How are you planning to build your legacy this year? One of the ways you could do it is by investing in real estate. Perhaps you’re hearing about the challenging real estate market in some areas of the GTA. But you’re eager to get into real estate investing so you can build wealth and leave a legacy for your family.
What’s the best way to get started investing in real estate? Is it worth it? How can you make money from it?
Today I’m going to explore three ways you can make money investing in real estate. And since I love acronyms, an easy way to remember this is A.C.E. — Appreciation, Cash Flow and Equity. Here’s a breakdown of each.
You make money in real estate investments when you buy. If you’re able to get a great deal for the property you’re investing in, you have an advantage. How? Buying something for less than market value (a bit challenging to do), buying when market conditions aren’t favourable (e.g. sideways or downwards moving prices), or buying properties that need a bit of work done on them.
Appreciation, however, is made year after year as the property goes up in value. One of the reasons is market trends. If there’s increasing demand in the neighbourhood where your investment property is located, prices will go up, and you make money from the appreciation of your property’s value.
Appreciation can also come in the form of inflation. Inflation is a term used to describe increases in the prices of goods (such as real estate) and a decline in the purchasing value of money.
One important thing to note: you can make money through appreciation, but you don’t actually realize the profit from the money you make until you sell your investment property. Say you bought an investment property for $650,000, and today it’s worth $800,000. You could say your property appreciated in value by $150,000, but you won’t see a dollar of that profit until you sell your investment property.
The simplest way to describe cash flow is how much money you’ve got left at the end of each month, after you’ve received your tenant’s rent cheque, and you’ve paid the costs of your investment property. Costs include the mortgage payment, property taxes, property insurances, and other expenses (such as condo fees, maintenance costs, repairs, etc.). Utilities are usually paid for by the tenant, so that’s not your cost.
I am a firm believer in investing for cash flow. Cash flow is one of the few factors of real estate investing you can control.
You can control how much you buy an investment property for.
You can control how much your downpayment is, hence controlling your mortgage amount.
You can be fully aware of property taxes, insurance, and maintenance costs — and calculating these gives you control over the decision of which property to buy.
You can’t control the amount of rent you’ll receive, but if you do your research, you’ll be able to find an investment property where rents exceed the costs of owning the investment property.
You most certainly can’t control appreciation.
When you’re analyzing properties for real estate investing, make sure you factor in cash flow calculations. If you’re cash flow positive at the end of the month, great!
But what if you’re not — what if after you’ve paid for all the costs of your investment property, you find yourself pitching in a few hundred dollars or so just to keep your property?
The good news is, even if you’re cash flow negative, you are still making money. I know, I know… that sounds contradictory, but you are making money covering your negative cash flow (as long as it’s a reasonable amount) due to equity build up. You build equity partly by appreciating property values, but also as a result of your tenant paying down your mortgage.
When you receive your annual mortgage statement, you’ll see a summary of how much principal and interest goes towards your total annual mortgage payment. If you’re cash flow negative, you may have to pitch in an extra hundred dollars or two (perhaps more) but one way to look at it is that you’re paying down a portion of your own mortgage.
So let’s say you’re $200 cash flow negative each month, and let’s just disregard appreciation for now… if your total mortgage payment is $2,500, and $1,400 of that is interest, the remaining $1,100 goes towards paying down your principal. The $200 you fork out from your pocket essentially goes to paying your mortgage, so you still come out ahead (as long as you can find a spare $200 or so per month to pay for negative cash flow).
Some investors have taken this to a level of extreme, betting that high appreciation will let their investment properties to pay off. They may be paying more than $500 or even $1000 per month as a result of negative cash flow.
Does it make sense to be cash flow negative?
If your monthly negative cash flow exceeds the amount of monthly principal payment you’re making, the excess amount better be made up in appreciation. Otherwise, in a situation where you’re paying money out of your pocket every month, and prices are declining, your investment property value would diminish and you may end up selling at a loss.
How do you find a suitable real estate investment?
Good old fashioned research. Using tools you find online, books on real estate investment, and consulting with a Realtor. Whoever it is you decide to work with, make sure they’re knowledgeable about the area, understand the market conditions, and have investing experience.