Taking the Step Towards an Investment Property.

Our topic for July’s webinar was ‘Investment Properties’. A firm favourite! This is an exciting theme, and it was a lot of fun putting some valuable content together for our Mortgage Allies tribe. We loved engaging with you on such a hot topic. We had a lot of interest in this webinar; with our participants almost doubling in number from last month’s new-to-Canada evening chat. This is the kind of stuff that makes us smile. We’d like to mention that we understand summer is here and sweetly presenting the best barbecue weather! Big up to those who sat in to join us despite the great outdoor conditions. We are grateful to have spent the hour with you, and enjoyed your feedback. Thank you! The Q&A session at the end was great. Our marketing desk has already had many requests for a recording and summary of the evening’s chat. So, here we go!

An Introduction

We understand you want to get ahead with your finances. Many of the world’s wealthiest people have found their financial freedom from owning investment properties. It takes a combination of points to create a winning formula, and the first hard question has to do with whether or not you’re the kind of person who can deal with owning a residential investment property. The truth of the matter is that this setup isn’t for everyone, and it’s important to go through all of the factors before making a decision.

First things First – Some important questions to ask yourself.

No matter what some say, when you buy an investment property you are buying a business. A business requires hard and continuous work and it must be profitable and be kept profitable. The idea that an investment property generates passive income is only true, because the seller (landlord) does not have to sell his/her product every day, but the business requires work to maintain the property, find the right tenants, monitor the finances, etc.

Think about this, someone who is selling a cellphone, for example, will have to go into the store to try and make a sale every day. With a property, this kind of work is not needed, but rather the ongoing maintenance and monitoring. It is important to realize that this is an active business that cannot be left to its own devices.

Is it okay to buy an investment property that makes a continuous loss and if so under what circumstances may that be acceptable? Would Richard Branson do this?

Will an entrepreneur purchase a business that makes a loss without the plans and resources to make it profitable? It’s important to make sure that you will be able to make a profit.

Think about this: do you have real estate experience beyond owning your principal residence? Real estate is cyclical and if your investment property is making an unsustainable loss in a down market you may be forced to sell the property at a loss. Not all real estate is the same and this needs to be considered when choosing the type of real estate you’ll be investing in.

It is ideal to buy a profitable investment property with above average value appreciation potential. However, it is extremely rare to find a property that is both profitable and rapidly appreciates. Which philosophy are you most comfortable with; profitability or appreciation? The property’s location is also very important as it will impact your quality of life in managing the property. Will you be able to manage the property and tenants yourself, or will you require a property manager?

How do you evaluate whether you will successfully own an investment property? Direct cash flow is the obvious criteria for evaluating profitability, but does it tell the whole story? You have to look at all of the elements. There are many other factors that you can use to determine whether or not a property meets your requirements.

Will, you own the property, or will you own it through a holding company? Changing the ownership structure after you have purchased the property will be costly. What are the benefits and cautions of each ownership structure? These questions need to be answered before you can move forward with confidence.

In 2008 when the real estate market crashed, things were very different. There are specific mortgage rules that buyers need to keep in mind. One of them is that the government no longer guarantees any rental mortgages for single-family homes. These are all still regulated, but not guaranteed. Lenders have a maximum amount of rentals that can be bought. You will have rate premiums, as these are not the same as what they used to be.

There are rental laws in Ontario. A rent switch cannot be flipped on and off, and rental payments need to be stable. Is it good to have variable interest rates on an investment property? Jacques says no because variables can change at any time which isn’t good for profitability. There are fixed-rates products which are good for cash flow. Please chat with us for more information on this.

A principal residence should be paid off before your investment property. Think about your resources and whether or not you can afford the “emergencies” that may pop up. A surplus fund should be available to cover vacancy periods and maintenance issues such as a geyser bursting.

If you are DIY kind of person you may be able to manage your investment property, but if the thought of fixing a broken toilet depresses you, you may want to hire a property manager who can take care of repairs and emergencies. Are you handy when it comes to these things? The best person to ask would probably be your spouse.

How do you qualify a tenant? Do you know what to check for? It’s extremely important to understand the criteria. You also need to know your and your tenant’s rights. It would be a good idea to surround yourself with professionals in the industry – this will ensure that any legal gaps will be covered.

The decision to become a landlord takes an entrepreneurial spirit and while it is not that hard to successfully operate an investment property business, it should not be treated simplistically. By asking these and maybe other questions you should be empowered and protected before you purchase your first investment property or if you already own one make adjustments, so you have a better ownership experience. We can help prepare you for property ownership and discuss mortgage options with you that will support your properties’ profitability.

Time for the Calculations

There will be no final call without being able to run the numbers. This section of the webinar got our maths enthusiasts smiling from ear to ear! An investment property can be a step in the right direction. We are here to help, but first, let’s dive into the sums.

This is the measurement of a property’s future direct cash flow and profitability using the proposed rent (income) and expenses without considering inefficiencies or actual costs for repairs. For example, vacancy, insurance, etc.

The Direct Cash Flow is normally calculated before you purchase the investment property to determine the property’s profitability. The calculation can also be modified to calculate the Actual Cash Flow of the property by using actual expenses and including repairs, etc.

Goal: The Direct Cash Flow must at least be bigger than zero for the property to be profitable. The bigger the Direct Cash Flow the better

You can calculate the property’s monthly or annual Direct Cash Flow. For monthly cash flow use monthly rent, expenses, etc.

