After consistently rising for many years in many locations across Canada, real estate has been on a tear in the last year, and rental property investing has been a hot topic for many individuals as a result.
However, a rising apartments for sale in tulum mexico market does not guarantee success. If you’re considering about becoming a landlord, you should think about not only the property’s purchase price and mortgage payback obligations, but also additional financial concerns.
How much does it cost to rent a house?
The standard down payment requirement when purchasing a rental property is 20% of the purchase price. There is a reduced minimum if the owner intends to live in one of the units in a multi-unit property. A buyer of a one- or two-unit property only needs 5% of the purchase price and can borrow the remaining 95%. If the property is valued more than $500,000, however, the minimum down payment is 5% of the first $500,000 plus 10% of the remaining amount. A ten percent down payment is required for a three- or four-unit rental property that will be owner-occupied.
Land transfer taxes and mortgage default insurance must also be factored into the closing fees for buyers. Land transfer tax is imposed on purchasers in all provinces except Alberta and Saskatchewan, and it is also imposed in Toronto. Mortgage default insurance is required for mortgages with a loan-to-value ratio of more than 80%, although certain lenders may require insurance for a house you intend to rent out even if you have a 20% down payment.
Mortgage rates for rental property purchases may be slightly higher than those available for owner-occupied properties. Mortgages for rental properties can be amortized over 25 years, or up to 35 years if a down payment of more than 20% is made.
Compare property costs to rental income prospects.
So, how do you evaluate a rental property? This is how I would calculate the figures. For the record, I do not sell investments or real estate, thus my goal is not to promote or discourage the purchase of rental property. In some cases, I believe it makes sense.
The figures below may appear high or low depending on where you reside; they are provided for debate only.
If you do the math, you’ll notice that this property has a cash-flow deficit of $6,716 each year, or $560 every month. Doesn’t it sound brutal?
There is extra tax owed on the net rental income if the investor does not claim depreciation on the property. Depreciation, also known as capital cost allowance, can reduce your net rental revenue to zero, but not to a loss. However, when you sell the property, your previously claimed CCA is turned into income and taxed at a high rate.
Despite the fact that the property is losing money in this example, the $10,939 in mortgage principle payments are not tax deductible, thus the property has a positive net rental income for tax purposes. Taxes would be $1,478 if you were in the 35 percent tax bracket (around average at $75,000 of income across the country). This indicates the owner will spend $8,194 in net cash flow in the first year to carry the rental property after taxes.
An investor would need a down payment of roughly $220,000, or 44 percent, to make this property cash-flow neutral; or, after taxes and assuming no CCA, they would need around $275,000, or 55 percent.
Aside from cash flow, there are other financial considerations.
However, cash flow isn’t always the best indicator of financial health. Here’s how I’d assess the property as a potential investment.
The property, which originally cost $500,000, now costs $508,170, including land transfer tax and legal fees. If the property increases in value by 3% per year to $515,000, and the $400,000 mortgage is paid down to $388,135, the net equity is $126,865. The buyer put down $108,170 ($100,000 plus land transfer tax and legal fees) up front, with a net cash flow loss of $8,194 after taxes. That’s a $116,364 investment that’s now worth $126,865—a 9 percent return. Of fact, that return is only on paper because selling the property would incur transaction charges of 4% to 5% of the property value, quickly turning the gain into a loss.
After ten years, how do the numbers look? The buyer’s total investment, including potential yearly cash-flow shortages, is $188,555 at this time, resulting in $398,700 in net equity and a 9 percent tax-deferred annualized return.
Due to lower leverage and reduced mortgage interest deductions, the annual return would drop to around 7% after 25 years.
The numbers for this analysis were chosen at random. I’m not claiming that a rental property will yield a 7% return in the long run. If we raise condo fees, property taxes, or other expenditures, or lower rent, let alone raise the mortgage rate, the statistics will worsen. The argument is that a rental property that is losing money is not always a terrible investment. Your return is not just determined by your cash flow. It is calculated using your initial investment, annual net equity growth, and cash flow.
When someone buys a rental property that will lose money, they can think of it as a monthly RRSP payment over time. However, they must ensure that they can meet the cash flow requirements, which may include a protracted vacancy or an unforeseen repair. And, given the high costs of buying and selling real estate, trying to achieve a quick profit on a real estate investment might be dangerous.
Prior to investment fees, a long-term return of 6% to 7% may be a reasonable estimate for equities in the future. You may earn a comparable return if you buy a rental property instead of contributing to your RRSP or TFSA, but you will miss out on the tax deduction and immediate refund of an RRSP contribution, as well as the tax-free growth of a TFSA account.
A rental property provides tax-deferred growth, with tax due when the property is sold. Instead of selling a rental property, a landlord may be able to borrow against it to access the equity and avoid paying taxes. Getting a mortgage, on the other hand, is usually more difficult in retirement, when you are more likely to need access to your savings, whatever they are at the time.
Obviously, a cash-flow positive rental property is preferable to one with a negative return on the surface. However, cash flow is not a good way to evaluate a rental property. If ongoing high property value appreciation is required for your rental real estate figures to make sense, there is a risk if real estate values revert to the norm or interest rates rise. Both are plausible future scenarios, but they pose hazards to highly leveraged real estate investors who receive low rents.