Cashflow Vs Return on Investment

Welcome to Canada's property management podcast, your number one resource for investing, managing, and maximizing the value of your real estate assets. And now here's your hosts, Carla Brown and Adrian Schultz, Canada's rental property experts.

Adrian Schulz (00:18):

On today's episode we're talking about kittens and rainbows. No, I'm just kidding. We're talking about cashflow versus return on investment, but it's kind of like talking about kittens and rainbows. Don't you think, Carla?

Carla Browne (00:33):

Yeah, well I thought you were going to say unicorns and rainbows, but...

Adrian Schulz (00:38):

Yeah, unicorns. Everything in my house is unicorns because I have a five year old daughter, as you can imagine.

Carla Browne (00:44):

That's right, unicorns and rainbows everywhere. It's very important.

Adrian Schulz (00:46):

Yeah. So cashflow versus return on investment, you must hear this all the time when you're talking to perspective or even current rental owners.

Carla Browne (00:58):

Yeah. Well, they all want a cashflow. If you ask any investor what's important... cashflow, cashflow, cashflow. What does not... I shouldn't say this out loud, but what is Grant Cardone? Was it cashflow baby? Is that his phrase that he uses?

Adrian Schulz (01:13):

I like it.

Carla Browne (01:14):

He uses for everything? Not whether you're a fan or is neither here nor there, but anyways, cashflow, cashflow, cashflow is so important. But as an investor, it's not all about cashflow, right, Adrian? I mean, there's other factors to really look at when you are purchasing a property.

Adrian Schulz (01:32):

Yeah. So I think it's important to think about for a moment, why are you investing in real estate? And the reason that people invest in real estate is to create wealth, okay? You want to have a long-term growing asset, right? And I think too many of us that are investing in real estate, prioritize cashflow over the actually more important thing, which is what is your return on investment? And when you're looking at, and we've spoken about this in the past, when you're looking at a perspective rental property, the most common thing that realtors will put into the marketing material is either financial statements, which are good, because those are going to be real numbers or a proforma, which is going to give you an anticipated cap rate.

Adrian Schulz (02:27):

And the cap rate being the net income, annual, divided by the purchase price of the property. And I think in most Canadian markets that desired cap rate, or what people are looking for, is going to be in that 4-6% range when the reality is that what you see in an anticipated proforma is usually going to be exaggerated. It's a proforma, it's forward-looking, right?

Carla Browne (02:56):

Mm-hmm (affirmative).

Adrian Schulz (02:57):

So if you knock a percent off of that anticipated cap rate, all of a sudden you're into a percentage that isn't attractive at all, compared to your stock market investments or your other type of investments. So Carla... Return on investment.

Carla Browne (03:17):

Yeah, just I want to go back to the cap rate because a lot of, like you said, realtors do advertise this cap rate and you're looking at these percentages and you're looking, you said four to six. And the higher the better, obviously, is in when you're looking at the cap rates, so you might see something out there that is as high as a seven or higher, but you have to realize how they've calculated that as they've taken the income from the rental property, taken off the expenses that were being paid and then they divided that by the purchase price, as you said. So you may not manage that property exactly how it was being managed or how this person who's looking at this, to do that cap rate. So it's better ,actually, to really go through a full analysis when you're doing that. Like what are the expenses that are going to be associated with this? And really figure that out yourself, not just take it as an advertised rate.

Carla Browne (04:03):

So I think that you look at cap rate when you're narrowing your search. So when your realtors bringing you a whole bunch of properties helps narrow the search is the way I would put that. Then return on investment is similar to a return on investment if you're buying stocks, if you're in investing in anything, you want to know what is that return going to be. 

Adrian Schulz (04:21):

It's the yield.

Carla Browne (04:23):

Yeah, our eyes start to sparkle when it's double digits, right? And you're not always going to get that, especially if you've only invested in your bank, you're definitely not getting double digits. So you want to be looking at where you could maybe increase that. So you're going to look at your annual income, your net income, minus your mortgage payment, principal and interest, divided by how much you've invested in the property. So this was where it becomes very, not tricky, but it becomes very unique to you because you might be willing to invest $15,000 to get into this property where somebody else is investing $30,000 to get into this property. So now you're looking at what return you're getting on that $15,000 or that $30,000 and those are going to be very, very different in that calculation. So that one is very unique, I guess, to the situation. And as an investor, if you're trying to get more on your invested money, you're going to want to try to go in with the least amount of investment that you have to put forward.

