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Canadians searching for passive income might be tempted to invest in real estate, thinking that collecting rent is easy money.
But once they try being a landlord, they find out that it’s not as easy as they thought. As soon as the mortgage papers are signed, they’re hit with expenses such as insurance, maintenance or condo fees.
So why are some people able to make plenty of money owning multiple properties, while others struggle to get even one to break even?
As it turns out, professional real estate investors think differently about real estate than the amateurs. Here are some of the ways.
The 1 per cent rule
First of all, the pros are very choosy about the properties they acquire. While amateurs tend to choose their properties based on features such as granite countertops, a pro uses specific financial criteria to evaluate each property.
One of these criteria is the 1 per cent rule. Here’s how it works: The rule states that a property’s gross expected monthly rent should be at least 1 per cent of the property’s purchase price.
So if a property’s price is $200,000, it should rent for at least $2,000. If the price is $300,000, it should rent for at least $3,000, and so on.
Why do they do this? Because the pros want to know how long it will take to make their initial investment back. The 1 per cent rule ensures that their property will pay for itself, not including costs, in 100 months, or about 8.33 years.
The 1 per cent rule is considered a bare minimum criterion for property to meet before further research is conducted. This is also the rule that explains why most investment properties in cities such as Toronto and Vancouver fail. The average one bedroom rents in Toronto for about $2,500 a month. This implies that an investor shouldn’t spend more than $250,000 on a property.
When’s the last time you saw a property changing hands for $250,000?
Cap rate
The next thing the pros calculate is a property’s capitalization rate. Cap rate is a formula that’s used to calculate an investor’s net profit as a percentage of the purchase price.
Cap rate = annual net operating income / purchase price
Net operating income is the rent you receive after subtracting all your monthly expenses, including property taxes, maintenance and insurance. Most amateur landlords don’t realize how much these costs add up.
Let’s say an investor buys a one-bedroom condo in Toronto for $500,000, expecting to rent it for $2,500 a month. What’s the cap rate on this investment?
To figure that out, we have to deduct all our expected carrying costs (below, on a monthly basis). Costs such as:
- Vacancy: The unit will not always be rented out. A 5-per-cent vacancy rate is a reasonable estimate, so this would be $125 ($2,500 x 5 per cent).
- Property taxes: The City of Toronto’s tax calculator predicts property taxes of $315.
- Insurance: An insurance quote from Ratehub.ca gave me $100.
- Property management fees: Property managers charge around 10 per cent of the rent, which would be $250 ($2,500 x 10 per cent).
- Condo fees: Condo fees in Toronto average between 50 cents to $1 a square foot, so a conservative estimate for a 700-square-foot condo would be $700.
- Maintenance: Professional real estate investors use 1 per cent of the purchase price a year, which would equal $417. (1 per cent of $500,000 divided by 12.)
Deduct all these expenses from the gross rent, and our net operating income is $593 a month or $7,117 annually. This makes this unit’s cap rate 1.4 per cent. ($7,117 divided by $500,000.)
That is awful. You could make more money in a savings account.
Don’t overleverage
You may have noticed that none of these formulas mention a mortgage and that’s deliberate. Professional real estate investors use leverage – that is, they borrow – to enhance their returns, but they don’t depend on it to make their numbers work. If a property’s not worth owning in cash, it’s not worth owning.
My friend Paula Pant, who runs the real estate investing blog AffordAnything.com, often says: There are experienced investors. And there are overleveraged investors. But there are no experienced, overleveraged investors.
The reason for this is that eventually, the overleveraged people get wiped out. And that’s when the experienced investors swoop in and scoop up their foreclosures at a steep discount.
The world of real estate investing is advertised as free, easy money. But the truth is, it’s an ocean of sharks (the pros who know what they’re doing) and prey (the amateurs who don’t).
Being a real estate investor is a full-time job. If you want to be a shark, you have to understand your market, and you have to do your homework before making your purchase. Fail to do so, and you’ll be the prey.
Kristy Shen and Bryce Leung retired in their 30s and are authors of the bestselling book Quit Like a Millionaire.
