I have put together a series of posts on the Rent versus Buy decision that many people face, especially in times of softening property markets.

I have found a useful tool on Yahoo Finance that lists key variables and will allow you to calculate the value of buying.  Be sure to account for all expenses like cable and other utilities that you pay for when owning.

Check out my posts for some qualitative information and then use the calculator to assist in the process.

Part 1, Part 2, and Part 3 are currently available.

Hope this helps you make a more informed decision.

Well, I must admit that I’ve not been making adequate time for FDF lately as a combination of travel and settling in from a move are my best excuses.  A ton has happened since I was last writing about Real Estate comparisons and getting into detail regarding a few stocks.

Most recently, I had an article in the pipeline on Labrador Iron Ore (LIF.UN) because a major expansion of the Iron Ore Company of Canada (of which LIF owns 15.1%) was announced in September.  The USD exchange rate was also turning in their favour amounting to a great buying opportunity at $45 a share.  During the process of researching and analyzing future cash flows for LIF, iron ore prices promptly shrunk with the commodity slide.

Now trading at $19.32 as of Dec 9 they don’t seem like such a great deal in the short term as IOC has just announced major scalebacks in production which will hamper distributions.

With the new information, I have to do more investigation into the potential of ore prices to recover (some say by 2010 when China gets back on track) because there is a lot of guessing going on.

I do think there are some great long term buys out there and will be looking to sniff some out over the next quarter.

I am also interested in the direction of the real estate market, especially in Southwestern Ontario.  Data keeps suggesting that sales are down and we are moving into a buyer’s market.  I have been looking at some properties in Waterloo that are cheaper than ever and have excellent cap rates (near 8.5%).  Given the direction of interest rates as well, this could be a great time to go shopping.

The wonders of Small Claims Court have been taking up a chunk of time also.  After a terrible group of tenants, I have a substantial amount in damages that need to be recovered.  I find this process both intimidating and chock full of learning opportunities. I will be keeping you posted on the process to give some insight and so you can learn from my experience.

Andrew has also been a busy man over the last 4 months and is taking in the entertainment (aka volatility) of the markets like most of us.

So bottom line, we’re back and ready to go. Look for continued writing on our activities and the lessons that can be had!

I am enjoying this format because it provides information on real estate markets not readily available (see Part 1 for the skinny). There is currently no free source out there green-lighting certain areas of Canada or the US. You could join the Real Estate Investment Network to get hot tips about where to buy in Canada, among many other useful things I’m sure, or just use these fundamentals and analyze markets that interest you. If the same analytical approach taken to equities was applied to real estate we would have a wealth of analysis available for the public. They could use it to guide their home purchases and increase the market’s efficiency.

Until something comes along, I’ll be stuck doing my own investigations.

I wanted to do another Canada / US comparison because some people might have thought I cherry picked New Haven to prove a point. Actually, I picked it because it is an area of interest.

I’d like to look at the fundamentals of 2 more cross border markets. I have decided to look at Cambridge, MA and Calgary, AB. Calgary was the hottest market in Canada for a while, but is now cooling off. I’m curious to see how the fundamentals look during this cooling process.

Cambridge, MA is a great area to spend time in. Being home to 2 of the best educational institutions in the world doesn’t hurt. I visit every summer but haven’t the foggiest what the real estate market is like.

Here’s a quick overview of the guiding factors in my analysis.

Take time to look at published information and data from trusted sources when looking to buy in an area. For Canadians, the CMHC, Royal Lepage, and individual city’s sites offer quality stuff.

In addition to getting good data, you also need to know which data is critical for understanding an area’s potential to support a strong real estate market. Taken from pg 39 of Don Campbell’s book Real Estate Investing in Canada, the 12 key fundamentals that affect real estate values are:

Passive Factors (out of your control):

1. Mortgage Interest Rates

2. Increase in Average Incomes

3. Increased In-migration and Demand

4. The Ripple Effect

5. Local, Regional, and Provincial (State) Political Climate

6. Transportation Expansion

7. Areas in Transition

Active Factors (in your control):

8. Creating Highest and Best Use

9. Buy Wholesale, Sell Retail

10. Quality Marketing

11. Renovations and Sweat Equity

12. Speculation

We’ll be looking at the passive factors because they do not depend on a specific property and you have no influence over them. You need to make sure factors out of your control will support your purchase.

