7 Profit Centres of Real Estate
Today I would like to explore the 7 Profit Centres of Real Estate. The reason is simple; we are experiencing interesting times on a world scale: oil prices are down, the stock market is volatile, interest rates on both the earning and borrowing sides are extremely low, and most people are trying to figure out how to earn a decent income from their investments. So where should we invest our money to get a decent and reasonably consistent return on our money? In my opinion, strategically selected real estate is still a safe option. It is extremely rare (I’ve never seen it so far) for real estate values to go to zero no matter what is going on economically. And in these times, it is important to go back to the basics.
“Seven out of 10 millionaires have made their fortune through real estate.”
In a turbulent economic climate such as we are currently experiencing in Canada, if not North America, the best way to purchase real estate as an investment is to begin with investigating several key criteria. Low housing prices and great cash flow are the obvious factors to consider, but there are many other variables that need to be included to make a sound real estate investment decision.
Utilizing the 7 Profit Centres strategy is an effective way to build your wealth in real estate because it focuses on optimizing every available aspect to maximize the profitability from your property investments. Real estate investing is not typically a sprint type of investment unless you are flipping, but more a long term or “marathon” type of investment whereby your ultimate payoff is several years “down the road”.
The first three profit centres are Cash Flow, Principal Reduction and Appreciation; my friend, Thomas Beyer describes them as the appetizer, main course and dessert, respectively. I’ll refer to this “full meal deal” as I discuss each of these profit centres below. I’ll also review the remaining four profit centres in the 7 Profit Centres strategy: Equity Growth, Leverage, Reinvesting Your Equity and Tax Benefits.
1. Cash Flow (appetizer)
Cash flow is the net money left over from the net rental income received from your investment property after paying all operating and financing expenses. Cash flow is called the appetizer, as this refers to the generally modest return on the investment provided by the positive cash flow at the beginning of the investment – while the mortgage is being paid down. Cash flow really grows significantly once the investment property’s mortgage is paid off.
That said, the appetizer is important as it sets up an enjoyable meal. Obviously, a positive cash flow is, in the long term, most desirable for an investment property, as it is often referred to as the “passive” income component in real estate investing, but there may be times when cash flow is neutral or even slightly negative, such as when you’re renovating a property or experiencing an occasional higher than normal vacancy rate.
When you’re experiencing a short term negative cash flow on your investment property it’s helpful to equate it to a “forced savings plan” such as when you contribute to a retirement savings plan like a RSP (Canada) or K401 (USA). Yes, you’re putting money into the property and thus not getting any cash flow out of it on a monthly basis, but you are gaining equity, as your bills are being paid and the majority of your mortgage is still being paid down through the rental income and therefore you should realize the investment later in your investment period (see Equity Growth section below).
|Cash flow example||0% vacancy||5% vacancy||10% vacancy|
|Annual Gross Rental income||$12,000||$11,400||$10,800|
|Operating & financing expenses||$11,000||$11,000||$11,000|
|Net Annual Cash flow||$ 1,000||$ 600||($ 800)|
|Net Monthly Cash Flow||$ 83||$ 50||($ 67)|
In order to achieve the long term positive cash flow that you require for a successful investment property, the property should have relatively consistent net rental income. In other words, the month over month rental income that you can reasonably expect from the property must meet or exceed all the expenses associated with the property. While it may be okay to occasionally “carry” a property with neutral or negative cash flow as described above, the property needs to be able to achieve a net positive cash flow over the longer term.As I’ve discussed in other articles, do your homework – research the property in which you’re interested, including the fundamentals such its neighbourhood and local market conditions in order to be sure that you can achieve the rental income you require to cover all the associated property expenses: mortgage payments and any other financing fees, property management fees, repairs and maintenance, insurance, property taxes, and condominium/strata (or home owners association) fees, etc.
It’s also beneficial to have a property where you have a reasonable expectation to be able to increase the rent charged to at least match operating expense increases in order to maintain a positive cash flow.
Achieving positive cash flow may also provide you with a somewhat passive investment – once you have set up your property so that your rental income covers all expenses from the property, you generally shouldn’t need to do much more than maintain the property, nurture a good tenant relationship, pay attention to your property’s performance and anticipate any changes that might affect the status quo.
2. Principal Reduction (main course)
Principal reduction refers to the portion of each mortgage payment that goes towards paying off the principal of the mortgage versus the interest charged on the mortgage loan. Thomas Beyer talks about the principal reduction as the main course – this is the part of a real estate investment that gives you the largest potential return from the operations of your investment.
