Real Estate  Resources

Real Estate Resources

Sales Representatives "Turning Realty Into Reality"

Harvey Kalles Real Estate Ltd., Brokerage *

Mobile:
647-991-5242
Office:
416-441-2888
Email Me
Real Estate  Resources

Real Estate Resources

Sales Representatives "Turning Realty Into Reality"

Harvey Kalles Real Estate Ltd., Brokerage *

Mobile:
647-991-5242
Office:
416-441-2888
Email Me

Real Estate Investment Banking

 

 Does real estate play a role in the financing plan of Canadians and/or should it play a more important role?

As Canadians grapple with ongoing concerns about taking on more debt, there are a few other realities that cannot be ignored:

  1. Canadians are sitting on an unprecedented amount of home equity.
  2. Although many may be ‘house rich’ they have growing concerns about their financial future and that of their children.

So it begs the question: Can your home equity be part of the solution?

Here is a story of an option  – we’ll call him George.

George is in his early 40s with a house and young family, and works in a great industry at a good paying job. But, like many Canadians, George has concerns over long-term job security along with his long-term pension needs. He has allocated some savings to both his RRSP and other investments, but has decided that buying one or two rental properties would be a great way to supplement his current pension.

Of course, a big question of George’s is affordability and, since he lives in a suburb of Toronto, a greater concern is the inability to find a positive cash-flowing investment property given the high cost of housing where he lives. When we sat down to analyze his investment options, the first thing I suggested was that he reviews his family budget. We looked at how much money he could afford to invest on a monthly basis over and above what the family was currently spending. His answer was between $300 and $400. Now I know what you’re about to say: “How can anyone afford to buy a property with only $300 or $400 a month?” That’s a good question. In fact, that’s where most people would end the conversation and look at an alternative investment vehicle.

Let’s assume we chose a conservative long-term investment vehicle – a bond, GIC, mutual fund, stock investment – whichever you prefer. It would likely look something like this over a 20-year period:

  • $300 cash (out of pocket/part of your family budget) every month for the next 20 years = $72,000
  • Value of the $72,000 invested over 20 years = X. This depends on the average annual rate of return, but if you were lucky enough to earn an annual average of 8%, you would have between roughly $164,000 and $178,000 to add to your pension.

Remember: these calculations were based on the fact that:

  1. George feels the need to supplement his current pension with an investment, and
  2. He is willing to invest at least $300 a month for the next 20 years out of the family budget.

Now let’s take a different approach to looking at real estate as an alternative option.

George, his wife and I sat down and analyzed the following:

  • George currently has a home valued at $600,000
  • The mortgage is $290,000
  • George will qualify to refinance the home to 80% of its value or $480,000
  • The potential new mortgage minus the existing mortgage = potential accessible equity (in George’s case this is $190,000)
  • We’ll only use $100,000 of the accessible equity (we don’t want George or his wife to feel that they are ‘over-leveraged’) and we’ll set up a new Mortgage/Line of Credit (LOC) on their home based on 65% of their house value (an amount both George and his wife are comfortable with)
  • This structure provides them with $100,000 of investable capital from his home equity
  • They can use $90,000 of that as a down payment on a $400,000 rental property and keep $10,000 from the LOC to place in a contingency fund (they could use it as a 20% down payment and buy a $500,000 investment property but again we are being conservative)

Now I know some of you are saying that this is going to cost a lot more than $300 a month since just the interest alone on the down payment is more than $300 a month. The answer to this is both yes and no. When buying an investment property, the down payment is typically considered the main expense. However, we sat down and analyzed the true out-of-pocket expense of making this purchase.

The first thing you have to realize is the fact that real estate, unlike many other investments, has the potential to create revenue (Note: We are referring to the purchase of a rental property not a recreational one). The challenge with writing this article is the fact that the amount of monthly rent you can get for a $400,000 purchase will vary greatly from Toronto to Kitchener, so we’ll try to be conservative with the numbers we use.

Remember, George was willing to invest between $300 and $400 per month out of the family budget. So let’s break this investment down to see what the true monthly cost is.

Let’s assume a monthly rental income of $2,000 (which is very possible):

  • We would access $100,000 from a LOC on the principal residence
  • We would take $10,000 of that and set it aside in a contingency fund. This is equal to roughly 5 months of rent
  • We would have a new first mortgage on the rental property for $310,000.