Factors 4-7 require a little more digging and insight than the first 3. The ripple effect concerns positive effects on prices in one market after a nearby town or city has experienced a “boom”. Canadians should think of Milton, being the ripple effect of Mississauga and Oakville, which were ripple effects of Toronto at one point.

The political climate concerns the area government’s ability to conceive, support, and implement development initiatives that bring people and capital to it. Some areas clearly excel in this regard. Waterloo Region is consistently viewed as a winner in this department. The City of Brantford, however, usually falls down on the implementation side and would get a lower rating.

Transportation Expansion concerns the construction of new highways that cut commute times to the big cities. Public transit improvements also have a positive effect on property prices, especially when they are within 500m of a new station or line. Vancouver (actually the GVR) is a great example of this. REIN has a great report to give you more details.

Areas in transition are often difficult to define. The word “gentrification” comes to mind. It could be an old rundown urban area that has recently seen more families move in. They buy old houses and either fix them up or tear down and build shiny new ones. This activity encourages restaurants, bars, and grocery stores to move in, bringing more people now that the area has amenities. In short an area in transition is clearly on its way, but not quite there, to becoming a great place to live.

So let’s look at Calgary, AB. It’s the heart of Alberta’s oil kingdom and the oil boom has created a huge growth in employment. The number of people moving there from all over Canada is staggering, so one can understand why property prices went a little nuts. Let’s see what the numbers say:

I was able to get population and income data from the City of Calgary.

The total population increase over this 5 year period was 12.5%. This is almost twice the Canadian average for the same period.

For the City of Cambridge, MA the population trend has been slightly upward at 2.1% growth from 2000-2007.

Advantage: Calgary

Now looking at average income growth for Calgary, we would expect to see the same growth trend.

From 2002-2006, growth has been solid from $73000 to $90700, representing a change of 24% before inflation.

Cambridge, MA doesn’t have a great deal of charts available, so I’ve pieced together the data. Median Household Income growth before inflation from 1999-2007 was 19%. This is very good relative to other cities I have looked at.

Both cities clearly have solid income growth, yet only Calgary has had above average population growth.

Let’s now look at property prices and see if these fundamentals are echoed.

Calgary Median House Prices

As you can see, prices have gone crazy in the past 4 years. Growth in property prices from 2000-2007 was approximately 161%!!! This will be hard to match in any environment and prices have seen a cooling, not a collapse, since their peak in 2007. I’m not sure if the population growth (though above average) and income growth completely justify such an increase, so it will be interesting to watch over the next 2-3 years.

Cambridge, MA has not had close to the same price performance of Calgary (very few places have!). Yahoo Real Estate provides data from 1999-2007 that shows an 85% increase in the median house price. This is a very good performance over an 8 year period but only half as much as Calgary.

Growth has also slowed in the last 18 months and prices are actually showing a slight decrease.

In comparison then, the price performance in both markets has been excellent. Calgary has a substantial advantage on the fundamentals because of the high population growth it has experienced. In income growth, both areas have shown above average performance.

Neither market has seen price decreases of 10-20%, rather it has been a slower cooling after the “boom” which is also a positive sign of the areas as a whole.

And the winner is……Calgary, by a substantial margin because of the population growth figure that will serve to support the real estate market well into the future. Cambridge is simply not growing as fast despite rising incomes and an 85% increase in prices over the last 8 years.

So there you are, a specific analysis of the fundamentals for two real estate markets allowed us to understand their behaviour. Go ahead and apply these fundamentals to other US cities. If the cities have great fundamentals and prices are still dropping it may be a great time to buy. Just be sure to do your homework!

Here is the continuation of my quest to produce a systematic tool for identifying if you should buy or rent. Keep in mind that when you combine these insights with some diligent research, you should feel confident in making a decision.

The previous post discussed your Plans for Savings and % Down Payment as key indicators. Below is the complete list.

Key Variables affecting the Rent vs. Buy decision:
• Level of Financial Education
• Plan for Savings
• % Down Payment
• Property Market
• Stock Market
• Nature of Income
• Location

4. Property Market
If you consider the purchase of your home to be an investment, it would be wise to investigate the current status of the market for such an investment. In case you’ve been living in a bubble for the past year (actually, you couldn’t because it burst a while ago…..), you’ll know that the US Real Estate Market is tanking. This is a macro trend that doesn’t apply to all areas however. Certain markets in the US are still strong due to good fundamentals. See my post outlining the fundamentals.
Buy or Rent? Let’s account for the status of the property market before making our decision. A large assumption in our calculations is an annual rate of increase in house prices for your area. After researching historical performance, it is important to calculate the average annual increase for the last 5,10, and 25 years.

