Five Things to Know Before Investing in Residential Real Estate

Announcer:

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 Browne and Adrian Schulz. Canada's rental property experts.

Carla Browne:

Okay. Today we are going to talk about five things to know before investing in residential real estate. So many people want to get into this space and Adrian, you are going to give us some great tips I think today, with regards to what is important for them to watch out for and be looking at before they actually make this decision.

Carla Browne:

You and I, both know it is a fantastic place to invest your money, but let's talk about what is your first step? Let's go with step number one. What do you think is most important?

Adrian Schulz:

Well, the first step to building wealth through real estate is obviously evaluating the property. So evaluating the property is a multiprong approach between your realtor, your property manager, potentially your mortgage broker.

Adrian Schulz:

And the terminology that you commonly hear is cap rate or capitalization rate. And many real estate listings will include an anticipated or an estimated annual pro forma or cashflow expectation or budget, whatever you wish to call it.

Adrian Schulz:

And one of the things to be very cautious of, although I believe most people are well-meaning when they're marketing a rental property or property for sale, it's very important to go through those pro forma and evaluate the true cost of the different expense lines before making an offer.

Adrian Schulz:

And just from a high level perspective for example, utilities. There's nothing stopping you from calling the utility company, telling them that you're interested in buying this house and asking them, what would this property be on hydro, on the budget plan or the gas budget plan?

Adrian Schulz:

Or calling your city civic water department, municipal water department, and saying, "For this square footage of home, with this many people in it, approximately what would the expected water usage and/or cost be?"

Adrian Schulz:

So you can really drill down on the true cost of operating that rental or that revenue property without necessarily taking the pro forma word for word. So really evaluating the economics and the potential cash flow of the property, independent of what's being presented as part of the marketing package.

Carla Browne:

Yeah. So that evaluation really takes that step back and get out of the emotion and the dream that you can see that you have this property that's yours, and you've got tenants in there and you're getting this money every month. And what that looks like later on, when now you have this property long-term and really digging into the dollars and cents which is so, so important.

Carla Browne:

But, I do see people skip over that. As you said, they're relying on the information that they're taking in print, possibly dealing with a realtor that maybe isn't well versed in understanding what that all entails.

Carla Browne:

So, evaluating the property. Okay, let's move on to step number two. What do you think is going to be... After you evaluate the property, what do we do next before we buy this investment property?

Adrian Schulz:

Well, my second is how to understand or how to profit from the real estate investment. Most people would put that above evaluating the property, but I firmly believe it comes second. And in property management, we focus very much on the positive cash flow. The money that is left over from the rent after the expenses have been paid, right.

Adrian Schulz:

And a lot of people purchase rental property or revenue properties based on the potential cash flow each month or each year. And some people don't even think about the passive income tax implications of that cash flow, right. And the positive cash flow. And some were experienced real estate investors actually know that making capital improvements, or maintaining the asset well can reduce your income tax burden on the passive rental income, right.

Adrian Schulz:

Yet we all focus on the cash flow of the property. So the cash flow can mean various things, but always being aware of the passive income tax exposure on that profit or the cashflow. Personally, I firmly believe that one of the greatest advantages of investment real estate is the ability to do refinancing commonly known as an equity take out.

Adrian Schulz:

And the beauty of the equity take out is two part. Number one, if it's refinanced correctly, you can actually stretch that amortization of the borrowing of up to 30 years, okay. Now you're going, "But I want to pay it off fast." That's an interesting concept. No, you actually don't.

Adrian Schulz:

What you want to do is you want to keep your debt service, your mortgage payments, the lowest possible because the interest on the mortgage is tax deductible and it lowers what is called your debt-service ratio, allowing you to buy more rental properties, right.

Adrian Schulz:

And the equity take out portion of doing a refinance on a rental property is the equity take out itself is tax-free cash. How often do we get to say tax-free cash? So in my opinion, my personal preference, how to profit from real estate? Is in fact, refinancing the real estate that you own and doing the equity take out.

Adrian Schulz:

And then if you really want to get sophisticated or if you really want to save yourself money, you take that equity that you've pulled out of your rental property, and you apply that against your principle home mortgage because that principle home mortgage interest is not tax deductible.

Adrian Schulz:

So that's why Carla is always referring to the real estate team, the realtor, the property manager. And in that case, you want to have an experienced mortgage broker that understands how to structure mortgage loan financing in your best interest that you in fact, truly do profit from real estate.

