Buying an investment property is a big decision and one that you must do your research into first before saying you want to be a landlord.
Today one of my fans Allyson shares her story of wanting to finish her education and buy an investment property to get her into the real estate market.
Since I was little, I have known that I wanted to move out into my own house. I wanted something that belonged to me that I could sell when I was ready to watch my own family move on.
When I was in high school we had a class that was supposed to prepare me for the future of living away from home.
We had to fill out a sheet with a basic budget format: monthly rent, food, utilities and expenses. I was the only person in the class that crossed out rent and labelled it mortgage.
For some people, renting is a valid option and I can respect that, but for me, renting never made sense in my head. Why would I want to give somebody else my hard-earned money for shelter when I can just buy my own?
Obviously I have a better understanding of that now, as I am currently renting a row house. But it doesn’t sit well with me. I have trouble accepting that once a month, 1/4 of my income is just gone and I will never see it again.
It occurred to me a couple of years ago that I wanted to own a rental property or investment property. Maybe a duplex so that I could have a portion of my mortgage covered while I paid significantly less to own my house.
But last week a conversation with a couple of co-workers and a good friend showed me that my investment property dream was just in its infancy.
Owning an investment property
This is what my pipe-dream has led me to. It is my future and I am determined to make this work for me. When I explained my plan to my parents they were surprised, but as usual showed cautionary support but support none the less.
My father asked me what kind of plan I had set up for my investment property and I looked at him blankly – I had none! So, I set out as I had been trained to do: make one.
Today, I share with you what I have learned. Much of this is applicable to being a first-time home buyer, but mainly in the field of buying a multi-family property. In my case, my first home or investment property will be a 4-plex or if I can find one, a 3-plex with basement suites.
Let’s start with the perspective of a landlord. In my research, I spoke with co-workers, landlords and read as much as I could about being a landlord online.
This was where I really had my “EUREKA!” moment. First and foremost a landlord must consider cash flow. This I felt was fairly obvious – money comes in from the tenants in the form of rental income and you pay your bills and it is done.
I thought about it a while longer and realized I wasn’t quite understanding cash flow in a real estate sense. The main things to consider in regards to cash flow is “does the rents being charged COMPLETELY cover the costs”? I knew that I had to have the mortgage covered, but what other rental property costs are there?
Costs associated with owning a rental investment property include but are not limited to:
- Property Taxes
- Maintenance and repairs
- Homeowner Associated Utilities
All expenses associated in owning a property should be fully subsidized by the tenants that live there, through the rental income. Now the mortgage is fairly straight forward, but I’ll go over that later anyway.
Property taxes are something that is charged every year (or two, four years or not at all depending where you live in Canada). You get a piece of paper in the mail that says you owe your municipal government X amount of money.
With all expenses, you will take the annual total and divide by 12 to see a monthly expense. This example applies to every homeowner. If your property taxes are $2500 a year then you should probably set aside roughly $210 a month to cover them when collection time comes.
Insurance is usually billed monthly, price depends on what you are insuring and often postal code related. Insuring a rental is seen has risky and can be fairly high. Be sure to shop around for a good deal that doesn’t leave anything out.
Insurance can also be mortgage insurance although having life insurance is a route you can also research. As required by law, if you do not have the required 20% down payment to purchase your home, you will need mortgage insurance. This is a cost that you can wrap into your mortgage and in the long run it doesn’t increase your payments by too much, but it does increase them none the less.
Maintenance and repairs can be calculated two different ways but provide vastly different answers. The first example is more applicable to a single family home or apartment.
At least 1-3% of the total purchase price of the home should be set aside each year for maintenance. This provides a large number for a property over $200,000. A more accurate representation for a multi-family home is 10% of the annual gross income from the property.
Utilities that are homeowner associated include garbage and recycling fees, strata (condo) fees, sewer/sanitation and any advertising costs. Unexpected expenses can include an increase in your mortgage interest rate, damage to the property and eviction costs.
Vacancy is the last landlord associated expense and it is very important with an investment property . Vacancy is calculated on average at about 5% a year. So 5% of your gross income is gone.
Maybe a tenant stopped paying their rent or moved out unexpectedly. Perhaps there was an accident and the unit needs to be renovated. Any time a unit does not have tenants residing in it is considered vacant and this must be accounted for.
Finding good tenants can be hard, but it is worth passing over many prospective tenants if something does not feel right or they do not pass your tenant background screening and/or credit checks. Even the location of the property can affect who comes and checks it out and that is something to seriously consider.