Combine this with a sustainability check. If you’re seeing rates over 20%, your market is bound to see come cooling in the near future (gradual or otherwise).

If you’re seeing high rates that are not likely to continue, renting might be a good option until you’re able to understand what form the cooling will take.

However, if prices are crawling at 2-4% a year and the area has good fundamentals, buying now is probably a better choice than renting. Either you might see more rapid price increases in the future or continued steady increase. Both are great conditions to be a homeowner in.

In the event your market is experiencing a long decrease there will clearly be some reasons behind it. Examine the fundamentals, and if they look really bad, prices may not reverse themselves in your lifetime! Renting would then be the way to go. In this case, make sure you get your Financial IQ up because you won’t be able to make your money from a primary residence.

In the event that your area has been depressed for a while, but could be on the “up and up” in terms of community development and steady population increases, you may be getting in a little ahead of a boom. Make sure you review the fundamentals thoroughly to ensure things are as good as they appear. Buying in an improving area is every homeowner’s gravy train, so this would clearly be a green light special.

In short, if the fundamentals in your area look strong and price increases have stayed reasonable (0-12%), buying is a good choice, all other factors being equal.

If the fundamentals look bad or your market has been really hot (Hello Saskatoon, or Calgary 2 years ago) with increases well over 20% for 3-4 years straight, find a good rental and wait for things to cool down.

Keep in mind that you should perform a forward looking cash flow and balance sheet analysis for the next 5 years to make sure that your favored option does indeed work out better.

Again, if you’re going to rent, you need to keep piling the savings into investments to truly realize any advantage calculated. Buying cars and trips with the cash will provide no lasting value to your balance sheet.

On a scale from 1-5, give yourself a 1 if the Market in your area is stable or “coming around” with solid fundamentals. You would score a 5 if your area is getting more like a ghost town all the time (bad fundamentals).

5. Stock Market
The other key assumption going into a Rent vs. Buy decision analysis is an expected rate of return on money invested. Your ability to generate a decent return will, along with all the other factors, be critical if you choose to rent. When renting, areas for growing your money are generally equities / funds / derivatives, starting a business, and buying an income property. I suspect most people would favour the first area because it seems easier (just click “BUY” and you’re good to go).

With relevance to the big decision, volatile markets or those that are clearly unstable require a high financial IQ to navigate. Obtaining the required return outlined in Part 1 of this series would therefore be difficult. This means that buying a house would be easier to handle and to count on a stable return.

In times of low volatility or sustained growth, it might be possible to achieve some steady, solid returns. This may give the illusion that renting is the way to go even for those with low Financial IQ. However, keep in mind the required rate of return to match the BUY scenario outlined in Part 1.

Give yourself a 1 in this category if the Stock Market is extremely volatile or going sky-high. A score of 5 would correspond to a market that is just out of a recession and has encouraging fundamentals to drive future growth (see: CHA CHING!). I think currently we’d be around a 3, because we are clearly in the middle of a recession, but there are plenty of good buying opportunities.

The Property and Stock Markets are going to have a large influence on your decision because they are the source of your 2 biggest assumptions in the balance sheet calculations. Your cash flow analysis will not really be affected by these variables as an increase in the value of your home or stock will not put cash in your pocket. Now if you plan to buy an investment with some type of payout (dividend or income trust distribution) be sure to include it in your cash flow analysis.

We’re moving along in the decision making process and I’m sure most of us already have an idea of whether Renting or Buying would be best.

We’ll finish up the analysis next time when we total the points up and look at the Nature of Income and Location.

Over the past 8-10 months every magazine and television channel has been discussing the fact that US Real Estate prices are tanking. This trend is well covered in the macro sense but up in the Great White North we get few specifics.

I wanted to do a little comparison between 2 areas that I have some experience with, New Haven, CT and Kitchener-Waterloo, ON. It will also highlight that all of Canada is not tied to US performance, contrary to opinions of many people I have met. On the plane or in the airport, when the topic of Canadian Real Estate comes up, people automatically seem to think that our entire market will collapse because of the US situation.

Teachable Moment: Don’t believe people’s opinions on topics like this. Instead, take time to look at published information and data from trusted sources. For Canadians, the CMHC, Royal Lepage, and individual city’s sites offer quality stuff.

