We talk a lot on TRB about “investment properties” in Toronto, and we throw around investment terminology and metrics, but often we don’t go into detail.
We also agree and disagree about the merit of these investment properties, or just what constitutes and “investment” in this city.
So today, let’s delve into a real-life example of an investment property – one that I just sold to a client on the weekend.
Then feel free to give your opinion on the merit of the investment, or input on the process, evaluation criteria, and everything in between…
What is an investment?
Silly question to ask at the start of a blog post with the savvy audience that I have, perhaps. But it’s not a rhetorical question; I mean it, what is an investment, to you?
I have a friend that buys older cars, drives them for a while, then turns them over. He says he makes money doing this.
I know absolutely nothing about cars, and I consider them to be one of the biggest depreciating assets in existence. But if my friend can buy for under fair market value, restore or rehabilitate some portion of the asset, and then sell for above fair market value, and/or with lower than average transaction costs, then to him, this is an investment.
What about this set of hockey cards?
Click the link – you have to see this.
This is the finest set of 1923-24 Paulin’s Candy V128 on the planet.
This is all seventy cards in this set; it’s complete. They’re also all PSA-graded.
It’s one of a kind.
And it’s $10,000 US, plus a 19.5% “bidder’s premium,” plus taxes.
So it’s over $18,000.
But is that an investment to you? Or is it simply something that people with too much money buy for no good reason?
Personally, I think in fifty years, that set of cards could sell for a million dollars.
But I also think that it would fetch more today if it were being sold via Christie’s Auctions than the website it’s currently being featured on.
So what I’m trying to get at is that anything can be considered an investment, so long as you have the opportunity to obtain a return on that investment, and/or find an opportunity for market arbitrage.
The return, of course, is subjective.
I’m fine with obtaining 7% in my RRSP. Are you?
Would you invest in a second mortgage for 13.75%, or is that too risky?
We all have different investment objectives, so the one thing I will say before showing you this investment condo example, is you can’t simply say “that’s not an investment,” or even “that’s not a good investment,” without adding the words “in my opinion.”
Alright, shall we?
When it comes to buying condominiums for investment, there are two different “types” of returns an investor looks at:
1) Appreciation. How much will this condo go up over time?
2) Yield. What am I getting back on my investment?
In any hot market, buyers look for the former: appreciation.
When I was a kid, I wanted to buy stocks for $10 and sell them for $50. The idea of getting a 6% dividend didn’t appeal to me.
There are still a lot of folks out there today, young and old, who are simply looking for the asset to increase in value, but I don’t think that’s how we should look at real estate. People do, but for the purpose of this example, and from how I advise my clients, I would put that second to the actual yield.
In addition to appreciation and yield, I also look at acquisition cost.
You can pay more than a property is worth, and you can pay less. In this market, you often pay more, even for an investment property. I had a client bid on a property in King West and go $10,000 past what we had set out to bid, because the appreciation potential was so much greater than anything we’d seen (based on location). We lost on that bid, but it goes to show you – sometimes you’re willing to pay more.
Then again, sometimes you pay less, which we’ll talk about in a minute.
I also look at the ease of investment, since some properties require more work (ie. a duplex, triplex, fourplex compared to one condo), and sometimes you get a really great tenant, and sometimes a really bad one.
You also might buy a property that’s rented, or vacant.
These are all things to consider along with the numbers; the appreciation and the yield.
A client of mine has been looking for an investment condo for the last two months, we’ve made two bids and lost, and this weekend, we purchased a unit that is the best we’ve seen.
Isn’t that always the way?
The property is in King East, and it’s in a boutique, low-rise building, with few amenities, no concierge, and very low fees.
List Price: $319,900
Monthly Maintenance Fees: $354.55
Yearly Taxes: $1,884.85
The property is currently rented by a young, late-20’s accountant, with great credit, a very high income, and having met him in person (during the showing), my client and I both felt he was an A+ tenant all the way. We also stalked him online through every social media application there is, and thus we’re doubly convinced.
The rent is $1,650 per month, and the tenant pays hydro.
So let’s work through the numbers, using the following assumptions:
Purchase Price: $310,000
Down payment: 20%, or $62,000
Amortization Period: 30-Years
Interest Rate: 2.30% (5-year-fixed)
Monthly Mortgage Payment: $952.92
A quick note here, perhaps…
I know that a lot of market bears, or anonymous internet commenters with an axe to grind, are cracking their knuckles getting ready to tear this example apart.
So I’m going to make the following assumptions, that you may disagree with if you may, but I will still sleep well at night…
1) Vacancy. I’m forecasting a 0.00% vacancy rate, and if you disagree, then you’re simply trolling, and you don’t understand the market. Put the “business” textbook down, and take a look at reality. In downtown Toronto, a condo is only vacant if the landlord allows it to be. There’s absolutely, positively, no reason for a downtown condo to have even one day of vacancy in this market, if the landlord knows what he or she is doing. End of story.
