This is Part 2 of things to consider when purchasing an investment property. In my last article, we discussed the macroeconomic factors to consider before purchasing an investment property like the GDP growth of an area, the job prospects, the major employers in the area, and the population growth. Assuming we’ve done the research on the area and have determined the city or neighbourhood we want to invest in. We will now look at the microeconomics of choosing an investment property where we run the numbers to determine whether a particular property is a good investment.
When running our numbers, we consider the following:
- What can we rent our property for?
- What are the expenses associated with our rental property?
- What is the cash flow?
- How much to set aside for a reserve fund?
When deciding how much to rent your property out for, consider all sources of income you derive from the property, including any parking spots and garage or storages spaces you would rent out in addition to the main living areas. In order to price your units accordingly, there are a few ways to find out what current rents are in an area. You can hire a company to do an official rental analysis of the area, which will give you an official report. This type of analysis is usually only requested by banks when you’re applying for financing on a vacant rental property. Otherwise, there are other ways to do your own research for free.
The first thing you should do is Google house rentals in your area and discover which main sites pop up. These are likely the sites most people go to find rentals in your area, so you should start with those sites. Find rental rates for similar properties in your area and start from there. Some popular rental sites include Rentfaster.ca, Rentboard.ca, Kijiji.com, Facebook Marketplace and Craigslist. Padmapper.com is a good site as well. They aggregate all the listings from various sites and list them all on one site. In addition, these sites are also great places to post your rental when it comes time to do that.
When comparing properties to determine your rent, do your best to find a property as close to and as similar to yours as possible. Look at the size, the age, the number of bedrooms, the quality of finishing, whether or not it has a garage, etc. If there is a range of prices, how does your quality compare to the others? Determine where you are on the spectrum and price yours accordingly. If you have a superior product to everything else that’s currently out there, don’t be afraid to ask for a higher price than everyone else. There have been times when I’ve done my research to discover that my property is the newest and nicest in the area so I priced my rent slightly above everyone else’s and it still got rented within a couple weeks.
As for expenses, there are a few more to consider. They can include the following:
- Mortgage payments
- Property Taxes
- Property Insurance
- Strata/condo Fees
- Property Management
- Maintenance Costs
Property management, vacancies, and maintenance costs may not be monthly recurring costs (sometimes known as soft costs), especially if you are managing the property yourself. However, they are still inevitable costs which have to be accounted for and are often overlooked by many new investors.
In Canada, for single family homes, most property managers charge around 10% of the gross rent per month as their fee. They also charge a markup on the contractors they have to hire for any maintenance issues and charge additionally to fill or renew a tenant. In the end, you’ll be paying close to 14% a month. Unless you want to manage the properties for the rest of your life however, they are a necessary part of your team, especially if you’re growing your portfolio. Today we will use 10% in our example below but keep in mind any additional costs when you’re interviewing for a property manager.
You should account for a one-month vacancy a year for your rentals. This comes out to 8% of your gross rent per month (1/12 x 100 = 8%). You may not have a vacancy in a particular year, and that’s great, but you want to account for it so that you’re not caught off-guard with unexpected expenses when you do.
Maintenance costs depends a lot on the age of the property, but even with a brand-new property, there are still maintenance costs. Typically, for an older property (10 years or more), you want to set aside about 5% a month, whereas you can probably get away with 3% on a newer property. There are no hard-and fast-rules, and there will always be unexpected expenses, but at least you’re prepared–and that’s what counts.
Now that we’ve accounted for all the income and expenses, it’s time to calculate cashflow. A typical cashflow calculation looks something like this:
Monthly Rental Income
Monthly Garage Rental Income
Total Monthly Rental Income
Monthly Mortgage and Interest Payments
Monthly Property Taxes
Monthly Property Insurance
(But paid by tenant.)
Property Management @ 10%
Vacancy @ 8%
Maintenance @ 3%
Total Monthly Rental Expenses
Total Monthly Income
Total Monthly Expenses
TOTAL MONTHLY CASHFLOW
At first glance, $160 may not seem like much, but think about it this way. You’ve just factored in all possible costs, including some you might not even incur, and you’re still making money. Factor back in the vacancy and maintenance costs and you’re up to $380 a month. If you’re managing it yourself for now, then you’re up to $600 a month! Don’t forget you’re still paying down the mortgage by about $600-$700 a month as well. $160 in cashflow doesn’t look so bad anymore, huh?
But just because the property isn’t costing as much as you think doesn’t mean you get to spend the extra, which leads us to our next very important topic.
Every investment property should have a reserve fund, a.k.a. sleep-at-night fund, a.k.a. not-having-to-explain-to-your-spouse-why-you-took-money-out-of-junior’s-college-fund fund. Remember all those extra expenses you accounted for in your analysis but didn’t have to pay? This is where that goes. You want to start the account with enough to cover at least one mortgage payment and during the following months, build it up to ideally have enough to cover you for three months. For the above example, I would keep $6000-$7000 in reserve. This should be enough for you not to worry about filling a vacancy right away and gives you some time to find a good tenant. It should also be enough to cover any maintenance expenses which might pop up along the way. Knowing you have enough set aside to handle any unexpected expenses which may come up is more important than you know for your mental health, so it cannot be emphasized enough how important having a reserve fund is.
So there you have it, rents, expenses, cash flow, and a reserve fund; everything a growing real estate investor needs.
Have fun and happy investing!