In addition to getting good data, you also need to know which data is critical for understanding an area’s potential to support a strong real estate market. Taken from pg 39 of Don Campbell’s book Real Estate Investing in Canada, the 12 key fundamentals that affect real estate values are:

Passive Factors (out of your control):

1. Mortgage Interest Rates

2. Increase in Average Incomes

3. Increased In-migration and Demand

4. The Ripple Effect

5. Local, Regional, and Provincial (State) Political Climate

6. Transportation Expansion

7. Areas in Transition

Active Factors (in your control):

8. Creating Highest and Best Use

9. Buy Wholesale, Sell Retail

10. Quality Marketing

11. Renovations and Sweat Equity

12. Speculation

I was curious how New Haven was doing because I visited there a few summers ago and found some interesting areas. I could have picked many other US cities I like, Boston / Cambridge, Phoenix / Scottsdale, Portland (Maine), and pretty much all of North Carolina and Florida. After a little searching on New Haven, I found the following chart that summarized the real estate market fairly well.

In the chart you can see prices have dropped over 10% from Q3/07 to Q4/07. This doesn’t even cover Q1/08, which data should be coming in for any day now. This decrease is substantial and should get some attention. However, I can’t take my eyes off the massive drop in the number of units sold. In one quarter homes sales dropped from 370 to 75!!! This is an 80% drop!!

Wow, now I realize the real crunch for property owners. A city with a population of 124,000 only had 75 properties change hands in 4 months! The real estate agents must be scared. This would seem to be a great buyers market because there must be a huge inventory of homes, condos, and investment properties. I would be curious to see what has happened to rents during this collapse of home sales in New Haven.

But let’s look a little deeper into the New Haven market using some of the 12 fundamentals.

Mortgage Interest Rates:

They have been low when compared to historical values over the past 30 years. The interest-only mortgages and other unique products also assisted in reducing borrowing costs and therefore stimulating home buying.

Increase in Average Income:

Estimated median household income in 2005: $30,603 (it was $29,604 in 2000)

New Haven	$30,603
Connecticut:	$60,941

Estimated median house/condo value in 2005: $188,200 (it was $109,200 in 2000)

New Haven	$188,200
Connecticut:	$271,500

Besides being around half of the state average, New Haven’s median income has essentially remained stagnant from 2000-2005, while house prices were increasing 72%. Does this make sense to you?

Increased In-migration and Demand:

The population of New Haven increased by 0.3% from 2000-2006. The addition of 375 people is hardly enough to justify a 72% increase in property values.

I can keep going through these fundamentals, but I think you already know the answer. The last 4 passive factors become more central when looking to predict an area’s future behaviour and we can skip them for this analysis.

Conclusion: New Haven’s fundamentals didn’t justify the increase in home values and they were bound to go back to reality. I realize that this may seem obvious now after looking at the fundamentals, but I truly believe I wouldn’t have been able to justify a BUY and HOLD investment in this market. It would have just been speculating and I don’t have the capital or risk tolerance to be doing that.

So let’s move on to Kitchener-Waterloo, where there is a large pool of skilled labour, a diverse mix of manufacturers and innovative tech companies, and great universities.

Here’s a summary of their real estate market:

As you can see there are a few differences from the New Haven chart, not sure if you can detect the sarcasm here or not…

For KW from 2000-2005 prices rose approximately 41%. This is good stuff for sure, but not as good as New Haven’s 72%.

As you can see the increase in number of MLS sales has also increased steadily.

Let’s look at the fundamentals now:

Mortgage Interest Rates:

Canadian rates are in a similar position to the US, low compared to historic levels. The difference in Canada is that interest only mortgages and subprime borrowing is around 5% of the market compared to 20% in the US. I got this info from the Real Estate Investment Network’s site, where they have a great speech by CIBC economist Benjamin Tal.

The climate is good enough to stimulate buyers, but not at a pace like the US.

Increase in Average Income:

Along with the median family income in KW being above the provincial and national average, unlike New Haven, it also rose about 10% from 2000-2004. This is a solid indicator of a region’s health, assuming inflation is also low.

Increased In-migration and Demand:

Just looking at the population increase for KW from 2001-2006 gives a good indicator of what is happening. A total of 25,201 people were added to the KW population for growth of 8.1%, almost 70 times the growth of New Haven over a similar period!

