Once upon a time, in a neighbourhood not so far far away, there lived two investors that chose differently. Who fared better? You be the judge.
On every edition of Tales of Two Investments, two different real estate investments will be weighed with the same scale. Let’s call it the “return on investment” scale. It focuses on how much profit someone’s initial investment is earning. The featured properties will always be actual properties for sale. We hope, in time, this will give you a new look on real estate investments and a new perspective on how to look for investments that are passive and profitable.
There is little to no focus on appreciation because it becomes an added bonus when the main return is made up of cash flow and equity. Appreciation is a constant in both investments.
Investors X purchased a three-unit income property in the very highly desirable Plateau, in the city of Montreal. The asking price was $1.75 million. The investor purchased with 20 per cent down, so he invested a total of $350,000.
The building was fully tenanted at the time of sale and earned $86,500 per year. The costs of owning these units, not including the mortgage, was around $20,000 a year (taxes, insurance, reserve, misc.). At three-per-cent interest and with an 80-per-cent loan of the $1.75 million, the annual mortgage was around $80,000, of which $38,500 was equity/ principal.
Cash flow = $86,500 total income – $20,000 expenses – $80,000 mortgage = around -$12,500 per year. Return on investment = -$12,500/$350,000 = -3.5 per cent.
The investment is losing cash flow every month despite being fully rented. And the down payment (money invested) is losing 3.5 per cent of its annual worth for every year of ownership. The hidden bonus is equity. By having the tenants repay the mortgage in full, Investor X is making $38,500 (from the debt repaid)/ $350,000 invested = 11-per-cent return on their investment on the first year.
Equity increases each year. However, the cash flow is negative 3.5 per cent. Without appreciation, Mr. X is making a total return of -3.5 per cent + 11 per cent = 7.5 per cent total yield. Appreciation will come; however it is very slow. It takes years for an area to appreciate, assuming no economic downfalls. No matter how many years owned, there is “dead weight” of -3.5 per cent for every year of appreciation. One step forward, two steps back.
Investor Y purchased a similarly sized three-unit property in Rosemont, also an up-and-coming area north of the Plateau. The asking price is $1.1 million. The investor purchased with 20-per-cent down payment = $220,000. The annual total income was $84,000 per year when the property was sold.
The costs of owning these units, not including the mortgage, is around $22,500 per year (taxes, insurance, reserve funds, misc., hydro, heating and internet). At three per cent interest and with an 80-per-cent loan of the $1.1 million, the annual mortgage is around $50,000, of which $24,000 on the first year is equity.
Cash flow = $84,000 total income – $22,500 expenses – $50,000 mortgage = around $11,500 cash flow per year. Return on investment = $11,500 / $220,000 = five per cent. Principal on the first year is $24,000. Total yield = ($12,500 +$24,000) / $220,000 = 13 per cent on the first year. Investor Y is making returns without waiting years for the property to appreciate.
Moral of the story:
1) Don’t bank on appreciation when the monthly costs of ownership are weighing you down. Appreciation will come but if appreciation is + two per cent a year and your invested money is losing three per cent a year, you will be at – one per cent return every year.
2) Location plays a major role in the value of any real estate product, but when the math is off, reassess which location would add value to your money (positive return) instead of losing value (negative return). The areas in this example were not that different. The fully tenanted incomes AND the asking price relative to those incomes played a much larger role on the cash flow than the location.