Real estate is of my particular interest due to the low initial cash barriers to entry for respectable returns, low volatility, ease of understanding, and high leverage available. To be consistent with my ongoing objective of a Ferrari by 30, almost everyday I am performing calculations and research and exploring new investment, business, and employment ideas. A great sense of urgency is important due to the ever-increasing competitiveness to get a piece of the pie these days. Already I am nearing the income ceiling for employment for someone with my experience and field, so I have increasingly been looking to stocks and real estate.
Most desirable rentals in this area exhibit similar rent to carrying cost ratios as consequence of supply and demand; that is, properties around the $300,000 range usually rent for around 1800/month all inclusive, and are slightly cashflow negative, or neutral. Properties around the $250,000 range are worth closer to $1500/month rent. And so forth. Those that are cashflow positive usually are less liquid and appreciative due to less demand; that is how they become cashflow positive due to lower purchase price and hence mortgage payment. For instance, you can buy an old house or a newer, smaller townhouse or fourplex unit for the mid $3xx,xxx range and rent it to 4 students for $700-750 each; $2800-3000/month rent, and have a carrying cost of just around $2400/month. But, the wear and tear will be double that of 2 renters in a similar-priced property, and the grade of tenants lower due to the type of people who are looking to save around $150-250/month to make ends meet, living with 3 other people they may not know. Resale and appreciation will be worse knowing the home’s usage history, or due to the design to rent out rather than be the most desirable personal home. Luxury home improvements or even non-essential home repairs though add to home value and resale ability, seldom see a significant return in rental rates, as those desiring them often are not renters. Rental income is also fully subject to tax, while only 50% of capital gains are. In short, there is no investment choice much superior to another, as if there was, demand would increase for it, increasing purchase price and decreasing cash flow until equilibrium.
In my personal realistic scenario, my next consideration would be a property around the $300,000 price mark in the university area. Rents for all utilities included fluctuate around the $1700-1900 mark, so we will take the middle- $1800. Now there are three worthwhile downpayment/financing avenues possible:
In the following calculations, for simplicity, we assume the following:
- If interest rates rise, it is done as consequence of a strengthening economy, where then market rents would rise in response, offsetting increased interest costs. Or, just assume terms are fixed (2.39%/5 year fixed terms exist, where the 0.04% increase affects numbers little).
- No maintenance costs, and any would be offset in slight additional appreciation.
- No vacancies.
- In the <20% downpayment scenarios, CMHC or Genworth insures mortgages as long as you initially live in the new property as a primary residence. Therefore, there will be an initial short time where you live in the property.
Option (1): 2.35%/5 year term with 20% downpayment, 1.5% for closing costs (where part of them are property taxes).
Carrying cost per month: -1742
Principal contribution: +37486
Initial misc. closing costs: -2200
Total gain: +38766; +7753/year.
Initial investment required: 64500
ROI w/ 2.5% YoY appreciation: 24.2% (we consider 2.5%, as historically in this area appreciation is around 5% in a robust economy. 2.5% is assigning a 50% probability of that scenario)
ROI w/ 5% YoY appreciation: 37.7%
Initial Leverage: 5x
Option (2): 2.35%/5 year term with 5% downpayment. 1.5% for closing costs (where part are the property taxes).
Carrying cost: -2000/month
Principal contribution: +49895 (net CMHC)
Total: +35,695; +7139/yr.
Initial investment: 19500
ROI w/ 2.5% YoY: 77%
ROI w/ 5% YoY: 121.6%
Initial leverage: 20x
Option (3): 3.89%/5 yr with 5% cash payment/rebate after closing. 1.5% closing costs. Catch is that you must not break the mortgage term, otherwise the rebate is added to the penalties.
Carrying cost: -2236/mo.
Principal contribution: +42469 (net CMHC)
Total: +14109; +2822/yr.
Initial investment: 9732 (closing costs + cash allocated each year to absorb negative cash flow for that year).
ROI w/ 2.5% YoY: 110%
ROI w/ 5% YoY: 199.3%
Initial leverage: 30.8x
We can conclude that the Reward for Risk philosophy remains consistent in all rational investment choices.
Option (3) has the highest ROI in appreciative scenarios due to the lowest amount of initial cash investment required. Though it is the most risky due to 0 liquidity in the next 5 years unless you pay a $15,000 higher penalty, highest leverage, and highest sensitivity to rising interest rates and fluctuating property values. Having the highest monthly carrying cost also affects the investor’s ability to acquire further non-real estate related credit as it increases the Total Debt to Income Servicing Ratio (TDSR).
Option (2) is second in line- less vulnerable to rising rates and fluctuating market values, more liquid than (3), but less than (1) due to initially losing part of your initial investment to CMHC, and the loss has a greater effect on ROI the earlier you sell, as the cost is spread out over a shorter period of time.
Option (1) last because of being the lowest risk and most liquid. You have $60,000 in equity to absorb a decline in property value and remain liquid, and the least outstanding mortgage balance vulnerable to rising interest rates. Unfortunately, it is also the most difficult avenue to get into due to the high initial investment requirement. Taking the longest time to get in also carries the highest opportunity cost of your money; you could already have your money working for you within a year, versus waiting 2+ more.