Conclusion: This case is also open and shut. Solid population and wage increases along with low interest rates bode well for KW.

If you had to pick the sustainable market, would it be New Haven or KW? You guessed it, even though KW’s house price increase was only 57% of New Haven’s performance, their underlying factors lean vastly in favour of KW for the long term.

So there you are, a specific analysis of the fundamentals for two real estate markets allowed us to understand their behaviour. Go ahead and apply these fundamentals to other US cities. If the cities have great fundamentals and prices are still dropping it may be a great time to buy. Just be sure to do your homework!

Here is the continuation of my quest to produce a systematic tool for identifying if you should buy or rent.

The previous post discussed the Level of Financial Education as a key indicator. Below is a complete list of the key variables.

Key Variables affecting the Rent vs. Buy decision:
• Level of Financial Education
• Plan for Savings
• % Down Payment
• Property Market
• Stock Market
• Nature of Income
• Location

2. Plan for Savings
Following up on my previous post, the next factor in the Rent vs Buy decision concerns your plan for savings. A large portion of savings is generally used to purchase a personal residence, tieing up a large amount of capital in the process.

Ask yourself what you would use the down payment money for if it didn’t go toward a house? If your answer would be to buy a car or some other consumable, buying a house is likely right for you because it would force you to put the money “away”.

However, if you can see yourself using the capital to purchase an investment property, start a business, or invest it in a great company, then you should at least consider renting. Definitely perform a detailed cost analysis with cash flows and equity projections to compare the 2 scenarios.

As for scoring, if you would spend your savings on shopping, travel, cars, etc. before investing it, give yourself a 1. If you would leverage it in real estate or through another investment, give yourself a 5. If you would plan on dumping it into a mutual fund give yourself a 3.

3. % Down Payment
My post regarding COCR / ROI variation with down payment amounts highlighted that lower down payment amounts are better for investment cash flow but worse for equity or a quick sale. These rules will be different for a primary residence and require more description.

Down payment amounts affect the rent versus buy decision because a low down payment will increase the mortgage owed. By putting down less than 20%, one would either be able to afford a larger property by using all of their savings or find one in their budget but use a small portion of their savings. Either way your expenses will be higher than putting down 20% or more to reduce your mortgage amount.

Complete a cash flow analysis because the higher mortgage payment might make renting substantially better. Then calculate the money you would save by renting and compare it to how much you would gain in “appreciation” if you owned. This number should give you an indication of the true winner in the debate.

Score yourself from 1-5 once again. A score of 1 would mean you intend to put down as little money as possible to get into a house (5%). Score yourself a 5 if you plan on putting down 20% or more.

Stay tuned for the next post outlining the Property and Stock Markets and their influence on the Rent vs, Buy decision.

I’ve heard varying opinions on the Rent vs. Buy topic. These opinions come from people with all types of education (financial and otherwise) and all levels of income. One will say “We bought because a house is the best investment you can make”, while others will back it up with “We bought because we were throwing money away by renting”.

The rent crowd looks to maintenance, utilities, and taxes (those other fees that come with owning!) when they say that “You’re throwing away money paying operating costs which can be almost as much as my rent”. One friend who is financially savvy rents because it gives him more cash (from reduced expenses and use of savings) to use in the markets. He figures he can beat whatever return a house/condo would provide. Whether he actually does I am not privy to.

There are valid points on both sides, but the argument still hasn’t been settled once and for all.

Firstly, I’m going to be like every other person that has touched this subject and say that the answer (Rent or Buy) will be different for everyone because there are too many variables to issue a blanket answer. However, I don’t intend to cop out and leave it at that. There are some clear principles one can use to make a decision.

Key Variables affecting the Rent vs. Buy decision:
• Level of Financial Education
• Plan for Savings
• % Down Payment
• Property Market
• Stock Market
• Nature of Income
• Location

Let’s take a look at the parameters and discuss how they could impact your decision.

I will use a scorecard approach to each variable, assigning points based on your status. Add them up and compare your score to the chart in the final post in this series. It should give you an idea about what option would be better for your situation.

