The new way to make money in real estate

Anyone can make money while property prices are surging, but what if the market turns?

 

by

From the May 2008 issue of the magazine.

 

The secret to successful real estate investing over the past decade has been simple: buy property, then sit back and watch it rocket up in value. With prices shooting skyward at double-digit rates in many Canadian cities, how could you not make money? Unfortunately for would-be Donald Trumps, making money over the next decade may not be quite so straightforward. A recent housing affordability report from Royal Bank proclaimed “easy money no more,” and warned that prices in both Calgary and Edmonton have “soared well above their fundamentals to unsustainable levels.” Meanwhile, the latest numbers from the Organisation for Economic Co-operation and Development say that Canadian homes are now more expensive than their U.S. counterparts, when you measure them in terms of their relationship to incomes and potential rents. Nobody is yet predicting a U.S.-style real estate collapse in Canada, but all the data suggest that the red-hot market of the past few years is likely to soon come off the boil.

If the housing market cools, the old way of real estate investing will stop working, and investors who rely on rising home prices for their profits will start losing money. Luckily, there’s another way to invest in real estate, and it works no matter what the market does.

Using this method, Dan Young made his first million by the time he was 34. He started investing in properties in his home town of Midland, Ont., when he was just 24, and made most of his money on a four-plex, a six-plex, and a 12-plex.

His secret was nothing more than a systematic method for evaluating potential investments. Rather than betting on possible gains in real estate prices, he made sure that the rent he received from a property put cash into his pocket each and every month, from the very first day he bought a property. “When things are going well, when interest rates are declining and property values are going up, then it’s really easy to look like you’re smart,” he says. “But when things go the other way, it’s really easy to lose money too. That’s why you need a long-term strategy based on some realistic expectations.”

To be honest, Young’s way of investing isn’t really all that new at all — it has just fallen out of favor over the past decade. David Southen has been using it for 24 years. He’s now 48 and he and his partners own 125 residential units in Southern Ontario worth about $7 million. He can sum up his secret in just three words: positive cash flow. “You need to be making enough from renting your property out so that after all of your expenses are paid and your contingencies are allowed for, you can pay the mortgage and still put a few shekels in your jeans,” says Southen from his London, Ont., home. “If you’re not, then it’s not a viable investment.”

If you want to generate a reliable stream of cash from your real estate investment, rather than just gamble that prices will go up in the future, Southen says you need to carefully assess each property before you buy it. Your fate as a landlord will be largely determined at the moment of purchase—pay too much and your mortgage and expenses will eat up all of your profits. Southen says there’s a simple three-step way to calculate the right price to pay for an investment property:

– First, get an honest estimate of the total income you can expect from renting it out each month

– Second, get an honest estimate of the expenses involved in running the property

– Third, figure out how much money your property will have to spin off after expenses to pay the mortgage and provide you with a profit

Once you know those three numbers, evaluating how much to pay for potential real estate investments is easy. Of course you’ll only get a trustworthy result if you use trustworthy numbers to begin with, and that’s the catch. Getting a grip on the true rental income you can expect and the true expenses associated with a property can be tough — mainly because the seller will supply you with a long list of bogus numbers. “There’s a well-known saying in real estate investing,” says Southen. “Trust — but verify. Getting a handle on the property taxes and insurance is easy. But people will lie to you about everything else.”

Sleuth out the real rents

If you want to get past the lies and figure out how much your potential investment is really worth, start by estimating the total rental income that the property can generate. Ask the seller for the “rent roll,” which tells you how much rent is being collected from each unit. Then scan the local papers to find out the typical rents being charged in your area. As a double-check, look for the rental market reports published by the Canadian Mortgage and Housing Corporation (see www.cmhc-schl.gc.ca) and find out the typical rents in your area. If the rents charged to the tenants in your building are lower than the local average, that’s good. It means there’s room to raise rents in the future.”However if the average two-bedroom is renting out for $850, and the units in your potential investment are renting out for $1,000, watch out,” says Southen. “They might be filled with the seller’s relatives, who will leave the second you close on the property. That’s an old favorite.”

Don’t forget vacancies

“The vendors will tell you the property is fully rented with a waiting list, so they don’t have any vacancy or bad debt,” says Southen. “But it’s not true. Every landlord has vacancy and tenants who skip out without paying.” When calculating your expected rental income, subtract 5% from the total income the building will generate at full occupancy to offset your expected losses from vacancy and bad debt. Then add in any additional income from laundry or parking. That will give you your “gross effective income.”

Add up the small stuff

The next step is to estimate expenses. Your first big cost is property management. If you’re buying a larger property, you’ll probably want to hire a professional property manager to rent out the units, keep the books, and oversee basic maintenance. If you’re buying a smaller property, you may want to do all that yourself” but you should still subtract your time as an expense because you may not want to do the chores forever. Southen suggests you count on paying 6% of your rental income for management in larger buildings and more in smaller ones.

Then there are maintenance and repair costs. “That’s where you’ll run into the biggest fudge factors,” says Southen. “The landlord will tell you: ‘I do all the repairs myself, so there’s no cost.'” Don’t believe it. You can count on spending at least $800 a year on maintenance for each apartment or townhouse. On top of that, you should budget separately for any major capital expenses, such as replacing the roof or upgrading an elevator. Have the property professionally inspected and do an environmental audit before buying to avoid nasty surprises.