Adrian Schulz:

And then the final way to profit from real estate is of course the dispensing or the selling of the asset when you've completed your time of ownership. So you may have bought that rental property for 300,000 and it increased in value to 500,000. And you've done your equity take outs to the maximum possible, which is always the initial principle balance.

Adrian Schulz:

That's your maximum principle equity take out that you can do with tax-free cash. So then you go and sell it, right. And you're going to have that capital gain and you may have tax exposure with it, but that's the final.

Adrian Schulz:

The third, and probably most common way of profiting from real estate is the selling of the asset, which many people refer to or connect with legacy wealth or family wealth, long-term generational wealth planning is the selling of the asset at its final stage. But as I said, my favorite refinance, equity take out.

Carla Browne:

Yeah. I can see our listeners, their wheels turning right now because you just laid out for them, what they really need to be aware of when they are buying an investment. It is not about my mortgage tax and insurance equals $1000 and I'm getting $1200 for rent and I'm going to put $200 in my pocket.

Carla Browne:

There's so much more to it. So, making sure that you're talking to an expert like yourself is so important through this process. What about pitfalls? What kind of things should we be aware of when it comes to buying investment?

Adrian Schulz:

Yeah. So my favorite way to profit from real estate being the refinancing of it, those equity take outs, the pitfall is essentially we are leveraging the real estate asset to the maximum possible amount, right. So, you really have to understand and have a certain comfort level with smart risk.

Adrian Schulz:

And smart risk means working with a team, or in this case, working with a mortgage broker and perhaps an accountant who understands the positives and the negatives to leveraging the real estate, to put you in the maximum benefit position of profiting from your real estate and also your other assets, right.

Adrian Schulz:

So you really have to understand leveraging, buying a property with too little down payment or having secondary financing or partners. Some of that can get very complex and potentially risky.

Adrian Schulz:

And you really want to make sure that it's well planned out both in the short-term and the long term, so that leverage pitfall, that risk is well thought out, well planned out. And that you do in fact benefit from long-term wealth that can be created from real estate.

Carla Browne:

Yeah. I mean like any kind of investment there is going to be a risk attached to it. So I think that as an investor, you need to really look at your risk tolerance and invest accordingly, especially in the early stages. And those are some really good tips to really look at that.

Carla Browne:

But the reason why I love real estate and have been in the industry of real estate for so long is that real estate does appreciate. It is one of those things that as far as that whole investment strategies, it's a safe one. And even though...

Carla Browne:

There's some been bumps along the road, but for the most part, you can see you're going to continue to gain and gain and gain. So if it is that long-term wealth, I always say real estate is a long-term play to get the most out of that asset.

Carla Browne:

There's times when you should maybe dispose early on. I'm sure that you'd agree with me there, but for the most part, you're going to see that long-term, slow appreciation happen.

Carla Browne:

So it's like a marathon and not a sprint, the way I look at it. And I think investors need to look at that too. Okay now, I'm going to let you really geek out here, Adrian.

Adrian Schulz:

Are we going to talk about IT?

Carla Browne:

Well, second best to you. We're going to talk about different types of mortgages. And I think that this is one that you really have so much expertise in, and I love to hear you talk about it. So, let's talk about understanding the different types of mortgages when you're going in to buy an investment property.

Adrian Schulz:

Yeah. And that potentially can be another episode all in its own someday, but I'm going to focus on the most commonly known types of mortgages. And those are of course, fixed and variable rate mortgages.

Adrian Schulz:

Canada's financial institutions, the big banks, and some credit unions as well, have really trained consumers to believe and accept that a five year fixed-rate mortgage is in their best interest. And their sales teams or their advisors have been very well trained and educated on how to use fear as a selling tactic to make people believe that a five-year fixed-rate mortgage is in fact best for them.

Adrian Schulz:

And that could be for their primary residents or their investment property. So we want to break that conception with good quality education over time, but I'm here to tell you that I firmly believe, unless you're a single parent on a single income with no other financial resources, you should consider a variable rate mortgage.

Adrian Schulz:

There is a consumer for whom a fixed-rate mortgage may be okay, but I want to talk about the majority of Canadians and the majority of investors who should actually be putting a variable rate mortgage at the top of their list when they are buying investment real estate.

Adrian Schulz:

And here are the reasons why. Number one, generally speaking variable interest rates are actually going to have your total cost of borrowing be significantly less than a fixed mortgage rate.