1. Level of Financial Education:
I think this one is obvious, but it is definitely worth explaining. The Rent vs Buy decision hinges on your ability to do something with your savings to earn a decent return. If you consider dumping it into a GIC to be a “good move”, this is a signal that buying is probably right for you. Here’s why:

GIC: Assume a GIC will be paying 5%, I’m feeling generous. So you rent and take your down payment money (assuming 20% of purchase price if you were to buy) of $50,000 and put it into the GIC. After year 1 your GIC is worth $52,500, for a gain of $2500 (5% return).
Condo or House: You use your $50,000 to purchase a house worth $250,000, leaving you a $200,000 mortgage. Assume your house appreciates at 5% (make this most accurate by researching property price increases in your area for the previous quarter) After year 1 your house is now worth $262,500 for a gain of $12,500 on your investment of $50,000 (25% return).

Comparison: The return on your money is 5 times higher by buying the house. Now, the gain on your place of residence is tax free, so your return is even higher relative to the GIC gain which is fully taxable as interest income.
But you’re not done yet. This is where the homework comes in. You need to subtract all of your related expenses from these gains.

GIC: Subtract your rent, tenant insurance, and any other expenses not common to buying a house. For example, don’t subtract internet if you will be paying the same for it whether you rent or buy.

Condo or House: Subtract your mortgage, taxes, insurance, estimated maintenance cost, and utilities.

Now compare the GIC and Condo or House numbers, which now don’t look nearly as good!

For fun, project the numbers out for 5-10 years to get an idea of their behaviour over time. Does this change the scenario?

Some people with a high level of financial education will look at a housing purchase as tying up a large portion of their savings. Putting $50,000 -$100,000 in their home (although you could likely convince your bank to let you take out some equity in your house if you really wanted to get into an investment) eliminates their ability to participate in other investments.

If you’re likely to use the money to buy some deep in the money calls, a great dividend stock, or want to put money into a company with a great long term story (see Sandvine, SVC:TSX) you may be able to generate a great return.

Let’s say that Johnny or Jane expert averages 25% a year for a 3-5 year period. Are they better off renting? Well if we take the $50,000 and it generates 25% in year 1 we would have $62,500 for a gain of $12,500. This would be a capital gain, so therefore taxed at half of your personal income tax rate.

If you bought a house for $250,000 as in the above scenario and it appreciates at 5%, you end up with a gain of $12,500 also.

Therefore, you would need a gain greater than 25% a year on your non-house investment, but accounting for the capital gains tax you will pay upon sale (30% bracket) 15% of the $12,500 in tax. This is equal to $1937.50 and decreases the return from 25% to 21%.

It would seem that you need to be realistic with your investment performance.
In order to match the gain on a property by using an investment, here’s a quick guideline:

E.g. Property Appreciation Rate (P) = 5%, Income Tax Rate (I) = 30%, Down Payment Amount (D) = 20% Required Rate of Return on Other Investment (IRR)=?

So to calculate the rate of return required to keep up with a house we do:
IRR = P / (D/100) / (1-(I/2))

For the example, you would need a return of 29% to equal the return on your house purchase. This would take a high level of financial education.

Scoring: 1-5 Give yourself a 1 if you think a high interest savings account is a great place to put your money. Give yourself a 5 if you can read a financial statement effectively and have successful experience with a variety of investment products.

Stay tuned for Part 2 where I’ll get into Plans for Savings and % Down Payment and how they will impact the Rent vs Buy decision.

I have been examining some more real estate deals lately and am back in a situation where I am debating putting 5% down to get into a deal with lots of upside.

This may or may not be a great idea. As part of my due diligence, and to learn from my past experiences, I want to analyze my potential rates of return with varying down payments.

The basic principle for mortgage insurance on investment properties still applies: Do your best to only borrow 80% of your loan value from your primary lender. Use a combination of your down payment and another source for the other 20%. This will avoid mortgage insurance in the first place. However, this is not an option for everyone. We don’t all have friends and family or a large line of credit to borrow from.

Here’s the key data on the place:

Purchase Price:$250,000
Closing Costs: 2.5% of purchase price
Initial Investment for Renovations: $10,000
Maximum Potential Selling Price in 6 months: $300,000

Expenses for Sale:
Real Estate Fees (5%) = $12500
Mortgage Penalty for Early Sale = $1500
Misc (Legal / Insurance) = $900

Alright, so I first analyzed the Cash on Cash Return resulting from a purchase with varying down payments.

• Cash on Cash Return = Annual Net Income / Down Payment

Some people also include closing costs and renovation expenses in the denominator. This will decrease your Cash on Cash Return, which is fine because COCR is only useful for comparison. For this example, my net income included all estimated expenses (taxes, utilities, insurance, mortgage).