As you make your mortgage payments, the percentage of the payment that is applied to the principal portion of the mortgage grows. This is why it’s important to understand your mortgage repayment schedule and to achieve a situation where the interest amount you’re paying with each mortgage payment is equal to or ideally less than the amount you’re paying towards the principal as soon as feasible. During these times of low interest rates it is really quite easy to accomplish this goal.
An Example of the difference between low interest rates and higher rates and how this affects Principal Reduction
|$150,000 mortgage, 25 am||3% Interest Rate||6% Interest Rate|
|Mortgage payment (annual)||$8,509.20||$11,516.52|
|Principal reduction (Yr. 1)||$4,107.51||$2,699.54|
|Mortgage interest (Yr. 1)||$4,401.67||$8,816.98|
|Principal reduction (Yr. 2)||$4,221.35||$2,863.95|
|Mortgage interest (Yr. 2)||$4,277.94||$8,652.57|
|Principal reduction (yr. 5)||$4,625.26||$3,419.70|
|Mortgage interest (Yr.5)||$3,883.98||$8,096.82|
|Principal reduction (Yr. 10)||$5,365.16||$4,595.79|
|Mortgage interest (Yr. 10)||$3,144.03||$6,920.73|
Investing in real estate takes time and generally time is your best friend because as each year ticks along, more and more of your mortgage principal is being paid off. If you look in the above example you can see how the principal paid down changes in the different years and for each interest rate. That is why we say “buy investment real estate and wait vs. wait to buy investment real estate.” Let time work for you!
Even if your cash flow is zero for a month or more, you are gaining equity as the principal continues to be paid down. As long as your property’s cash flow is positive or neutral you’re using other people’s money to pay off your investment. Even in the case of a short term negative cash flow, the majority of your investment’s expenses should be covered by the property’s income/other people’s money.
3. Appreciation (dessert)
Appreciation on your investment property is what Beyer calls dessert; I think of it as the icing on your investment cake. While cash flow and principal reduction will enable you to achieve a decent gain on your thoughtfully managed investment property, appreciation should be considered the bonus. It may be more difficult to control or predict than cash flow or paying down your mortgage principal, as it is for the most part out of your control.
This type of appreciation is usually under your direct control, you can choose to make capital upgrades to your investment property knowing that they will improve its value. This is not property flipping, rather this is still a longer term situation where you choose to invest in a property that has good potential for a value increase resulting from renovation and improvement. I call this “finding the dog on the block” – a property that you can purchase at a reasonable cost, make improvements to it, rent it out at a higher rate than you could achieve with the unimproved property, and then have it reappraised to verify the higher value thus confirming an increase in your equity.
Market appreciation can’t be controlled directly by you as an investor. However, you should monitor the market value of your investment property as this will help to determine:
- whether to do capital upgrades,
- the timing of when you may wish sell your property and,
- most importantly, the amount of potential equity in your property.
4. Equity Growth
I’ve talked a lot about equity (Asset value – Liabilities = Equity). Beyond positive cash flow, equity is the element of real estate investment where you can actually realize the majority of gain in your investment. The rate of equity growth is determined by Uncontrolled Factors (that you need to research, understand and continue to be aware of) and Controlled Factors (that you have the ability to optimize).
- Market appreciation – as mentioned above
- Mortgage Interest rates – these are influenced by means beyond the individual
- Market vacancies – will determine what vacancy rate you can expect
- Market rents – will influence what rental rate you can expect
- Amount of Down Payment – pay as much as you can afford or makes sense for the investment
- Your property rent – set a reasonable rent to attract the quality of tenant you desire to keep your property tenanted and your vacancy rate low
- Type of Mortgage – this is most dependent on your own financial situation; if you don’t have solid direct knowledge in this area, then be sure to have a dependable, experienced team to provide you with advice: accountant and mortgage broker. Ask questions and don’t feel pressured to make a decision until you understand these factors and how they’ll impact you and your capacity to invest:
- Rate – the amount of interest charged
- Term – the length of time this interest rate will be provided to you by the lender
- Amortization – the length of time over which the mortgage loan is calculated and ultimately extinguished
- Conditions – the payment schedule; the ability to increase monthly, bi-weekly, or weekly payments; the ability to add extra mortgage payments at the end of each year, etc.
As mentioned in earned appreciation, instant equity can be achieved by making capital improvements that should improve your rental rate (positive impact on cash flow) and the market value of your property.
Real estate is an imperfect market, meaning that it is possible to buy a property at a discount or at a premium, depending on the market conditions. For instance you could find a motivated seller who wishes to sell fast and is willing to sell for less than the normal market value in exchange for a fast closing. The reverse is also possible as you may have witnessed, properties can sell for over asking and over what is considered (normal) market value because of a bidding war between buyers.
