Why do I need to know this before investing in property?

Known as cap rates for short and a common metric used in real estate to determine the return of an investment.

So you want to dive into real estate and want to determine whether it’s a worthwhile investment? Here’s what you need to know.

The Math

Expressed as

Total expense / Total Revenue. It’s basically

1 — OER

or

(Total Revenue — Total Expense) / Total Revenue

Expense as follow eat up your monthly cashflow

• mortgage
• HOA if applicable
• Property tax
• Electricity while untenanted
• Utilities
• Hiring the guy when you can’t fix the repair. Parts and labour.

Future costs that eats into your sale profits

• Realtor fees when sold (future expense to consider down the road)
• Capital Gain Tax

All this eats up into the money you can potentially make from rent and sale.

For the purposes of the cap rate calculation we only consider the annual operational costs.

So let’s say, after mortgage, HOA, tax, utilities, electricity, and maintenance, you net a cap rate from your rental income of 3%. Guess what? You could have made more on a 4% dividend ETF with NO hands on maintenance, driving out in the middle of the night, interviewing people, checking references….

Now you may say, I’m looking to cash in on the capital gain. I’m leveraging with a mortgage to see magnifying gains! But don’t forget to calculate the 50% capital gain tax.

Most of the time, operating a rental property is not a more profitable means than investing in an index fund. However, if you have no mortgage, and looking to diversify away from your stock market positions, then this could be an alternative asset class. Of course, if you are buying real estate in cash in today’s market, then you wouldn’t be reading this article in the first place.

The Reality

1. Rental property is not as passive as you think. For amateur landlords, you’re better off investing in newer properties for less maintenance. But in reality, if you’re a young person learning to manage properties the first time, and in most cases, the rental property is usually older, and not as nice as your primary dwelling.
2. Get the property insured before you even find a tenant. Ask for business interruption coverage as add on. This covers you on lost revenue in the event a loss or damage renders the unit unliveable for the occupant.
3. You’ll be doing a lot of maintenance — usually for problems you’re encountering for the first time as an amateur landlord. You can be fielding calls from the tenant while you’re out of town on vacation, in which case there’s nothing you can do, but tell them to call the repair guy. There could be a water leak in the middle of the night. You could be the irresponsible landlord and ignore the call after 10PM but if the property is flooding, are you not responsible as the owner? There could be seepage for days, or weeks, and the tenant could be too lazy to let you know, or doesn’t even notice. This is your baby. You need to make sure everything gets repaired. Some slum lords will try to do a half ass job or weasel their way out of a proper fix, via a temporary fix, but just remember when you sell the unit, the buyer is going to inspect the unit and request all these issues be repaired prior to sale. Did I mention property management is not as passive as it turns out to be after all?
4. You need to develop a good relationship with your tenant. What comes around goes around like any other transaction. It’s a gamble every time you find a new tenant. Let’s just hope they don’t become squatters. Don’t be too lazy to actually check references on the application.
5. Tenants can break a lease and there isn’t much recourse on your part.
6. Know your region’s landlord tenancy act well.
7. Hiring a property manager to do all the work will eat at least 8% of your gross revenues or 1 month of rent standard in the property management industry. If you’re landlording for the first time, you should go through the learning pains before you become hands off.
8. Incorporating may not necessarily be a taxable benefit with only your first property after annual filing fees, and accounting fees. You still have to pay the deferred taxes when you dissolve the company -like when you die. The tax man always has a way. Death and taxes. If you start playing monopoly, you can always incorporate later down the road.
9. Expenses, and even traveling to the premise for maintenance can be reported for a tax credit. Keep those gas and repair receipts.
10. Set aside reserve for sudden maintenance costs. Tradespeople charge high rates in this part of the world from the minute they start their car to your place.