The breakdown is as follows:

As you can see, a lower down payment results in a higher COCR. Despite the higher mortgage payment and lower monthly net income, putting less money down gives me a higher rate of return.

This favours a long term hold approach where there are no clear plans to sell.

Lesson 1: If you plan on holding for a while, favour a lower down payment.

Next, I examined a potential quick sale resulting from some renovations to increase the value. These renovations would be performed either way, but I would have the option to sell if I choose.

I analyzed varying down payment amounts with the sale. I also altered the length of sale because this would influence the amount of cash coming in (from rent) and the return on investment.

The chart clearly shows that ROI is reduced with both time and a lower down payment. This contradicts the COCR analysis because the highest return comes from a high down payment. The time component is obvious because, even including appreciation of the property, when the shorter sale’s profit gets annualized its multiplier is relatively large.

Lesson 2: If you plan on selling quickly, and will be paying mortgage insurance, a higher down payment is best.

Now I have two lessons to guide my investment property purchases.

I will work to unify these two approaches to allow for a “governing” principle over down payment amounts. However, I think this is a good start and it will guide my decision making over the next few weeks with regard to this property.

In light of operating my investment property for a little over 5 months I’ve learned some pretty hard lessons and also discovered some that make life a lot easier. I realized very quickly that if you live more than 1 hour away from your property you must be able to manage a property at a higher skill level. The ability to be there quickly and often can compensate for a few errors along the way. A resource I’ve used to learn about the landlording gig is by Jeffrey Taylor “The Landlord’s Survival Guide”(see below). Over such a short period of time relative to other veteran owners, I feel like my next property could be managed significantly better just after what I’ve learned so far. Here’s a summary of the key lessons learned so far. Please examine this info and see if it applies to your situation so you don’t repeat my mistakes.

Say goodbye to cheques

I started out picking up cheques every month, which meant I had to make a trip to the property every month guaranteed. Then I went with postdated cheques that eliminated the need for the cheque pickup trip. After talking to other property owners, even postdated cheques are archaic. The new way to do it is through direct account withdrawal. If you belong to a health club they usually do this.

Requesting a void cheque and having the residents sign a form granting approval for the rent to be withdrawn by you is a great way to eliminate unnecessary trips. In addition, a cheque takes a couple days to clear, where you don’t know if they have the funds or not, while a direct withdrawal clears the funds right away if there is enough in the account.

You are also in control of when the rent is withdrawn, so late payments or delays in collection are eliminated. This process is part of a veteran manager’s toolbox.

Not studying local tenant laws

This one sounds easy, but I didn’t do a thorough job of reviewing them. Therefore when I was recruiting new residents I didn’t know what standard terms of agreement were for leases. I had a friend send me a lease he used for his property and changed it to reflect my situation. In essence I was using leases but didn’t know the underlying laws governing the agreement.

Perform recruiting as early as possible

In most markets it will take some time to get new residents. You have to post, show the place, and then sign them up. The first person to see the place may not fit your profile. Also, the person may be looking at other places and not select yours after viewing. There is definitely a lag between starting to look for residents and having them signed up that could last for months. I only had 3 weeks after the purchase of my property to get it rented out. Consequently, I was in need of tenants and didn’t go through a thorough screening because I just wanted to start getting paid. BAD IDEA. In the future I will wait as long as needed to get great residents.

Wear and tear resulting from sloppy residents can cause floors, kitchens, and bathrooms to age faster. Repair bills go up by a few hundred dollars to a few thousand dollars. Having to put in a new floor because of wear and tear, and the headache of dealing with resident problems consume time and energy which also have a value.

Bad residents also affect your ability to rent it out the next time, because when you’re taking them through they’ll likely be turned off right away. This impacts the amount of rent you can charge and the ease with which you can find residents. These are longer term consequences of bringing in bad residents.

Not knowing what a good resident is

A good resident is neat, pays in full and on time, and is respectful of you and your property. Most people fit into this category, so you are really seeking to screen out a small percentage of the population.

Performing a credit check will give you an idea of their likelihood to pay in full and on time. This should be done before bringing any resident in.

The others are tougher to discern. One trick is to look in the person’s car quickly as they pull up. Their car will give some reflection of the level of cleanliness they like to keep. References will also provide an important insight into the person you will be dealing with. Personal, business, and previous landlords can help out in this regard.

