Why rental income properties make a sound investment?
There are a number of reasons of why real estate and rental income properties specifically make a good investment, but here are few basic reasons:
- i) You are leveraging and using Other People’s Money
The beauty about rental income properties is that you are making money using Other’s People’s Money: the bank’s money (i.e. via a mortgage loan), and via your renter’s rent money (i.e. the person paying the mortgages and property bills on your behalf). Obtaining a mortgage from a bank is a fairly simple process and bank’s love to loan out money especially when it comes to real estate – I can’t think of another investment whereby a bank will spot you up to 80% or more of the total investment amount so easily (typically banks require 20% down payment for a rental income property). Further, the rent on a good rental income property should cover all or most of the expenses related to your property including mortgage payments, property taxes, and insurance. As long as you can keep your place rented, and as long the property is in a good area you are likely to profit handsomely over the long term while leveraging OPM.
- ii) Real estate is generally a sound/stable investment over the long term and a good way to diversify
The real estate offers an opportunity to diversify one’s portfolio beyond equities and the stock market.
iii) There are favourable tax advantages in owning rental income properties
Most investors are familiar with the two points above, however many are not aware of the favourable tax advantages involved with owning rental income properties. Unlike one’s own primary residence, an investor in a rental income property can make a number of allowable tax deductions to offset income including the interest on your rental income mortgage or associated loan, maintenance and management expenses, advertising expenses, insurance expenses, property taxes, and utilities amongst others. The key item in this list is that the interest you pay on your mortgage is tax deductible just like it is for home owners in the U.S.! This expense alone will likely offset most of your rental income for the year allowing you to escape having to pay income tax on the rental income.
How do you make money off of rental income properties?
- i) The renter pays off your mortgage over time
A good rental income property will bring in enough rent to cover all or most of the mortgage bill, which is comprised of a principal and an interest portion. Over time, the rent will pay off more and more of the mortgage principal adding to the investor’s equity and adding to the investment’s returns.
- ii) The property appreciates
A property in a good location will typically appreciate over time. As the property appreciates, so does the investor’s equity and return.
iii) The multiplier affect
As time goes by and the investor’s equity grows as per points i and ii above, one can refinance the property with the bank and use a percentage of the the gained equity to make an additional rental income investment (i.e. pull out a percentage of the equity from the investment based on the bank’s minimum requirements). I call this the ‘multiplier affect’ – in essence the returns earned from one rental income property can be used to purchase another property allowing one to add to his/her real estate portfolio and allowing one to grow their returns exponentially. It’s like a fruit tree bearing more and more fruit over time.
Perhaps an example will best sum up how rental income properties can be used to make a solid investment return over the long term:
An investor, let’s call her Susie, buys a 2 bedroom condo in downtown Toronto for $300,000 in the year 2009. The condo fees are $300/month, the property tax is $2,400/yearly and the property insurance expense is $40/monthly. Susie has made a down payment of 20%, or $60,000 as per her bank’s requirement on a rental income property. The bank has granted a mortgage of $240,000 amortized over 25 years on a 5 year fixed, closed rate mortgage of 4.25%/annualy. To make things simple we’ll say that the condo is rented for all 12 months of the year at $1,890/month + utilities (i.e. renter pays for utilities).
Monthly Expenses: $1,890, Monthly Rental Income: $1890
Mortgage (including principal and interest): $1295/month
Condo Fees: $300/month
Property Taxes: $200/month
In the first year, the property appreciates in value by 2.0% or $6,000 and about $5,500 of the mortgage principal is paid off based on 12 monthly mortgages payments made using the rental income. Total investor’s equity has increased by $6,000 + $5,500 = $11,500 in one year! What is Susie’s first year return?
Total investment made by Susie: $60,000 for down payment
Total gain in equity in year one: $11,500
Total return on invested capital (ROIC): $11,500/$60,000 = 19.1%
Wow – Susie was able to use $240,000 of the banks money + rental income to make a handsome 19.1% return on her investment! Ok – this example perhaps makes it seem all too easy but really there isn’t much more to the rental income investment story then what was described!
So how did Susie fair after five years? Well – her 2 bedroom condo appreciated on average by 2.0% over the next 5 years and was worth about $330,000 in the year 2014. Her apartment was rented for all 60 months because her property was in a highly desirable location near the financial district; home to thousands of jobs. Only $210,000 was left on her mortgage after 5 years and after 60 monthly payments had been made from the rental income. Susie now had $120,000 of equity ($330,000 – $210,000 = $120,000) in the property! It was now time to refinance/renew her 5 year mortgage, so she talked to her banker who told her that she only needed to leave $66,000 or 20% equity in the condo after she refinanced/renewed her mortgage. Susie therefore withdrew $54,000 from the investment property ($120,000 – $66,000 = $54,000) and used it as a down payment on a second rental income property, which the bank was happy to finance considering her success on the first property. Susie now owns two rental income properties in just five years. Her gains in the following five years are likely to be double that of the first five years now that she has twice the properties – the ‘multiplier affect’. Good job Susie! I wonder how many properties Susie will own at this pace in 25 years, and how much wealth she would have accumulated?
What are the risks involved with rental income properties?
Of course there are risks involved with any investment and rental income properties rarely work out as rosy as Susie’s example above. Here are some common risks to be aware of:
- i) Buying at the peak of a market, which is followed by a bust and falling real estate prices. Buying at the peak and encountering falling real estate prices can dramatically affect your long run returns. The key is to pickup properties at the right times.
- ii) Excess maintenance
Older properties generally require more yearly maintenance and therefore erode your profits. An investor must do a thorough job in assessing the key maintenance components of a property including the furnace, air conditioning, electrical systems, and plumbing. The last thing you want is for your property to become a money pit, although maintenance is tax deductible on rental income properties.
When a rental income property is vacant, it is money out of your own pocket – not fun! Remember location, location, location! The more desirable a location, the less likely you’ll encounter vacancy and the higher the rent you’ll likely command. Of course, some vacancy is always expected and it is fairly common to expect one or more months of vacancy per year.