Adrian Schulz (05:20):

Yeah, and there's another term, which we're not going to go into too deeply, but there is actually something called an internal rate of return, which in fact would include the appreciation of the asset as well, compared to the amount of money that you invested in. So there's a variety of different angles to look at the investment. And I agree with you, as you said, use the cap rate as a filter to determine which ones to investigate further, but always do your own full analyzation of the property and do your own budget, right?

Carla Browne (05:59):

Yeah, you have to analyze the property as you're going to manage it because there's so many people who are selling a property and this is really even more interesting when you're selling a property that might be distressed. How did it get distressed, Adrian? That's because it wasn't maintained properly. So it is just going to show a really good cap rate probably, or a pretty decent one. And you're going to be basing that on what you are going to be able to rent that property for once you've fixed it up because you know that it needs some work. So you have to put all of the money that you're going to be now putting into that property on maintenance in order to see what that real cap rate is going to be. So the numbers can really just be... They can just bedazzle people. You have to actually go through and analyze the property from start to finish.

Carla Browne (06:41):

So this is where I see a lot of new investors and I love it when they come to me and... I want to look at this, I don't know what I'm looking at and they send me samples. So they'll send me some MLS listings. Well, what does this look like on a cap rate or return on investment if I was going to be investing this amount of money? And now we can start to play with the numbers. Now we can see where they're going to be comfortable and then we can see where the cash flow comes into play, going back to what we were first talking about, right?

Adrian Schulz (07:04):

Yeah. So the cashflow for someone that's looking at potential properties and if they're really focused in on the cashflow, I would invite you to think about this for a moment. Let's say that a property is cash flowing $200 or $300 a month. And let's say $3,600 a year, for sake of argument. Think about return on investment in another way. And that is, once you've owned the property for five or ten years and it has increased in value, okay? Think about the potential to refinance that property, right, the increased value. Take out all of your equity, right? And now you've used that equity to go and buy another rental property, okay?

Adrian Schulz (07:46):

So all of a sudden you're going, wait a minute, I'm creating long term wealth. I'm creating legacy wealth for my family or for myself, whatever it is for your retirement. And you can very quickly shift from focusing on cash flow to really looking at a big picture return on investment when you look at things like refinancing opportunities down the road. And that's where speaking to a professional property manager is really going to help put you on the right track. And I know, Carla, you're going to say the magic treat team or the eight. What do you call that team that puts together?

Carla Browne (08:24):

Power team. The power team.

Adrian Schulz (08:26):

The power team, the power team. Yeah.

Carla Browne (08:28):

Yeah, and that's where you have to, as an investor, getting comfortable with being in smart debt. Many people were raised where you buy a house and pay it off. But if we go back and think about how many people were raised as when you are in your 20s, you buy what we called a starter home, because you would never go and buy your forever home... You couldn't afford it. Well, how did you get from your starter home to your forever home? That's because you built up some wealth in that property and you were able to then move into a higher priced property, because you're able to sell your starter home for less. Or now you may be able to rent your starter home and you'd be able to leverage your equity there to buy your forever home.

Carla Browne (09:05):

There's a couple ways that you can do it where people never thought of before, because they weren't comfortable with that smart debt. They were very comfortable in putting down a down payment and paying off that house. That is not how you're going to become wealthy investing in real estate. You have to get out of that mindset and you have to realize how you can make the asset work for you. And speaking to somebody... you're in the mortgage industry, Adrian, like yourself, can really help understand how you can leverage that property to buy another property.

Adrian Schulz (09:34):

Yeah, the final thought that comes to mind is the importance of also speaking with your financial planner and an accountant is usually part of the power team. But a financial planner may also play a role in all of this only because your entire long-term financial picture could and should include real estate. And you want to get the full picture, not just the real estate piece and not just the stock market piece, because there are tax implications involved with all of this. And if it is structured correctly, it's not called tax evasion, it's called minimizing your tax exposure.

Carla Browne (10:16):

Okay, I didn't know where you were going there.

Adrian Schulz (10:17):

Yeah, my accountant and my lawyer have pointed this out to me. It is not called tax evasion. It is called minimizing your tax exposure. This message brought to you by the government of Canada CRA.

Carla Browne (10:30):

Okay, I'm wrapping this up before we go into deep here.

Adrian Schulz (10:34):

I'm kidding. I'm kidding, but it was real.

Carla Browne (10:35):

It was real. That is definitely real property management.

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