is what you’re looking for in that area then you can modify the formula:Cost (Value) = NOI / Cap Rate = $16,500 / 0.08 = $206,250
So you now know, even if they are asking $225,000, you are only comfortable paying about $206,000 for the property given the comparable cap rate in the area is 8%.
What about Vacancy?
There are other things you can (and should) factor into your cap rate calculations. The biggest one we left out in our example is vacancy. I’ll cover how to estimate many of the variables in other posts, but for the sake of argument if you were accounting for a 6% vacancy rate, your NOI in the example above would be adjusted to $20,962 and the cap rate would therefore drop to 7.5%. If you wanted to maintain an 8% cap rate on all your properties, you could use the formula in point 3 above to determine what you are now willing to pay for the property:
Cost (Value) = NOI (adjusted for vacancy) / Cap Rate = $20,962 / 0.08 = $262,025
After factoring in vacancy, you find that in order to maintain an 8% cap rate the property must come down in price by over $15,000.
The more you do the calculations the more natural they will become and the more confident you can be in what a potential investment property is worth to you as you build your portfolio of income properties.