2) Tenant Acquisition Cost. I’m also using $0.00 for this, because at the risk of costing myself business, and putting all the rookie agents who live on leases, out of work, dare I say that you don’t need an agent to find a tenant in this market. I think an investor should use an agent, if they’ve never done it before. But I have clients that own 5-6 condos who have done this again and again, and through Craigslist, Kijiji, ViewIt, and Padmapper – they’ve found tenants, done credit checks, got employment letters, checked references, stalked them on social media, met them in person, and paid nothing to an agent.
3) Insurance. Part of your monthly maintenance fee covers building insurance, and the tenant is responsible for obtaining a $2,000,000 insurance policy, so it’s up to the landlord whether he or she wants to obtain additional coverage, but most of my investors do not.
4) Land transfer tax. This is a big number, no doubt about it. And since it’s an initial cash outlay, you can choose to include it in the first year’s ROI, or spread it over a 20-year horizon. Whatever you want – and we’ll come back to this.
5) Legal fees. Same as above.
6) Realtor fees. You don’t pay any fees to buy real estate, only to sell. And since the answer to the old adage, “When is the best time to buy real estate?” happens to be “never,” I think we’ll run our examples without including any disposition fees.
7) Maintenance. This is a condo, not an 80-year old brick building. The only maintenance you’ll need is a new appliance every 5-6 years. That’s a nominal cost.
Now the three metrics we want to look at are the following:
1) Cash Flow
2) Return on Investment
3) Cap Rate
The cash flow, quite simply, is the amount of money you’re left with after each month.
It’s the income minus the expenses, and in the 1-bedroom condo market in downtown Toronto, you’re usually cash-flow neutral.
In this case, our income is $1,650, and our expenses are as follows:
Mortgage – $952.92
Maintenance – $354.55
Taxes – $157.07
Hydro – $0 (tenant pays)
The condo is $185.46 cash flow positive each month.
You’ll be hard-pressed to find condos in the city that are cash flow positive, and that’s what makes this investment property such a great buy.
Of course, we’re using a 30-year amortization, but this unit would still be cash flow positive on a 25-year amortization, and using a 30-year amortization makes the ROI lower, so it doesn’t make the investment look any better than it actually is.
Return on Investment (ROI).
Here we’re looking at how much equity we get, as a percentage of our cash outlay.
Our cash outlay is the $62,000 down payment, and while the land transfer tax in this case is $5,950, I’m not going to throw this in, because there are so many ways investors choose to look at this.
Our condo is $185.46 per month cash flow positive, or $2,225.52 per year.
The $952.92 per month maintenance fees is made up of an average (in the first year) of $485 of principal and $468 of interest.
So that $485 of principal is $5,820 in the first year, plus the $2,225.52 is $8,045.52 in equity in the first year.
From a $62,000 investment of cash, that’s a 12.98% return on investment.
Even if we added in the $5,950 of land transfer tax, the ROI would still be 11.84%.
But as I said, some investors will spread that land transfer tax over twenty years, or five, or what have you.
Capitalization Rate, aka “Cap Rate.”
This is simply the net income as a percentage of the acquisition price, irrespective of financing.
In my opinion, this is a metric that works best when we’re considering cash purchases, but investors still use it no matter what.
Our income is $1,650 per month.
Our expenses are:
Maintenance – $354.55
Taxes – $157.07
The purchase price was $310,000.
That’s a 4.41% cap rate.
If you want to add the $5,950 of land transfer tax into the mix, then our cap rate drops to 4.32%.
So there you have the investment my client has made, and the three metrics that are most commonly used in real estate to evaluate the investment.
Now three more items to note:
1) Acquisition Cost. Call me biased if you want to, but I believe this is a $325,000 property. The property was listed at $319,900, but we couldn’t get in for a week. The showings were severely restricted, as either the agent had to be there, or the tenant had to be home. In my professional opinion, if this unit was vacant, cleaned, staged, and painted, it would list for $329,900, and it could sell overnight. But a conservative estimate of value is $325,000, and thus my client did very well at $310,000.
2) Ease of Investment. There’s already a tenant in place, on a lease until next year, with first and last month’s rent secured as a deposit. Having met the tenant, and done our due diligence, we feel he’s an exceptional candidate.
3) Overall impression. Simply put, $310,000 condos don’t rent for $1,650. Or another way of saying this is – $1,650/month units are worth a lot more than $310,000. We made an offer a while back for a unit at $350,000 with $1,625/month in rent, because it was in an A+ location. But on the whole, you just don’t see $1,650/month coming from $310,000.
That’s it, folks!
I welcome your thoughts.