Principal Reduction is one of the most commonly overlooked areas of profit, though arguably it is just as important as cashflow or appreciation.  Principal Reduction comes from the portion of your mortgage payments that is not eaten up by interest.  For the first few years this will only make up a small portion of your payments.  As you pay down the mortgage, the principal of the mortgage shrinks.  What is left is called Equity.  This is something that adds to your overall net worth, and should be used in any calculations of the same (including loan applications and such).

The biggest difference between the equity you gain from Principal Reduction, and Cashflow, is that equity is a lot more difficult to either spend or leverage.  Most usually only benefit from their equity when selling a property, and using it to ‘trade up’.  You’ve probably done this yourself, when you moved into a bigger house.  There are some ways that one can leverage this equity without selling, though we will leave those for another time.

In order to calculate the first year ROI for your principal reduction, you will need some information.  First, the total amount of the mortgage (after downpayment).  Next you need to know your interest rate.  And finally, what your monthly payments are, excluding any insurance, taxes, or fees.  You can get a lot of these numbers from an online mortgage calculator at your bank, if you’re just trying scenarios.

Consider this scenario:

Mortgage: $175,000
Monthly Payments: $856
Interest Rate:  3.80%

For the purposes of demonstration, and since we’re only doing a 1 year projection, we will use a simple interest calculation:

Total interest per year = Interest Rate x Mortgage
= 0.0380 x 175000
= $6650
Total Monthly interest = $554

Total Principal Reduction for year 1:  (Monthly Payments – Total Monthly interest) x 12
=($856 – $554 ) x 12 = $3624

The difference between the Total Monthly interest and your Monthly payments will nicely approximate your principal pay-down.  The annualized number, $3624, is the number we will use in the final ROI calculation, in part 4 of this series.  For now, thanks for listening, and remember – if you make a map, you don’t get lost!

Part 3: Appreciation will be coming next.

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

Usually they aren’t 100% sure they trust their Real Estate agent, or they aren’t using one.  In either situation, probably the best advice for most people would be to either get an agent, or a new agent.  That’s not who I am talking to today.  Today I’m speaking to the people who are genuinely interested in being more self reliant, and expanding their context.

The first rule: Information is Power.

I don’t think I have to back that up with any empirical evidence, no one will argue that point.  The real question is, what information?  And how do I gather it?  These are the questions that need to be answered.  In order to make good deals happen, you need to be confident in your position.  You need to know, better than your opposition what a particular property is worth to the market, the seller, and even the agents involved.

What information is needed?

You need to know what competing properties exist out there.  Think of them as companies bidding on a contract with you.  You want to get the best bang for your buck.  You need to know what factors  differentiate the properties, and why their asking prices may vary from each other.  If you’re looking for investment properties, then you also have to do a lot of calculations, and projections based on the 3 primary income streams an investment property can generate: Cash Flow (my favorite), Capital Appreciation, and Principal Reduction.  I will leave the details of those for another post.

How do I gather this information?

The key factor here is exposure.  Most people will only look at a few properties before they see the one they like, and bid on it.  I make it a point to stay away from those ‘love at first sight’ properties until 2 things have happened.  The first is the rose coloured glasses need to come off, or fade at least.  I’m talking, of course, about that feeling we all get when we see something we want.  It’s that feeling that drives most of consumerism, and, costs people most of the money they make in their lifetime.  The second, I need to know the market.  What that really means to me it viewing as many similar properties as I can, not necessarily because I want to buy them, but because I want to know for myself how they differentiate.  I’m gathering the information mentioned above.  You can do this in two ways.  One would be to be meticulous, track every little detail, and compare them methodically.  The other way, my favorite, is to simply expose yourself to all these properties, and gain confidence in knowing what they are really worth (to you, the agent, the vendor).

Now I have to point out a subtlety that may trip some people up.  This last technique is simply to assist you in making offers that will not lose you money.  It will protect you from buying an overpriced property (especially if you opt not to use an agent – though I really cannot recommend that practice).  It does not mean that you do not need to do a financial analysis on the property, especially if it is an investment property.  Those 3 income streams are how you will make money, and even if you are bidding confidently, knowing what the property is worth to the agent and vendor – unless you’ve done a financial analysis – you don’t know what it is really worth to you.

To sum up: Make sure you look at many more properties than you are really considering.  As long as they are in the same market, you should know about them.

Stay tuned, I will be presenting more information in the near future, including ROI calculations, gaining investors, and analyzing the 3 pillars of Real Income.