Buying An Income Property - Still A Good Idea Even Though The Vacancy Rate Has Risen
Recently a couple bought a Toronto condo as an investment for their retirement. The rent they charge on the condo pays for the mortgage and condo fees, they get a tax deduction for other associated negative-cash-flow costs of the unit and they get to write off depreciation. Their thinking was that stock-dominated RRSP’s seem to be going nowhere but down these days, but property always goes up. It is quicker, you don’t have to cash it in at 69 and you can keep the property in trust for the kids.
Buying rental property can make a lot of financial sense, if you can stand the headaches of being a landlord or simply hire a property management company to take care of it for you. If you do your research correctly, it can be extraordinarily lucrative, with the likely return from buying, renting and eventually selling a Toronto condo falling between 10-15% annually!
Investing in rental property such as condos in Toronto, whether it’s a single-family house, duplex, condo or small apartment building, is particularly enticing because of the low vacancy rate in rental units. According to figures published by the Canada Mortgage and Housing Corp. last year, Toronto has a 1.4% vacancy rate, which means that only 1.4 apartments out of 100 units is available. This is higher than we’ve experienced for a number of years but still highly competitive compared to other municipalities.
Interest rates hovering near 40-year lows are another important reason that owning rental property is particularly attractive now. Five-year closed mortgages can be had right now for around 5%. Rents rise and, when the monthly fixed costs of owning a rental unit fall, the positive cash flow then ends up in your pocket (Anyone read the book by Robert Kiyosaki entitled ‘Rich Dad Poor Dad’ or one of his latest ‘Retire Young, Retire Rich’?). Landlords are allowed to raise rents approximately 3.9% annually for existing tenants (this number changes every year in Ontario according to inflation) and have no restrictions when pricing to a brand new tenant.
Besides the attractive vacancy rate and low interest rates, there’s the cost of property itself which, relative to incomes, is historically fairly affordable. In the 1980s, people were spending from 40% to 50% of their before-tax income housing. Today that figure is between 20 and 30%. In other words, the value of a Toronto real estate purchase today isn’t likely to fall in value even during the recession or economic slowdown.
In recent years, the average price of a two-storey home in Toronto has increased 7 - 10% annually and Toronto condos have increased about the same. Appreciation rates for 2007 will be lower, but even a 2-5% rise in housing prices annually on a leveraged investment is terrific compared to stocks (assume a 15% down payment on a purchase of $300,000 - if property values go up only 5%, that’s $15,000 on that $300,000 home. That $15,000 compared to your $45,000 initial investment is still an excellent 33% ROI!).
Over a long period of time, real estate prices keep up with wage inflation, and wage inflation is usually higher than price inflation. The cap rate on duplexes and 4- to 6-unit apartment buildings has moved below the target of 10%. This, too, will put upward pressure on prices in the future. The cap rate is determined by dividing the property’s net annual operating income by its purchase price. A cap rate of 10 or less is considered attractive for investment purposes.
So how do you know if a rental property is going to be a healthy cash machine? A simple rule of thumb: the cost of the property divided by its annual gross rent should be no more than 10. Some brokers believe buying a condo unit before it is built, before the ground is even broken, offers a good prospect of making a profit on the eventual sale of the condo. Also, stay away from the expensive neighbourhoods because the rent doesn’t keep up with the purchase cost. Buying small units - from 500 to 700 square feet is ideal - is best, because the rent per square foot is always higher on smaller units than on larger ones.
Potential investors should note that the mathematics of rental numbers is usually calculated on the eventual sale of the property. If you move into a property after renting it instead of selling it, the math stops working because converting a rental unit to a principal residence triggers unfavourable tax consequences.
The switch from rental to principal residence is treated for tax purposes as though you actually sold the property. You have to pay capital gains tax and recaptured depreciation without receiving the cash from an actual sale.
If you think the demographics favour a cottage as an investment instead of an urban rental property, think again. In a recession, the first type of property to lose value is recreational, but if you’re still keen on country digs, it is recommended to look for an excellent location, not one that is isolated or hard to get to.
To get the most rent for the fewest dollars invested in a residential rental, choose a unit with a contemporary floor plan and an attractive finish, in an area of Toronto that is up and coming, but not yet hugely popular. The numbers work best with the maximum mortgage and the longest amortization since this gives the most leverage on your own money. Arranged properly, rental property can generate monthly income for your retirement years and a robust capital gain when the property is eventually sold. After all, it’s great if somebody else is paying your mortgage off for you!
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Contact the Jeffrey Team for more information
