The Reality Of Owning A Rental Property

Having worked for one of Canada’s largest Real Estate Developers as well as Canada Revenue Agency’s Rental Property Section – not to mention being a landlord for over 30 years myself – I have developed unique evaluation tools that allow for my clients to evaluate a rental property purchase, and provide ongoing evaluation of that property. These tools I have developed for my clients illustrate the realities of rental property purchases, and ownership.

How Does This Rental Property Evaluation Work?

The evaluation begins with an initial evaluation of the purchase, to a comprehensive long-term analysis of its ongoing value. The first question we ask is…

“What will the purchase of a rental property do for me in the future?”

My biggest takeaway from working in the Real Estate Development Industry is that whether you have a multi-billion dollar portfolio, or if you have a single rental property, the robust principle is this –

“Real Estate Is Patient Money”

In the case that you’re looking to make a quick flip, then we’re speaking more in terms of Real Estate Speculation and less about Real Estate Investments. Of course, it’s likely that you will sell the property at some point when the sale makes sense, but buying solely to flip is not my focus when evaluating a purchase. So, from a general evaluation point of view there are 3 types of return on your Rental Property Investment.

Let’s have a closer look into these 3 elements of your Return on Investment (ROI)

Building Equity with Rental Properties

A simple example would be to buy a rental for $200,000. On that rental, you will likely need a down payment of 25% ($50,000), leaving a mortgage of $150,000. Assuming an amortization period of 25 years, this means if your rent covers the mortgage (what is called Positive Cash Flow), you will have invested $50,000 of your own money to earn $150,000. This $150,000 is a 300% return on investment over 25 years. That same $50,000, without considering the market appreciation, would need to earn 5.7% compounded annually to give you the same return after 25 years.

Market Value Appreciation

When evaluating market value appreciation, the location of your rental property matters. Let’s say that the property increases by a modest amount of 1% on average per year over your 25-year amortization. That means the $200,000 home you have purchased will be worth $256,486 after 25 years. This means your $50,000 has grown by $206,486 – or, 412% of your initial $50,000 investment.

($ 150,000 in debt paid off + market value appreciation of $ 56,486 = $ 206,486)

By comparison, the annual rate of compounding interest, for a $50,000 investment to increase by $206,486 would be 6.75%.

Evaluating Cash Flow For Rental Properties

I use the term “cash flow” as opposed to “earnings” because earnings does not consider how you are going to repay the mortgage principal. Earnings or, rather, “Taxable Rental Income” is calculated by subtracting all your “current year” expenses from your rental income; these current year expenses include insurance, repairs, and perhaps utilities. Most importantly, the current expenses include only the interest portion of your mortgage payments. The repayment of your mortgage principal is not tax deductible. This means you may cover your mortgage payment with the Rental income. However, after you pay your income taxes on that rental income, what is left over may not be enough to pay the full principal portion of the mortgage repayments.

Things To Remember When Purchasing A Rental Property

If the rental does not provide a positive cash flow it does NOT mean that investing in a rental property is not worthwhile. I personally have owned properties where there was a negative cash flow and even though I had to put in some of my own money each year, my renters still paid “most of the principal”. This brings us back to my evaluation process. My clients receive advice and key knowledge on an ongoing basis that is unique to their own financial situation. Each year when I prepare their Income Tax Returns, we take a look at what is occurring in the market and re-evaluate their properties. I find that this creates an opportunity for my clients to build their wealth and explore new and exciting possibilities for their futures.

We know that this is a lot to digest, so please feel free to call Bruce if you have any questions, or send Bruce an email.