Now is a good time for me to mention this. Start early! Look at the properties that interest you now so you aren’t way out of the ballpark when it comes to how much you will need to pay. Get an idea of the market for these properties and check what kind of rent you can charge.
If the property is fully rented it usually mentions the monthly income of the property somewhere in the listing or feel free to contact the agent representing the property. These are all things that the bank will be asking you.
Once you have an idea what you will need to pay, you can begin setting up your financing. It is good to get your pre-approval out-of-the-way because if there is a hiccup in securing your financing the property you are after won’t be sold out from under you.
From the Bank’s point of view.
They say that they are protecting you when they don’t want to lend you more than a certain amount because it’s all you can afford. In reality they know that if they lend over this amount, you are more likely to default which costs them time and money.
They aren’t really lying, but the banks aren’t really interested in helping you but helping themselves in the easiest, most painless way possible.
This makes the process for you as easy and painless as possible. The first thing the bank will ask you is what kind of property are you looking to buy? Remember where I said look at the market? This is where you can show them a couple of properties you were interested in.
They’ll ask you for your household income (you and your partner) and how much money you have to put down. Next they will look at the potential income of the property and if it is fully rented and put that against the monthly mortgage, but you will need to get signed agreements from the tenants stating that they plan to continue residing there (basically new leases).
- How long have the tenants resided there?
- Any plans to evict any of them?
Based on your answers they’ll determine an appropriate lending level and if you need mortgage insurance. They will also ask you if you have a plan in place.
- What happens if you have a variable rate mortgage and the rate jumps from 3% to 9%?
- Do you plan on taking advantage of any first-time home buyer grants (if available)?
When banks do calculations for rental unit financing they default to a 5% vacancy estimate and 10% of gross income for expenses. This is why I chose those ratios for my suggested calculations. They also ask if you know what the market rents for the unit are.
There are many costs to consider when purchasing a home. I have summarized the most common ones as best I can:
- CMHC financing from 80% to 95% ranges from .5% to 3.15% of the total purchase price can be paid up front or absorbed into your mortgage.
- Many banks have processing fees for mortgages of around $250. Some smaller brokers will not have this.
- Survey Certificate – To ensure that no buildings cross over the property line. New surveys are around $400 or you can ask the existing homeowner for their survey from purchase. If you are putting less than 20% down this is REQUIRED by the CMHC or you will not get your funding!
- Property Transfer Tax – Some provinces have this, others don’t. In BC it’s 1% of purchase price up to $200,000 and 2% on anything over. First time home-buyers are exempted from this
If you are buying an investment property, confirm with your realtor if you can be exempted if you plan to live in one of the units.
- Legal Fees– You will need a lawyer to check over your purchase documents to ensure that everything is worded correctly. Ranging from $900-$1200 when purchasing and up to $1700 when selling.
- Purchase Adjustments– If you purchase your home after Property taxes are paid for the year, you will need to repay the current owner your portion of the taxes. So if you bought your home on August 1st, you would need to pay the equivalent of 11 months of property taxes to the previous owner unless they have opted for some other form other than total payment.
- Property Inspection – Many lenders these days will not give you financing without a property inspection. Expect it to be roughly $400
- Strata Fees– Also known as Condo Fees, they are the monthly maintenance fees. A form will need to be filled out to ensure that the previous owners do not owe any strata fees.
- Fire Insurance – Speaks for itself I think, you pay for what you get, so it can be as high or as low as you would like it to be.
- Interest Payments – This is a fun option. This determines when your first payment is. Usually persons set their mortgage payments to the first of the month. With how mortgages work and when you purchase your property, your first payment can either be a full payment or just the interest portion. So if you purchased your property 6 days before the 1st of the month you could choose to make a full months payment (pay it down baby!) or pay the interest portion of the payment and begin full payments on the following 1st of the month. (Takes you an additional month to pay off your mortgage in the long run.)
There are spreadsheet templates available online to help you figure out if this property will be a good buy or a bad buy for you called Real Estate Pro Forma but if you work with a realtor they can help you do this much more quickly.
All in all, if all your expenses cannot be fully subsidized by the rental income then you will not see a profit.
Seeing as profit is the whole point of owning a rental if it doesn’t work, pass it over and wait for the next golden opportunity. And as with all properties, the larger your down payment, the less of the property you need to mortgage, the more your cash can flow!
Do you own an investment property?
What did you learn about it after that you wished you’d known before you purchased?
Post contribution: Allyson is a long-time fan of Canadian Budget Binder who lives in the Sunny Okanagan in beautiful British Columbia. She works for a crown corporation and is saving up to go back to school full-time and finish debt free.
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