The DCR determines how much of the property’s debt is covered by the Rent minus no-mortgage expenses. Lenders use the Debt Coverage Ratio to determine whether a landlord’s existing mortgage portfolio can cover its mortgage obligations. Every lender has its criteria, but most lenders require a DCR of 1.1. The DCR is especially important for landlords who want to own more than one investment property.

Insurance* = Lender Defined Percentage (E.g. 5%) x Rent
Maintenance* = Lender Defined Percentage (E.g. 5%) x Rent
Management* = Lender Defined Percentage (E.g. 5%) x Rent
Vacancy* = Lender Defined Percentage (E.g. 5%) x Rent

Goal: The DCR should be more than 1.0. The bigger the DCR the better.

You can calculate the property’s monthly or annual DCR. For the monthly DCR uses monthly rent, expenses, to mention a few.

Use our DCR calculator below!

This is a conservative and more realistic version of the Direct Cash Flow calculation. This calculation measures the property’s cash flow and profitability using the property’s proposed Rent (income) and expenses, including potential and likely inefficiencies and/or costs. Although this is primarily calculation lenders use to determine a landlord’s mortgage eligibility, it is also a good calculation for potential owners to determine the future profitability of a property.

Insurance* = Lender Defined Percentage (E.g. 5%) x Rent
Maintenance* = Lender Defined Percentage (E.g. 5%) x Rent
Management* = Lender Defined Percentage (E.g. 5%) x Rent
Vacancy* = Lender Defined Percentage (E.g. 5%) x Rent

Goal: The Debt Coverage Cash Flow should at least be bigger than zero for the property to be profitable. The bigger the Debt Coverage Cash Flow the better.

You can calculate the property’s monthly or annual Debt Coverage Cash Flow. For monthly Debt Coverage, Cash Flow uses monthly rent, expenses, etc.

This ratio is primarily used for commercial real estate, but it is still useful for residential investment properties. The Cash-on-Cash ratio is sometimes called the cash yield on property investment and determines the landlord’s return on actual cash invested in the property. In other words, it tells the landlord how much profit s/he can expect to make on the cash they invest in a property.

*Cash Invested: This is the landlord’s upfront cash investment in the investment property and should include the down payment, closing costs, inspections, appraisal, renovations and repair, etc.

Goal: The Cash-on-Cash ratio should be positive and be at least equal to a return the investor can get if they invested their cash in the market. The higher the Cash-on-Cash Ratio the better.

This ratio is more common for commercial investment properties, but it is also very useful for residential investment properties. The Cap Rate is synonymous with the rate of return on a real estate investment and it estimates an investor’s earning potential. Needless to say, the Cap Rate is also a very good measure of a property’s profitability.

Goal: The Cap Rate is relative and dependent on the property type, geographical area, etc. The Cap Rate for a particular property must be compared to other similar properties in different geographic areas to determine which property will give a better return in the long run. The higher the Cap Rate, the better.

Debt Coverage Ratio (DCR) Calculator

Licensing Details: Jacques du Preez | Principal Broker Brokerage License #: 12358
Disclaimer: Based on approved credit. | Mortgage Allies E.&O.E.

Terminology, Definitions & Notes to Help You Win:

  • Rent: The rent you will charge your tenants. It is the income associated with the property. 
  • Mortgage Payment: Mortgage payment for the investment property. 
  • Prop. Tax: The Property Taxes for the investment property. 
  • Condo Fee: The Condo Fee for the property. This is only applicable to properties that are subject to condo fees. 
  • Utilities: Only the Utilities paid for by the landlord. The utilities paid for by the tenants are not an expense to the landlord, thus they are not factored into the profitability calculations. 
  • Home Equity Line of Credit (HELOC) Interest Only Payment: If you will borrow the down payment, repairs, etc. from a HELOC then add the interest-only payment of that portion of the HELOC to the calculation. 
  • Insurance: Fire, tenant insurance, etc. associated with the property and property ownership. Since the actual insurance amounts are unknown before the property is purchased, mortgage lenders normally use a pre-defined percentage of the Rent for Insurance. Usually, it is 5% X Rent. 
  • Maintenance: Repairs, maintenance on the property. Since the actual maintenance costs associated with the property are unknown before the property is purchased, mortgage lenders normally estimate the maintenance as a pre-defined percentage of the Rent. Usually, it is 5% X Rent. 
  • Management: The cost associated with managing the property. E.g. property manager, etc. Mortgage lenders normally estimate a property’s management cost to be a pre-defined percentage of the rental income even if the landlord intends to self-manage the property. Usually, it is 5% X Rent. 
  • Vacancy: This is a cost allowance for the times when the property may be vacant, and the landlord does not earn an income from it. Mortgage lenders normally estimate a property’s vacancy to be a pre-defined percentage of the rental income. Usually, it is 5% X Rent. 
  • Current Market Value: This is the current value or the purchase price of the property 

Thanks to everyone who took time out to join us. We loved having you! To our readers and the larger community who couldn’t make the live event, we hope you’ve got some value from this summary. The team at Mortgage Allies look forward to putting together these action-packed webinars to serve you. Reach out to us on our social media platforms – we’d love to hear from you. Our next webinar to do with buying a secondary home will take place on the 27th of August at 6:30 pm EDT. We hope to see you there!