Finding out if they will be respectful of you and your property can be ascertained from conversations, body language, and ability to deliver on completing applications. If they are straightforward to deal with such as filling out the application promptly and being pleasant in all dealings, you will likely be fine. If the person is putting you through the ringer to get a $10 cut on the rent or some special request this is a warning sign.

Cleanliness is critical at all times

Pick up all trash, rubbish, and eyesores around the property. The first thing that stands out to a potential resident or neighbors is rubbish lying around the exterior of the property. If you want new residents that are neat and tidy, you have to start with it in great shape to set the standard.

Lack of Mentors

I mentioned this one in my top amateur investing mistakes but it applies here as well. Being a landlord without knowing anyone that has experience doing it is taking on unnecessary risk. At the very least you should be able to find a discussion forum where you can post your questions. Make sure that people responding will own properties near where yours is. Jeffrey Taylor’s www.MrLandlord.com could start you off.

This is a tiny glimpse into the veteran landlord’s toolbox. I am working to continuously improve my skills realizing that I’ll make a lot of mistakes, but that they won’t be repeated. As I buy bigger and bigger properties you need a higher level of management skill to be successful. Take the opportunity to hone your skills on smaller properties. Put in your work, energy, and commitment then tell us about your experiences!

What do you know about mortgage loan insurance? In Canada it is provided by the CMHC, Canadian Mortgage and Housing Corporation. To quote the website, insurance is required when homebuyers make a down payment of less than 20% of the purchase price. These homebuyers are deemed to be more of a lending risk but because the CMHC steps in to insure them, lenders respond with a loan and lower interest rates.

So, this is a good thing right? Yes and No.

Good thing:

If you don’t have 20% and want to buy a home, mortgage insurance allows you to make the purchase. Without it you’d be back to the stock market as your only investment vehicle. Keep in mind that you can borrow money on top of cash you have to get to 20%. It is the primary lender that charges CMHC fees for lending more than 80% of the purchase price.

Bad Thing:

It comes at a substantial price. The insurance premium breakdown is as follows:

Note: See your lender for premium surcharges and other terms and conditions that apply.
Taken from http://www.cmhc-schl.gc.ca/en/co/moloin/moloin_005.cfm.

At 20% down payment, most purchases will not require any insurance. However, in some cases where the lender still feels the deal is a risky one, they could require it for up to 65 % of the purchase price. I have changed to top of the chart (down payments > 20%) to reflect that one would opt out in most deals.

As you can see, there could be a trade off between the increasing rate of return but increasing mortgage insurance amounts with low down payments.

From the above chart, you can see that putting 20% down will eliminate mortgage insurance and save $4800 relative to a deal where one puts down 10%. This savings is partially hampered by the fact that one would have to tie up the 10% ($24000) in order to save $4800 (20% return on additional 10%).

Assuming it is an investment property being purchased, positive cash flow is the first priority. If positive cash flow can be achieved by putting any amount down, which means you have a great deal, then we can begin to discuss altering the down payment amount to maximize returns.

Currently, my investment property has $500 per month positive cash flow with 5% down payment. This results in approximately $6600 in mortgage insurance or 13.2 months of operating profit. Therefore, you would use up more than an entire year of operating income to cover the mortgage insurance. Selling after 1 year is not a profitable option in this scenario especially when you include real estate fees of 5%.

Putting 20% down would reduce my mortgage payment by $200 thus increasing my cash flow to $700 per month. This is a cash on cash return of 18%, not bad ($8400 profit per year / $47400 down payment). However, the above example with 5% down has a cash on cash return of 51% ($6000 profit per year / $11850 down payment).

In a case where you plan to buy and hold, putting 20% down is the best strategy to avoid such a significant penalty. However, if you use some borrowed money to get you to 20%, you can avoid mortgage insurance and maximize your return on investment while ensuring positive cash flow. A line of credit, family, or friends can serve as a means to borrow money to get you to 20%, therefore you’re not asking the primary lender for more than 80% of the purchase price.

Overall, it is key to get to 20% whether you need to beg, borrow, or ……okay, just make it happen!
1)Figure out a full cash down payment amount to ensure you will have positive cash flow.
2)Borrow or put cash down to get to 20% from a source other than the primary lender
3)No mortgage insurance needed! You’ve just saved from 1.75 – 3.10% of your purchase price.

Keep this in mind and the exit strategy from your real estate deals will be more profitable.