Investing in real estate can feel quite daunting at times and it can sometimes appear that you had to buy back in the 1970s in order to see a good return. Real estate prices have never been this high and surely the numbers don’t work anymore for real estate investing in the GTA.
Take a look at this quote from the Globe and Mail.
“Looking ahead, we expect that housing policy changes, stretched affordability and rising interest rates will exert a cooling effect on the market,” Robert Hogue, senior economist at Royal Bank of Canada, said in a research note.
While that seems pretty clear, we should include the full quote.
“Clearly 2016 was a remarkable year for Canada’s housing market with resales setting a new record high. Looking ahead, we expect that housing policy changes, stretched affordability and rising interest rates will exert a cooling effect on the market,” Robert Hogue, senior economist at Royal Bank of Canada, said in a research note.
Predicting a real estate crash has been a staple of the Canadian media for over a decade now and it can be difficult to know who has a crystal ball. If you read the above quote in December, 2016, you would be forgiven for sitting on the sidelines for a bit.
In order to see what happened if you decided to risk buying an income property back then, let’s look at a specific example. Let’s go back in time and tell a story about you buying an income property. Grab a cup of coffee and settle in – it’s a good story.
The numbers ain’t good.
It’s December, 2016 and you’ve saved about $200,000 and have decided to buy an income property. We find a three-bedroom townhouse in Toronto and you ask us to run the numbers.
When we do so, the results are not exactly impressive.
- Back in December, 2016, the average discounted 5 year fixed mortgage rate was 2.29%.
- With 20% down on the $872,000 purchase price, the mortgage amount is about $698,000. Add in the municipal and provincial land transfer taxes and the upfront investment is about $200,000.
- On a five-year term with a 25 year amortization period, the monthly payment on the mortgage would be about $3,052.
- The average rent for a three bedroom townhouse as of Q4 2016 was $2,287.
Let’s do the math.
You buy the home, and you’ll receive $2,287 in rent each month, but you will have a mortgage payment of $3,052, which meant every month you have to deposit $765 in the bank, or the mortgage payment would bounce.
$2,387 Rent Received
$3,052 Mortgage Payment
$765 Top-Up Required
Paying over $750 a month for the privilege of being a landlord sounds like a bad deal. Wouldn’t you be better off taking the $200,000 you invested as the down payment and having your financial advisor invest it in the stock market? You could even contribute $765 each month to that investment account and rather than losing that money each month, you’re actually growing your investments.
Before you say thank you and leave to go meet your financial advisor, let’s dig a bit deeper into the numbers.
Well, the numbers actually aren’t that bad.
When we look at the $3,052 mortgage payment, it turns out that over your five year-term, about 60% of that will be principal repayment. That means that while you are paying $3,052 a month to the bank, about $1,830 of it is effectively a forced savings plan, where you increase your equity in the property by that much each month.
If we put it another way, you’re receiving $2,287 from your tenant each month and the interest on your mortgage is $1,220. Which means, your tenant is paying down your principal to the tune of $1,066 a month and you’re paying down another $765 of the principal out of your own pocket.
$2,387 Rent Received
$1,220 Interest on Mortgage
$1,066 Principal Paid Down by Rent
$765 Principal Paid Down by You
If you consider the $765 a forced savings plan and you get that money back when you sell the home, plus the $1,066 a month your tenant paid down on your mortgage, the numbers aren’t that bad. You’ve got property taxes of about $3,000 per year on top of that plus any maintenance on the townhouse, but we talk it over and you decide to take the plunge and you buy it. Congratulations, you’re a landlord!
Huh, the numbers got a bit better over time.
As the years pass, your costs remain largely the same. Property taxes increase a bit, but your monthly payment on the mortgage remains $3,052. As time passes, rental rates increase and by the end of five years, the average rent for a three-bedroom townhouse is now $2,949 per month. That’s a 29% increase in five years!
You still have to pay some money out of pocket each month, but as rent increases, the amount lessens by a bit. At the same time as your rental income is increasing, you see with satisfaction that similar townhouses in the complex are selling for a lot more than what you paid.
Actually, the numbers got a lot better.
As we approach 2022, you’re curious as to where you stand with the townhouse. Your mortgage is coming due and you owe about $588,000 on the property. Though those monthly top-ups felt a bit painful initially, they got better as rent increased. This past year has felt easy, as you only had to put in about $100 per month to make sure the mortgage payment went through.
You’ve paid off almost $110,000 in principal over the five years, and about $26,000 of it was from your monthly top-ups. The rent from your tenants paid off the other $84,000 and when you think about making $84,000 on your $200,000 investment (or $110K on your $226K investment if you prefer to think of including your top-up payments), you’re pretty happy.
$697,586 Initial Mortgage
$587,919 Remaining Mortgage After 5 Years
$109,667 Principal Paid Down After 5 Years
If you sold the townhouse for the same $872,000 you bought it for, that works out to about 42% over the five year period, which is a bit over 8% per year. That’s not the best return, but it’s not bad.
Hold on, the numbers just got crazy.
We do a valuation for you and have some very good news. Since December 2016, the average price for a townhouse in Toronto has gone up about 44%. You bought when the cost was $872,000 on average and it is now $1,252,000 on average.
You have a mortgage of $588,000 and that means that you have about $664,000 in equity in the property. The $226,000 you invested over time (your 20% down payment, the two land transfer taxes, and the top-ups each month) is now worth $664,000.
$587,919 Mortgage Owing
$1,252,131 Property Value
$664,212 Equity in Property
In the course of five years, your investment has almost tripled. The combination of principal repayment made through your rental income, additional principal repayment by you each month and market appreciation has given you a return of about 60% per year.