We’ve been seeing a number of headlines recently that state that investors in real estate aren’t doing very well. It’s caused a number of our clients, both investors and end-users, to ask us if it’s true and what it means for the real estate market as a whole.
Our answer to the question as to whether it is a bad time to own income properties is no – now is not a bad time to own income properties.
That might be a bit surprising if you’ve been reading any of the headlines we’ve referencing, as they are all enthusiastically trumpeting the death of investing, particularly in condo buildings.
The impetus for the headlines was a report that was released on May 29th, 2023. The report was from CIBC and real estate research firm Urbanation, and the big news from their research was that 48% of leveraged condo investors who bought pre-construction units to rent out were cash flow positive in 2022.
The report has a very specific description of the circumstances under which investors are not breaking even on their rentals, but it is resulting in pretty vague headlines, such as “More than half of GTA condo investors losing money on properties”. That’s taking a negative view of something that we feel is fundamentally a neutral statistic.
Here’s the three reasons why we don’t agree with the headlines about this report and why we feel investing in real estate (even condo units in the GTA) remains a smart idea.
Leverage affects profitability.
When we read the report from CIBC and real estate research firm Urbanation, our initial reaction was a bit confused. We understand the report, we just don’t understand how it’s news.
The key finding that the authors said marks a “meaningful shift” is that the majority of investors were seeing the rent they receive for newly-completed units be less than their mortgage, maintenance fees and property taxes. Put simply, they paid more in expenses each month than the rent they received.
A key reason that real estate is such a good investment is leverage. The vast majority of people buy real estate by taking out a mortgage on the property. If you put down 20% and receive a mortgage for the remaining 80%, you have leveraged your 20% five fold.
Leverage is wonderful in that you own an asset that can appreciate (or depreciate) but you haven’t invested all of your own capital into it.
If an $800,000 condo unit that you put $200,000 down on goes up by 10% in the time you own it, it is worth $880,000. An $80,000 increase means that the $200,000 in equity you had in the property is now $280,000, which is a 40% increase in the money you actually have invested in the property.
Contrast this against how most people invest in the stock market, where they take their $200,000 and buy $200,000 worth of investments. If those investments go up by 10% in the time they are owned, the $200,000 becomes $220,000. Without leverage, the gains (or losses) are simply what they are, with no multiplier.
The flip side of leverage in real estate investments is that leverage affects profitability.
If you own that $800,000 condo outright, with no mortgage and therefore no leverage, your costs are the maintenance fees and property tax. It is quite easy for a property to cashflow positively (for you to make money every month) if you have bought it outright and have no mortgage. Rent comes in, the maintenance fees and property taxes come out, and each month you make money.
The more highly leveraged you are, however, the more it costs you each month with your mortgage payment. If you have a $100,000 mortgage on your condo, you’d pay roughly $600 per month in principal and interest payments. If you have a $500,000 mortgage, that’s up to about $3,000 per month. The higher your leverage level, the higher your mortgage payment and therefore the harder it becomes to be cash flow positive on the property.
The report states that less than half (48% to be exact) of leveraged condo investors who bought pre-construction units to rent out were cash flow positive in 2022. Put another way, 52% of condo investors who bought pre-construction units and have a mortgage, are cash flow positive each month.
We feel like the headline could have been “Mortgages cost money each month” and made about the same amount of sense.
Income is going up and expenses are (probably) going down.
The second aspect of the report that made us shake our heads when we look at the headlines, is that the report actually says that they expect the situation to get worse, but also that the situation may not get worse and could in fact get better.
On the pessimistic side, the report says that increasingly expensive new condos that were presold to investors will be completing in coming years and that the costs of those mortgages will be too high compared to the rental rates that can be charged.
This again falls into the category of “Yes…and?” because that’s simply how math works. If an investor pays a lot for a property and they are highly leveraged (i.e. a big mortgage) and can’t charge enough rent to cover the resulting mortgage payments each month, they will lose money each month.
Will rent rates go up? Almost certainly. Will interest rates go up? Possibly. Will interest rates go down? Possibly.
The report almost immediately contradicts their prediction that things will get worse by noting that a reduction in interest rates and further growth in rents would lighten the impact. If we recap the overall story then, it could be bad for investors if their new condo units come up with big mortgages that cost a lot to pay each month, unless rent goes up and interest rates go down, in which case it wouldn’t be that bad.
In other news, if it rains you will get wet, unless you have an umbrella in which case you will remain dry. Only one of four people bring umbrellas with them when the forecast is for rain, so the headline will be “Vast majority of pedestrians to suffer soaked clothes”.
In essence, most headlines take a conditional statement (if this happens in these circumstances, then this may result) and remove the conditions. It seems clear, but the reality is far different.
Principal repayment is a good thing.
The final aspect of the headlines about this report that is frustrating is that no stories discuss the difference between monthly cashflow and principal growth.
If you have a $500,000 mortgage that costs you about $3,000 per month in mortgage, it could indeed be challenging to have enough rental income to offset those mortgage costs, particularly when combined with maintenance fees on the condo and property taxes charged by the municipality.
While the property may have negative cashflow, that doesn’t take into account the fact that a significant chunk of your monthly mortgage payment is in fact principal repayment. The higher your interest rate, the more of your payment goes towards that interest, but there is still a good amount of your monthly payment that is not going to the lender, but it building your equity in the property.
If we take a $500,000 mortgage, amortize it over 25 years at a 5 year fixed rate of 5.54%, your monthly payment will be $3,063.61. $854.38 of that monthly payment is principal repayment and when you sell or refinance at a later date, you get that money back. It is, in essence, a forced savings plan.
If an investor owned a condo that costs $800,000 that they are paying $4,000 per month in mortgage payment, maintenance fees and property tax, and they’re getting $3,500 per month in rent, then they are absolutely losing money each month from a cashflow perspective. They’d have to deposit $500 each month into the account to prevent the charges from bouncing at some point.
Are they “losing money” though? With the principal portion growing, their effective monthly cashflow is positive to the tune of about $354. That’s not a lot, but if there is market appreciation over time, they have an asset that is worth more than when they bought it, that has also built up some principal appreciation over time with the mortgage payments that were made.