Karen and Keith Anderson have never felt better about their finances. They’re sitting on more than $2 million worth of real estate, and they just gained thousands of dollars a year in passive income. And get this: it all happened by accident.
The Andersons’ financial fortune was made when they became landlords, but it wasn’t something they were planning on. Two years ago, they were regular homeowners trying to sell their three-bedroom Okanagan, B.C., ranch-style home. They bought it back in 2007 for $750,000, but with two growing children, they were already running short of space. The problem was, they were trying to sell in 2009: the economy was tanking and local housing prices were falling rapidly. The Andersons (we’ve changed their names to protect their privacy) realized that they would have to sell for at least $50,000 less than they paid.
Rather than taking the hit, they decided to keep the old house and rent it out. In order to pay for their new place—a $1.6-million, 3,000-square-foot custom home just 15 minutes away—they had to take out two mortgages. The first was a $315,000 second mortgage on their old ranch home for the down payment, plus a new $700,000 mortgage on the new place. (The rest of the money to buy the new home came from stock market investments.) It was a gutsy move, but so far it’s working out very well. If you’re interested in renting out your old place rather than selling the next time you move, read on and I’ll tell you how.
How does it work?
There are several things you need to consider when deciding whether to keep your old place as a rental or sell it. The first is whether you’ll actually make money. In other words, whether your investment property will be cash-flow positive.
To do this calculation you first need to find out how much you could rent your old place for. Scan reports released by your local real estate board and look through sites that offer free rental listings, such as Craigslist or Kijiji.ca. Or you can do what the Andersons did and get advice from a local real estate agent and property manager.
Once you know what you can expect in monthly rental income, you’ll need to add up the costs of carrying the property. The largest will likely be its mortgage payments. But don’t forget other operating costs such as insurance, taxes, maintenance and a contingency fund to cover advertising, administration and bad debts, like tenants skipping out.
When they ran the numbers, the Andersons figured they’d get a gross income of $32,400 per year from renting out their rancher. The total costs of keeping and maintaining it added up to $24,400 a year. Those costs included a monthly $1,500 payment on the $315,000 second mortgage to cover the down payment on the new place, plus $285 per month on the rancher’s first mortgage, which they took out when they originally bought it. They also decided to hire a property manager at a cost of $250 per month. (If you don’t hire a property manager, include at least $800 per year for each rental unit to cover maintenance costs.) In their case, that still left about $8,000 a year to cover insurance, possible vacancies and, of course, their profit.
Are you cut out to be a landlord?
There’s one more important thing you should think about before taking the plunge, and that’s whether you want the hassle of being a landlord.
When Mike and Joan Gaye moved from their Scarborough bungalow to a downtown Toronto condo, they initially intended to rent out the bungalow and use the income to accelerate their condo payments. But then the Gayes got honest. “I didn’t want my down time to be consumed with tenant complaints,” says Mike. So, the Gayes (we changed their names to protect their privacy) sold their bungalow, and used the money to make a lump-sum payment against their condo instead. Yes, they lost an asset, but they knew that becoming a landlord doesn’t work out when your heart’s not in it.
What about the risks?
When you go from homeowner to landlord, you are becoming a real estate investor. As with any other type of investing, there are risks.
The biggest threat is a drop in local housing prices, a very real possibility in many Canadian cities where the ratio between property prices and rents is currently at an all-time high. As with any leveraged investment, if you borrow money against an asset and the value of that asset drops, then you could get into trouble. You could find yourself in a position where the bank has loaned you more than your property is worth. Even if a mortgage repayment isn’t demanded, it can make refinancing your home impossible, as no lender will offer a mortgage that’s worth more than the house. Other risks include rising interest rates, which could mean higher mortgage payments, and, if you’re paying down the mortgage on the new home out of current earnings, job loss or disability.
The Andersons currently have a massive debt, but so far everything is working out fine. Their local real estate market is much healthier now and they’re no longer even considering selling the rancher. Why should they? It’s earning them money.