What’s the ROI? (Part 1)

If you’re interested in the Return on Investment on a rental property in Canada, you’re not alone.  Many people are interested in the ’secret’ to analyzing a proforma, or a properties income statement.  Knowing how to do this effectively will probably be a key factor in your success or failure in the Real Estate market.  In my ‘What’s the ROI’ mini-series I will teach you the basics of making accurate, informed buying decisions.  Decisions that will be easily accepted when the bank does their own analysis on your viability when you apply for a mortgage (be it commercial or residential).  At the core of this analysis are the 3 pillars of income in the Real Estate rental investment market;  The series will be written in 4 parts, Analyzing Cashflow, Principal Reduction, Appreciation, and finally the ROI Calculation.

Analyzing Cashflow

I consider cashflow the most important pillar of income.  Many will argue with me on this point, indicating that most money is made in the Appreciation area.  While this may be true – it’s actually extremely hard for you to control, and predict.  Consider the markets in the US.  For decades people have been investing with the assumption that property values always increase, and never loses value.  Huge amounts of money were being made on this, lots of areas were averaging 10%+ a year. It was insane to expect that to go on forever.  Those who bought at the top, who were left holding the bag, paid the price for all that unfettered growth.

Cashflow is very important because it’s your safety net.  Historically many people have purchased properties that have a break-even or negative cashflow, year over year.  This has been acceptable because of the 10% in appreciation that they were ‘getting’.  However, a lot of bets were being made here.  It is being assumed that interest rates will continue to be low.  It is being assumed that the property will continue to appreciate (which in this case is how money is supposedly made).  And it’s being assumed that there will be no major expenses.  In my eyes, all of these are dangerous, if not downright irresponsible.

When calculating Cashflow, it’s good practice to look at all your expenses in an annualized form.  This allows for a greater margin of error, and since most of these expenses are estimated, that is a good thing.

Here is an example of the expenses you should consider when analyzing your yearly cashflow:

Vacancy Loss, Maintenance

Realty Tax, Hydro, Gas, Water, Insurance, Mortgage, Business License, Fire Inspection, Furnace Inspection, Cable, Advertising, Professional fees

A lot of these expenses can be provided to you before you purchase the property, as part of the proforma, or expense sheet.  These expense sheets are always different, and usually not complete.  It is always up to you to make an educated guess as to what your real expenses will be.  You probably noticed that I separated Vacancy Loss and Maintenance out from the group.  This is because they are variable from year to year, and you have some influence over them.  I like to estimate them pessimistically, or high, so that my actual results are always better than my projections.  Here are some of the numbers I use for calculations:

Maintenance  = 0.0060*value of property

Insurance  = 0.0080*value of the property (though you can get a quote, I’ve seen it as low as 0.0059)

Vac Loss .050*gross yearly income (you should get CMHC numbers on what the actual vacancy rate is in your area, then double or triple it)

Below I’ve included an example income statement for a duplex that I bought a while ago.  The income is enough to cover the expenses (with pessimistic projections) and still have a margin of error.

Based on this scenario, the net income for the year is $4574, roughly translating to about $380 per month.  The margin of error is that $380 per month.  What this means is that if you made a mistake in your projections, or there are unexpected expenses, these can total about $4500 before you have to pay for them personally.  Now, that is not what we want, of course, we want that cashflow going into our pockets each month.  And in my experience the cashflow each month is a lot greater than that.  The point of this exercise is educate yourself as to how much risk you are taking on.  If your margin of error is small, your risk is high, even with very accurate projections.

Another exercise you can do is to do an optimistic projection.  This may be good to inspire you to make the property perform better, just by seeing what the real potential of it is.  Just remember, when you’re analyzing risk, be as pessimistic as possible.  And don’t try to force the numbers to work.  If they don’t work, don’t buy the property, no matter how much you like it.

You may have noticed that there are no closing costs or legal fees in the above scenario.  That is because I like to include the up front legal fees in the initial investment, as they are really one-time fees.  I will get into the details surrounding that in Part 4 when I discuss the actual ROI, which will bring everything together.

Stay tuned for What’s the ROI?, Part 2: Principal Reduction