[Editor's Note: This is a guest post from Aden B. Eng, MBA, a Canadian engineer who runs a service that analyzes a prospective investment property for profitability for a flat fee called Independent Real Estate Financial Analysis. We have no financial relationship at this time.]
When getting into the real estate market whether it’s your first home or an investment property, there are a number of things that most people consider:
- Financing – how much should I put down and how much can I get pre-approval for.
- Market analysis – what is the health of the market, trends regarding rate of appreciation, profitable areas to invest, amenities like schools etc.,
- Personal requirements – what are you/your family’s personal needs with respect to the property itself, location etc.
- Property management – ease and cost of managing the property if you’re a landlord or maintenance requirements if you’re buying the property for your personal use
- Profitability – this is the overall return on your investment you expect to obtain as a result of factors such as your financing, appreciation in your property due to the market, overall costs and taxation.
Even if you are buying a home for yourself or your family, you want to make sure that the property will be increasing in value as much as possible. Most of this value will come from market appreciation and pure force of inflation. At the same time, you can get greater value from your property by analyzing many other factors such as financing, costs, taxes, and your investment time horizon to name a few.
Many people these days also consider properties that they live in and rent out part of the property to act as an investment property. This may be a basement (especially in northern US and Canada), a duplex, triplex or other types of multi-home properties. This approach can act as a catalyst to propel returns and increasing the size of one’s investment portfolio faster.
The Newbie Approach to Buying a Investment Property
For newbies to the real estate arena, financing and market conditions are often the main concerns. Once they know how much they are pre-approved for and have located what they consider to be a good area, they start their property search based on their personal requirements. They then proceed to visit properties. Decisions are then normally made based on the desirability, location and, costs of the property.
The main revenue stream of the property will be the rent.
The main costs of the property that are normally considered include:
- Market or asking price of the property
- Opportunity cost comparing mortgage monthly payment to current monthly rent if renting
- Mortgage interest rate
- Condo maintenance fees or home owner association fees
- Property taxes, and
- Closing costs
Cash flows are then calculated by subtracting these costs from the revenue stream. If you include an expected rate of appreciation to the property based on market conditions, you can also calculate a return on investment (ROI.) You will have to make your own evaluation of expected appreciation based on your own research, what information your real estate broker provides you, and potentially any information you may obtain from paid or non-paid financial advisors. This evaluation is typically very subjective and debatable. No one has a crystal ball for this.
The adrenaline rush of buying one’s first home or investment property and a dramatic increase in income for a newly graduated professional often cajoles newbies in making a fast decision based on these costs alone or a subset of these. Excitement after all these years of study and training can be great. That being said, sometimes market conditions are hot, and if you don’t make a decision quickly, you will lose the property.
The Veteran Approach to Understand ROI on Rental Property
I encourage all my friends, alumni and family to take the time to look at the profitability of the property before entering the market, continuously during your property search and all the way up to the final moments of making a decision on buying a specific property.
Why do we need to go through all of this rigour? Especially when we are buying the property for ourselves, is this really necessary? If this is only my first investment property, is it going to make a difference?
Absolutely yes, it is necessary because:
- Returns on investment property are diminishing in many markets. Monthly rents are not keeping up with property prices in many major cities in North America. Governments often protect families and tenants (vs. landlords) and limit annual rent increases.
- Taxes. High income bracket earners pay more tax and all impacts to tax need to be carefully considered during the investment life of the property and when selling the property.
- Future investments. You will eventually want to build your investment portfolio regardless of what combination of investments it may be (paper assets like stocks and bonds and real property). You must be able to compare the profitability of all alternative investments in an objective way. Choosing even slightly more profitable investments will add up in the long-term.
- Liquidation costs. The cost of liquidating an unprofitable investment property, especially if it is not your primary property, can be very high when you consider taxes, closing costs, and market conditions.
Decisions to Consider When Evaluating Investment Property
- What decisions confront property buyers and investors? How can these questions impact the profitability of your investment?
- Financing. How much should you put down? What is the amortization period?
- Opportunity costs. When should I stop renting and start buying for it to impact my return on investment?
- Investment horizon. Are you getting a starter home or your dream home? How long do you plan to own the property for? How long do I have to hold on to the property to make a decent return?
- Alternative investments. Should you buy an investment property or other types of investments (active or passive)? What is the ROI differential for each alternative?
- Property management. Do you have to manage the property yourself to make money and is it worth it to you?
- Time. For busy professionals, is it worth enlisting any of the different real estate / financial advisory services that are available either one-time or on an ongoing basis? Preference would be for trust worthy and independent advice at an affordable rate that is not biased upwards based on my income.
- Hidden costs. There are a lot of costs that are not obvious to the first time home buyer that have an impact on profitability. These can swing a property investment’s ROI more than you might expect. More on this topic below.
These questions all affect a property’s return on investment (ROI) and should be assessed quantitatively so an educated decision can be made. For some items, you will have gathered the information from your research and can make good assumptions based on them, and for others it might be easier to reach out to trustworthy advisors or your broker to obtain as much info from them as possible (keeping in mind they may not be willing to provide as much as you'd like.)
How To Calculate ROI on Investment Property
ROI is calculated by dividing the net profit divided by the initial purchase price and can be annualized. It is not a complicated calculation.
There are other expenses to consider aside from those mentioned earlier, especially for an investment property. An investor should also consider any utility costs the tenant won't be paying, rising HOA fees, property management/tenant finder fees, insurance, warranties, expected and unexpected maintenance expenses, realtor commissions, other liquidation costs, opportunity costs, moving costs, property taxes, and depreciation.
For each decision noted above, you need to calculate the profitability for each scenario or option you are considering. Do a scenario analysis and calculate the ROI for each. This will give you the quantitative criteria for you to compare along with all the subjective criteria you derived from the initial market analysis performed and your own personal requirements.
There are many factors to consider when you do scenario analysis depending on the decision you are trying to make. Make sure you take the time to do your research and do the financial analysis. If you’re a first time home buyer or property investor, find someone to help you determine what reasonable costs should be for each of the expenses based on experience and identify any additional expenses for the particular property. If you don’t have the expertise or time to do the financial analysis, look into getting some financial help. Make sure the financial analyst you seek is independent of your broker to avoid any conflicts of interest and commission charges.
You would expect that your broker would provide you with this service to help narrow down your property search, but unfortunately a realtor does not have the financial incentive [and often the expertise – ed] to do this. They are sales professionals. Financial advisors often only look at market conditions and will provide you with an economic analysis from their research, which is important but very subjective. Lastly, accountants will help you with your annual income tax returns and provide useful information on reducing taxes, but not necessarily to crunch the numbers for you to determine profitability of a property, to narrow down your property search and to facilitate making a decision. The consumer is often left alone to make one of the most important decisions of their life.
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What do you think? Do you calculate a return on investment before buying an investment property? How do you do it? Do you also do it for a property you're going to live in? Comment below!