Monthly Expenses:

  • Interest on the LOC taken out on the home   = $334 
    (based on rate of 4%)
  • Interest on new first mortgage on rental property = $1,390 
    (based on a 5-year rate @ 3.5% with a 30-year amortization)
  • Property taxes   = $140
  • Property insurance    = $100
  • Property management (8% of rent)    = $160
  • Condo/strata fees (if applicable)     = $200

              Total Monthly Expenses               $2,324

Assuming George's first purchase had the above scenario, he would find himself subsidizing this rental property by about $324 a month. Conventional thinking would say that George is losing $324 a month on this investment but I would like to challenge that thought process. Again, assuming the above scenario, the only amount of money that would actually be coming out of George’s family budget in order to make this investment purchase part of his long-term financial goal is $324 a month. Remember, the key here is to realize that even though George and his family are making a down-payment of $90,000 in order to buy this property the only actual money that is being spent out of their family budget is the difference between his total monthly expenses and the amount of revenue the property is generating every month.

Based on the above assumptions, the purchase of a $400,000 investment property that has a shortfall of less than $400 a month fits into George’s investment, long-term planning, and budget criteria.

It may seem counterintuitive to suggest that an investment that loses money every month is a good thing, but let’s take a closer look:

  • Assuming that the property has to be subsidized by $300 a month every month for the next 20 years (Please note these few caveats):
    1. I have rounded the negative cash flow down to $300 for an easy comparison (It can work just as easily by rounding it up to $400 a month).
    2. Interest rates will go up in the future but the principal balance of the loan will go down, so those should offset each other.
    3. They may have higher expenses in any one year, but in the last 10 years of the loan, the mortgage balance will be diminishing so cash flow will become positive.
    4. A 30-year amortization can be paid off in 20 years by applying all positive cash flow in the second half of the mortgage to the principal balance, thus accelerating the debt reduction and maintaining a $300 a month out of pocket expense.
    5. We all know that all real estate has unexpected annual expenses and that there is no guarantee that you’ll be able to rent your place out every month. That is why we set aside $10,000 in the beginning from their LOC. This is the contingency fund to allow for vacancies and other unexpected costs.
  • $300 x 12 months x 20 years = $72,000. This is the same amount of total invested money that we discussed in our earlier example.

Now, let’s see what the end result could be if George keeps this property for the next 20 years and pays off the mortgage:

  • We all know that property values can go up and they can go down so I’m going to be very conservative and suggest that the value of his property is the exact same in 20 years = $400,000
  • Dave and his wife would have a $400,000 asset
  • Let’s assume that the rent stays the same in 20 years (since that’s not realistic, we’ll keep the expenses the same for argument’s sake)
  • Rental income = $2,000
  • Non-mortgage expenses = $1000 (I’ve allocated some extra to pay off the remaining LOC on the principal residence which was used for the down payment)
  • Net income = $1,000 a month

The simple comparison is quite startling:

  • You have an alternative investment of $300 a month at an 8% annual rate of return over 20 year which equals roughly $178,000 with potentially no cash flow or income

OR 

  • You have the exact same investment of $300 a month for 20 years in an investment property valued at $400,000, which equals a $400,000 asset with $1,000 per month net revenue

If we were to simply look at these numbers, it would beg the question: Why isn’t everyone doing this today? The answer is quite simple:

Real estate investing is not for everyone. Any investor or financial planner would likely be the first to tell you there are pitfalls associated with being a landlord. Also, many would-be investors have been scared off from purchasing real estate as an investment in major centres such as Vancouver and Toronto out of fear or concern that the investment would have a monthly shortfall. But what if we re-labelled the term negative cash-flow and instead saw the monthly shortfall as your long-term investment capital. All you need to do in order to make a sound investment is to determine the maximum amount of investment capital that your budget could afford each month and that would act as a filter when shopping for the right property to fit your needs. Keep in mind that in many parts of Canada, a $400,000 investment would actually create a positive cash flow which makes the potential returns virtually infinite.

The purpose of this article is not to convince you to buy real estate – although that argument could be made and debated. The real purpose is to get the conversation going. Too many Canadians are passively handing their savings over to investment advisors in hopes that their financial goals will be met. I’d like to suggest that, when it comes to wealth management in this country, real estate can and should play a bigger role. George and his wife realized this and made a creative choice that will positively impact their financial future. Investing in real estate may or may not be right for you, but it’s a conversation that’s certainly worth having.

Contact me if you'd like to know more.

 

 

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