Increasing the equity in your property results in tax-deferred growth, meaning that the equity increase in your investment is tax-free until you sell the property. However, the tax implications of selling an investment property are very different from those when selling your own home. Working with your accountant to ensure you’re achieving the maximum tax benefits you’re entitled to and structuring your investment income appropriately is fundamental to successful real estate investing (see the Tax Benefits section below, particularly the discussion re Capital Gains.)
Leverage could be characterized, in real estate, as achieving the maximum amount of “return” (output) on your investment for the least amount of effort and capital (input).
Using other people’s money to buy an investment property is financial leveraging. No other investment vehicle has this degree of leverage on itself. Institutional lenders will not lend you the vast majority of the value of a paper investment that you wish to buy. At best, they will typically look to collateralize other asset(s) in order to lend funds for you to buy that paper asset, and the loan to value ratio will typically be at a much lower percentage i.e. 50%. Whereas in real estate, lenders will lend you the majority of the funds against the actual property that you wish to purchase without necessarily tying up your other assets as collateral.
- Down payment versus the lenders’ portion – to further expand on the point above, the lenders will lend up to 80% (conventionally) against the property you are purchasing. I recommend a 25% down payment, which means you’re leveraging other people’s money for the remaining 75% of your investment and you have built in a bit of a buffer for market value fluctuation.
- Gain on the value of the whole property not just your down payment
- The return on your investment is multiplied because the gain is on the whole property. So if your property achieves a 5% increase in value and you put 25% down, your gain on your invested amount is actually 20%.
- Due to the compounding effect of real estate investing, over time you gain on the growth of the whole value of the property, this means for example that on a $100,000 property that realizes 5% a year, at the end of that first year, the property is now worth $105,000; the following year if the property again realizes 5% growth in value on that $105,000, you gain $5,250 the second year and your property is worth $110,250 and so on and so forth, so you are getting compound growth in addition to the leveraged return on your invested dollars.
6. Reinvesting Your Equity
Real estate investing done well, results in equity growth in your investment property. As you pay down your mortgage significantly enough, you are able to refinance and reinvest in more properties, thus making your money working even harder for you.
- Renewable source of capital
- Refinancing to utilize the equity in one property in order to provide a down payment for a new investment property can offer tax benefits, such as making that interest on the newly borrowed funds tax deductible.
- Your rental income from the new property should enable you to pay down its mortgage and operating expenses, and hopefully provide a positive cash flow, as well as allowing you to realize equity gain on the new property.
“It’s not all about Location, location, location! It’s about market timing, timing, timing.”
7. Tax Benefits
Real estate investment starts with educating yourself – speak with your accountant and make sure you understand the applicable tax rules with respect to money realized from this type of investment.
- Mortgage interest is tax deductible on investment properties that generate rental income.
- Depreciation on specific components of your real estate investment may be tax deductible for example:
- Appliances in a rental property should be treated as a capital asset for the owner and subject to depreciation which is known in Canada as Capital Cost Allowance
- Capital Asset depreciation and building/structure depreciation should be recaptured in the net income calculations for final sales proceeds and the Capital Gains treatment in the sale of an investment property, but it is important to speak to your accountant and understand this before you even start applying depreciation expense.
- The costs of repairs and maintenance should be deductible on investment properties as long as they are actually deemed as permissible repairs and maintenance expense items and not capital items by the tax authorities.
- There may be additional eligible business expenses if your real estate investments are being treated as a business and not a hobby (please consult with your accountant).
- Understand what’s involved in selling an investment property before you purchase the property.
An investment property is subject to Capital Gains treatment where the investor must first meet the requirements for Capital Gains treatment and would then be taxed on the portion of the gain after all applicable selling and payout expenses have been deducted. In Canada, at this time, 50% of capital gains are tax-free and the remaining half is taxed at your marginal tax rate – for this reason it’s again important to talk with your accountant before selling in order to understand all the tax implications.
There are significant differences in the tax implications of investing in properties versus flipping properties. When you flip a property it most likely would be considered an inventory item and is not necessarily eligible for Capital Gains treatment in Canada.
“Real Estate purchased with common sense and managed with reasonable care is one of the safest investments.”
Franklin D. Roosevelt
Given the current volatility in the world’s stock markets, strategically selected real estate investment makes more sense than ever. The diversification that real estate investing offers your overall investment portfolio is more important than ever. Real estate investing is a long term investment and utilizing the 7 Profit Centres of Real Estate Strategy will enable you to maintain this fundamental component of your investment portfolio.