First things first, one of the things that agents here at the Refined team have in common is that we love income properties.
- We love seeing a mortgage go down each month, paid for by tenants.
- We love seeing the property appreciate over time.
- We even love overseeing renovations that add value and allow us to charge a higher rent and attract better tenants.
It’s because we love income properties that we get excited when we start working with a client looking at buying one.
Here is a quick way of assessing income properties.
It’s called the capitalization rate, or cap rate for short.
The cap rate for a property gives you a number (expressed as a percentage) that tells you how long it will take for the rental income from a property to pay off the purchase price.
The higher the number, the quicker the purchase price is paid off.
For example, a 5% cap rate means that every year, the rental income (less operating expenses) pays off 5% of the purchase price. For those of you that are good with mental math, that means that in 20 years, the cashflows from the property have paid for it completely.
Let’s attach some dollars to the example.
Say it’s a $600,000 purchase price. The property is triplex with three units in it, which bring in $3,250 per month in rental income. We have property tax, building insurance, a property manager to handle the calls about problems and then some funds for keeping the place up. That totals $9K a year, which leaves us with net rental income of $30K.
On a purchase price of $600K, that $30K net rental income gives us a cap rate of 5%.
Note that the cap rate is calculated without taking into account the cost of borrowing. This is done because every investor will have different options for borrowing. Some may have the money to buy it upfront, some may have a connection that will invest for 2% interest a year, others may need to borrow from banks or other lenders at hefty interest rates.
The cap rate allows income properties to be compared on an apples to apples basis.
Investors can look at a $300K single family home in Guelph or a $1.6M multiplex in Toronto and be able to see what the cap rate will be for each property.
Now that we’re clear on how cap rates work, let’s get into how you choose a great income property.
Multi-units almost always beat single-family
Properties with multiple rental units in them (whether a bungalow with a basement apartment or a multi-plex with 4 purpose built apartments) almost always beat single tenant properties. While it can be very easy to rent out a lovely home to a lovely family, the rental rates are not typically high enough to provide the same return as multiple unit properties.
The Greater Toronto Area means greater cap rates
While properties in Toronto are certainly in demand with renters, the cost of buying the property means that your cap rate will likely be lower. An income property in Ajax can literally be half the cost of a nearly identical property in Toronto. While rents may be lower in Ajax, they aren’t half the rent of Toronto. As long as you are careful to buy in a good location where you don’t have lots of vacancy, the lower rent can be easily made up for by the lower purchase price, which means a much better cap rate.
Focus on the negatives to get the positive returns
Some of the best income properties are properties that we would never advise a client to buy as their own family home. Stigmatized properties – such as those backing onto power lines, fronting onto a busy street, or located beside commercial elements – can make fantastic income properties. Buyers looking for their own home aren’t too interested, which keeps the purchase price lower. Tenants take shorter-term views than buyers and are often more interested in the utility of a rental (transit proximity, amount of space inside) than the long-term prospects for the property.
We really do love working with clients to find them income properties and we’d love to work with you to find a great investment property.