June 10, 2017 0 Comments Other Categories

Common Fallacies of Real Estate Investing

Whatever you invest in, do your due diligence and research using multiple sources… or advisors, if you like people. You’d be surprised at the conflicting opinions you’ll get, especially talking to an aggressive investor and businessperson, versus someone working at a bank, or a grown kid in Mom’s Basement dream of interest rates rising to infinity, everyone losing their houses, jumping out and getting a deal, and waiting for a rebound to get rich.

One common fallacy you will hear is that the return on a piece of real estate is simply equal to:

cashflow/initial investment

Which is false, because you also make money from principal contributions (the amount you pay off the mortgage by) and appreciation.

That being said, generally those looking to real estate can aim for either cashflow or appreciation. There is no perfect investment- so, no definite answer to your question. Otherwise, all the investment money would be flocking to one direction and drops yields. You’re best to do the best for your current financial situation, goals, and risk appetite. Generally there is a trade-off between cashflow and appreciation:

High cashflow, low appreciation. High cashflow results usually from a low, slowly appreciating property value and hence low mortgage payment.

These are usually places people do not want to call home so the low homebuyer demand keeps prices low. Financing through banks is usually easier due to the high rents relative to carrying costs- that is, the debt to income ratio resulting is low.

e.g. “Roomie” houses where as many bedrooms are made as possible to house many renters, low income housing, student housing, old worn apartment buildings.

Drawbacks are:
(1) 100% of rental income is taxable while only 50% of capital gains are.
(2) Poor quality tenants who usually look for these properties being all they can afford.
(3) Illiquidity since most of your prospective buyer market when it is time to sell are mostly going to be other RE investors.
(4) Low appreciation.
(5) Usually older problematic buildings requiring more unpredictable maintenance costs. Condo fees usually higher.

Low/negative cashflow, high appreciation

These are usually very desirable places people want to call home. People who can afford these places often do not rent and just want to buy. Consequently, rents often don’t catch up with property prices. High property prices and appreciation resulting from high buyer demand makes high mortgage payments and hence high carrying costs. But, appreciation and liquidity is usually much higher as a result of high buyer demand. These places often “lose” money every month aside from principal contributions and appreciation. People who have $500K+ to spend on a tiny shoebox or a million or two on a nice big house don’t look to rent one- they want to buy one. You lose money from going in the hole every month, but you make big money from the place going up in value. Tenants are often higher grade who can actually afford to pay the higher rents. Capital gains are also only 50% subject to tax.

e.g. Detached homes, Vancouver and Toronto condos that investors even leave empty.

Drawbacks are:
(1) Expensive- harder to get into, harder to maintain, with small downpayments
(2) Difficult to quantify for through banks due to high debt-to-income-ratios relative to the rents you’ll get
(3) Riskier due to negative/low cashflow nature and betting on appreciation- a number that differs overtime.

Personally I like something in between. Not something that is hard to sell and attracts a bunch of weirdos that I have to keep chasing rent cheques from and are hard on the property. Yet not something like a higher grade GVA/GTA property that’s so expensive to buy that I’m bending myself over just to make the mortgage payments and take an eternity just to collect a downpayment for.

Contrary to popular belief, from a ROI perspective, it is illogical to pay down the mortgage as much as possible or use a large amount of cash to artificially produce a positive (or less negative) cashflow situation. A lot of people believe RE investing ROI is strictly cashflow/initial investment, but it is not, as you also have principal contributions, appreciation, and tax writeoffs. Flawed logic here because:

(1) Interest used for an investment purpose is a tax writeoff... being an investment expense.
(2) ROI is highest for the highest amount earned for a given invested amount. You want to make as much as possible per dollar of yours. It is more profitable to make $2 using $1 than $15 using $10. This is the main reason people get into real estate aside from it being a semi-fixed income- leverage/using the public's fear/savings to increase your investing power. Cash-on-cash returns on real estate are not that great relative to many stocks after factoring in transaction costs, illiquidity, and upkeep.

So in theory, using one property I have as an example:

$330,000 cost; $66,000 downpayment. $1,155/mo. mortgage payment 
Principal contribution over 5 years: $39,707; $7,941/year average
Rental income: $1,900/month
Condo fees and insurance: $448/month
Property tax: $197/month

Total monthly carrying costs: $1,800/month. $100/month positive cashflow.
So your profit over a year before appreciation and transaction costs is $1,200 cashflow + $7,941 principal = $9,141/year; 13.9% ROI.

We will omit taxes and maintenance in our calculation since they are highly variable depending on your unique situation.

RE Agent commission and lawyer fees: $8,000; $1,600/yr. average if property held for 5 years
Appreciation YoY based on average historic stats: 5%; $1,520/mo. (though last year to this, it was 7.2%, but use 5% for simplicity).

Now ROI is (9141+18240-1600)/66000 = 39.1%

You can take the advice of the average financial “advisor” or risk/debt-averse public to pay down your mortgage/increase downpayment to artificially inflate your cashflow. Let’s say now you want to double your downpayment to 40% – $132,000:

$330,000 cost; $132,000 downpayment. $866/mo. mortgage payment 
Principal contribution over 5 years: $31,131; $6,226/year average
Rental income: $1,900/month
Condo fees and insurance: $448/month
Property tax: $197/month

Cashflow: $389/month (almost 4x the previous example with 20% down).
ROI: (4668 cashflow + 6226 principal + 18240 appreciation - 1600 RE and lawyer)/132000 = 20.9%

Notice ROI declines with more cash you use. Per dollar you’re using, you are making less. But, it is less risky given the lower leverage.

Now let’s use the public’s dream of 0 debt, so strictly aiming for a cash on cash return:
Property cost: 330,000
Rental income: 22,800/year
Carrying costs of condo fees, insurance, property tax: -7740/year
RE agent and lawyer fees: -1600/year averaged
Appreciation: 18,240/year (averaged)
ROI: (22800 + 18240 - 7740 - 1600)/330000 = 9.6%

In the scenario with only cash, it makes more sense to just invest in blue chip stocks, especially not even factoring in maintenance costs and illiquidity yet. So if debt and risk scares you, you’re better off just buying ETFs or a bunch of blue chip stocks with cash.

But for people who fear volatility in short-term, especially those older and are retired/looking to retire soon, they like the more predictable nature of the semi-fixed income rental properties bring.