Utilities, your next expense, can be an opportunity. “If I go into a building and see that it’s stuffed full of old incandescent light bulbs, then I know right away that I can peel 10% to 20% a year off the bill just by changing the bulbs,” Southen says. Similarly, old furnaces and boilers, old toilets and leaky showerheads offer you the chance to improve your annual income from the property with a few lost-cost upgrades.

To get a good idea of what you’ll be paying for heating, water and electricity, ask for at least one year’s worth of bills.”A lot of people will say they don’t have them,” says Southen, “but utility companies will provide a summary of the previous year’s charges if the owner asks for it.”

Don’t forget the cost of advertising for new tenants. If you have a lot of units like Southen has, you can count on paying about $400 a month for newspaper ads and the like. If you have a single triplex, the expense can be negligible.

Your final three expenses—property taxes, insurance and bank charges—are usually straightforward, but Southen offers a couple of tips. With property taxes, watch out if you’re paying a lot more for the building than it was last assessed for, because the very act of purchasing it could trigger a new assessment and higher taxes. With insurance, make sure the building isn’t underinsured. If it is, be prepared to pay more for a better policy.

By now, you’re probably starting to see why inexperienced real estate investors would rather just focus on rising house prices. Getting a good grip on your true income and expenses is a lot of work, and you may feel like you’re worrying about nickels and dimes when there’s big money to be made from rising property values. But remember that you want an investment that doesn’t depend on rising home prices to make you money.

If you diligently tote up all your various costs, you’ll be astonished by what you find. Almost always, vacancies and expenses eat up a full 50% of your gross rental income, though many sellers will deny it. “Underestimating how much it’s going to cost to run a building is the No. 1 mistake made by inexperienced investors,” says Southen. And it’s the No. 1 reason why investments that look good on paper can end up costing you tens of thousands of dollars in the long run.

So what’s your return?

You’re now on the home stretch to determining what your building is worth. Subtracting vacancies and expenses from your rental income will give you what’s called your “net operating income” for the property. You use that to determine the return from your property, commonly referred to as your “cap rate.” The cap rate is simply the cash yield you get from your property, after accounting for all expenses but before mortgage payments. In other words, it’s your net operating income divided by the price of the property. It has to be higher than the interest you’re paying on the mortgage or you won’t make any money. These days, Southen says he looks for cap rates between 7% and 8%. “If someone came to me with an honest 8%, I’d buy all day,” he says. “A 7.5% would be okay, but a 7% —well, I’d have to think long and hard about it if it were a 7%.”

And the true market value is?

Now that you have your cap rate, you can calculate what you should pay for your building. Just subtract the expenses from the annual rental income, then divide by the cap rate. For instance, if the building has four units renting for $900 a month each, expenses that eat up 50% of your gross income, and a cap rate of 7.5%, you can quickly calculate that you should pay about $290,000 for the building, tops. If you pay more, it’s probably not a good long-term investment.

We know what you’re thinking: “Where on earth am I going to find a four-plex that’s going for less than $300,000?” Certainly not in Vancouver, where the average detached house is now selling for north of half a million. Probably not in Toronto, Calgary or Edmonton either.

But that doesn’t mean the calculations are wrong. What it means is that now may not be a great time to buy. Your annual return is essentially the spread between market rent and the cost of buying and owning a property. In many cities, property prices have been climbing by as much as 10% a year. Rents have been edging up far less. Thus, the rising prices have squeezed the profit potential right out of the buildings.

If you’ve read books or attended seminars on buying real estate, this may surprise you. Many gurus talk up how easy it is to succeed in real estate and offer up tricks that are guaranteed to make money. They chatter about the power of leverage, the secrets of bargain basement financing, and how to identify up-and-coming neighborhoods. All of those tactics can help you get more out of a decent investment. But none of them will help you if you pay too much for your property. It’s almost impossible to turn around a true money-loser” which is why positive cash flow is king, and all other considerations are secondary.

David Southen and Dan Young made a killing in years past because they bought when prices were lower. Southen says that since then, prices have surged too high. “I’d like to buy right now,” he says. “I’ve got lots of money available to buy with. But I’ve found that there’s really nothing to buy that’s reasonable.”

Young largely concurs. His first investment was a four-plex in the Midland area that he bought back in 1998 for just $135,000. His second investment was a six-plex that he bought in 1999 for $190,000. He’s not seeing many prices like that today. In fact, he’s been looking to buy a new property for seven years.

He thinks he may have finally found a prospect. It’s a nine-plex in Midland that he’s had his eye on for some time, although it wasn’t officially for sale. He liked it because he knew that the landlord was charging lower-than-market rents, which meant that Young could raise the rents as the tenants rolled over. Not only that, but the landlord had been paying for the utilities. Young knew that the units were separately metered, so he figured he could also download the utility expense to new tenants, who could pay their utilities directly. On the off chance he could persuade the owner to sell, Young asked his real estate agent to inquire. “The owner was interested, so I moved in fast,”he says. “Really fast.”

Young’s latest adventure shows the challenges of investing in this market. At first, the price for the property looked too high, but once Young factored in the artificially low rents and the effect of downloading the utilities, he found that the building could carry itself at a decent cap rate. “It’s really hard to find investments that make any sense right now,” he says. “But there are some. You just have to wait and persevere.”

Comments are closed.