The more important a decision is, the more we wish we could see what the different outcomes would look like for each choice.
Buying or selling real estate is a monumental decision and as a result, we have conversations with clients that involve a lot of “what ifs”.
We recently had a conversation like that with an investor client who was considering whether she wanted to buy an income property that was currently being built, or one that we could take possession of quite quickly.
It can be hard to know which is the better option, and while your available finances play a big part, we like to go over what it would look like from both a cash flow perspective as well as overall equity growth standpoint.
So, let’s take a journey into the real estate multiverse.
In one universe, you buy a new build condo from plans that will be ready in a couple of years, and in another, you buy an existing condo from the seller and close in a couple of months.
Let’s see how the two different choices play out.
Welcome to New Build Universe.
In the New Build Universe, we find you a development you like the look of in a growing town near a bigger city and we sign the paperwork to buy a two bedroom unit for $500,000 plus HST of $65,000.
The tentative occupancy date (when they will try to have the project done) is two years from now and the outside occupancy date (when they really have to have it done) is four years from now.
You pay $5,000 today, $10K a month from now, $20K three months from now, another $20K six months from now and a final $25K in a year. A total of $80K in deposits, plus the $65K HST brings the total investment to $145K.
You go about your life for two years and are disappointed but not particularly surprised when the building isn’t done by the tentative occupancy date. A year after that, it is done and you sign the mortgage for $420K, pay the legal fees and land transfer tax and get the keys.
We find you a tenant who is happy to be moving into a brand new, modern building and sign a two year lease with her for $2,450 per month.
We apply for and eventually receive a rebate of around $24K in HST, reducing our effective purchase price from $565K down to about $541,000 and your total investment down to $121,000
In the New Build Universe, the condo cost you $541,000 after you take into account your HST rebate. You didn’t rent out the unit until three years had passed and the building was completed. Your rental rate of $2,450 is the prevailing market rent for a newly constructed two bedroom unit in that town.
You signed a mortgage pre-approval document with a lender three years ago for 3.49%. That was high at the time but lenders who guarantee a rate out for three or four years build in a buffer in case rates rise. Rates have indeed risen since three years ago, so you happily keep that mortgage for $420,000 at an interest rate of 3.49% for a two year term.
Your mortgage payment is about $2,050 per month. Maintenance fees and property tax cost you about $600 per month, bringing your total costs to $2,650 per month. Your rental income of $2,450 doesn’t quite cover this but the $200 out of pocket per month is made up for by the principal repayments you are making with your mortgage.
You pay down about $22K in principal over the two years and pay $4,800 ($200 per month) to cover the difference between rent and your expenses. Let’s round that up to $5K.
Five years after you bought the unit (and two years after you started renting it out), your mortgage is about $398,000 and you’ve had out of pocket expenses of about $5,000.
Welcome to Resale Universe.
Let’s check the numbers of the Resale Universe.
In this world, we find you a two bedroom unit in the same smaller town near a bigger city. After a bit of a search, you like the look of one we see that’s in a nice area, the building is about five years old, and we buy it for you for $500,000, with a $50K deposit, provided the following day.
The closing date is set for two months from today. On that day, you sign the documents with your lawyer, pay the legal fees and land transfer tax.
You pay an additional downpayment of $30K, to bring your total downpayment to $80K, leaving you with a mortgage of $420K.
We find you a tenant who likes the unit even though it isn’t brand new. Rental rates back then were about $2,200 for a two bedroom unit in that town.
Three years pass. The tenant who moved in stays for two years, then moves out. You have vacancy of a month before you find a new tenant at $2,250 per month and he is still there at that rental rate.
The condo cost you $500,000, with no HST payable on resale properties.
The best mortgage rate you could find when you bought today was about 2.99%. Rates were predicted to rise and given what happened, you feel pretty happy that you signed a 5 year term for the mortgage of $420,000 at a monthly cost of just under $2,000.
Maintenance fees are higher in this 5 year old building than a new build. New builds have low maintenance fees initially but they often rise significantly as the new condo corporation and its board figure out what they need to have the building run as they would like. For your condo in this 5 year old building, the maintenance fees for your unit are $600, plus another $200 for property taxes, totalling $800 per month.
Your initial rental income is $2,200 and your mortgage, maintenance fees and property tax cost you $2,800 per month. You are out of pocket about $600 per month, but you know you are paying down significant principal and can handle having to supplement the rental income each month. Your rental rate goes up after two years, but so do maintenance fees, so the $600 per month stays constant. The one month you had the unit vacant meant you had to pay the $2,200 yourself.
You pay down about $61,000 in principal over the five years you own the unit. Your mortgage is about $359,000 and you have had out of pocket expenses of about $38,000. That’s a significant amount but you’re pleased with the principal repayment your tenant has mostly paid for with their rent.
Which universe turned out better for you?
Five years after the decision to buy an investment condo, whether you bought a new build or resale unit has had a significant impact on the financial result.
With the new build, your HST costs resulted in a $41,000 extra investment you had to find. The lack of rental income and therefore not paying down the mortgage for the three years it took to complete the building means you have paid significantly less principal down on the unit. You also have a higher mortgage interest rate than you could have got three years earlier.
With the resale unit, your investment is less but the lower rental rate an older unit receives meant you had significant out of pocket expenses over the five years of renting the unit out. The principal repayment over the period of $61,000 was more than these expenses though, and you have about $39K more equity in the resale unit than you do in the new build unit.
From a pure cashflow perspective, the Resale Universe is the better choice in this scenario. You own an older unit that commands lower rent, but you’ve got close to $40K more equity in the property than you would have in the new build unit.
Anything else we need to consider?
The issue of what the two units are worth after five years is the final critical factor as to which reality we’d like to have created. In all likelihood, the new build will be worth more than the resale unit. The new build is two years old after our five year time period has passed and the resale building is now 10 years old.
We find that many investors focus solely on the appreciation that a new build sees rather than considering what happens during the building phase.
In our two different realities above, a low down payment meant out of pocket expenses for both units. While the numbers don’t seem very good as a result, the fact that resales make their owner money immediately (via principal repayment through the mortgage payment) would remain the same with higher downpayments and positive cashflows.
The HST cost and lack of principal repayment during the building phase means that we need to see a considerable appreciation in the new build unit value for it to be as good or better than the resale purchase. In this case, we’d have to see units sell for about $40K higher in the new(ish) build after five years, versus the 10 year old building.