Adrian Schulz:

And here's just an example of how on a fixed-rate mortgage, the penalty to get out of that mortgage, when you want to refinance to do that equity take out is an interest rate differential, which is where the banks essentially charge a very large penalty to get out of the mortgage, the fixed-rate mortgage.

Adrian Schulz:

The beauty about a variable rate mortgage with most lenders is that the penalty to get out of a variable rate mortgage is exactly three months of the interest portion of the mortgage payment, right. Let's put that into perspective for a moment.

Adrian Schulz:

I had a client just recently who had a mortgage with a major bank in a fixed-rate product. And she had two years left in her mortgage. The penalty to get out was $13,000. She was wanting to refinance to buy a cottage, right. She wanted to take equity out to buy cottage.

Adrian Schulz:

Had she had a variable rate mortgage, her penalty would've been $1600. So she had never been told about variable rate mortgages, and even worse she didn't understand the penalties with fixed-rate mortgages, right.

Adrian Schulz:

The bank told her that a fixed-rate mortgage is the safest thing and it's an her best interest. Well, I would argue that fixed-rate mortgages are primarily only in the bank's best interest and the shareholders of the banks, hardly ever for the borrower.

Carla Browne:

Yeah.

Adrian Schulz:

So, that's just one example of why a variable rate mortgage product is better for most Canadian borrowers. And when you're building a real estate portfolio, you regularly may need to refinance certain assets in your portfolio.

Adrian Schulz:

And you now have the freedom with a variable rate mortgage product to refinance, to do equity take outs, potentially pay off the mortgage in its entirety whenever you choose without this exposure to large penalties.

Carla Browne:

Yeah. Thank you for that. When you're just dealing with your own personal residents, locking in has a different feel if that's what you feel your comfort zone is. I mean, we know the banks spin it that way, but in investment real estate, sometimes you need to act fast. And it's something that you don't just write it and then forget about it.

Carla Browne:

You write that mortgage and you might be looking at that mortgage every year. And that's what I think is important when you have this power team that is going to help you with that, so that you can take advantage and build that portfolio when it works best. To not maybe when it works, when the mortgage is up for renewal.

Adrian Schulz:

Are we allowed to share mistakes we've made?

Carla Browne:

Well, I think that people would like to realize we're pretty human and mistakes do happen. So yeah, share away.

Adrian Schulz:

Here is a real life scenario. My wife and I, we bought our first home together, a bungalow about seven years ago. And two years into the ownership of that home, we began family and we had our first child. And when that first child arrived, our daughter, Ava, who's now five years old, we quickly determined that, that home wasn't going to suffice size-wise and location for our long-term family needs.

Adrian Schulz:

So all of a sudden, two years into a five-year mortgage, we went and bought a new home and we had to move. So we called and said, "Hey, credit union, what's our penalty to get out of this mortgage?" And in error, because we had a family coming. We'd just been married. We bought into the fixed-rate game at that time. That's seven years ago, I wouldn't do it again.

Adrian Schulz:

And so, the penalty was so big that we actually decided it was too big of a financial loss to pay that penalty. So we opted to rent out that single family home, right. And we held it for quite a few years after that. And recently we divested of it because it had gone up much in value that it couldn't have gone up anymore.

Adrian Schulz:

I see that now. And in five years we'll be having a talk and I'll be saying, "Do you remember that story?" But we did. We divest it and did well with it. The point to that story is that even experienced people sometimes get fooled by the perceived fear and risk of a variable rate mortgage and life happens, okay. And just like life is variable, so should your mortgage.

Carla Browne:

So should your mortgage. Is that your tagline?

Adrian Schulz:

Yeah. It's not mine. I think I heard it somewhere, but it fits.

Carla Browne:

Okay. We're going to soon wrap this one up, but we have one more point left to cover. So I'm just going to review so far where we've been, we've evaluated the property. We're understanding the profit, where the profit comes from in the real estate investment.

Carla Browne:

Some leverage pitfalls that you need to be aware of, understanding those different types of mortgages when you're moving forward. And now, what would you consider as that fifth one that we need to be aware of before we start this investing game?

Adrian Schulz:

You, the property manager.

Carla Browne:

Yes,

Adrian Schulz:

... obviously as a revenue property or investment property owner, you have two options. You can self-manage, or you can hire a professional, licensed, experienced property manager or property management company.

Adrian Schulz:

And I think that's really where or Real Property Management hits the spot is it is the only national property management company that has offices all across Canada with consistent operational quality and workflows, etc. So yeah, the fifth thing is deciding how you're going to manage that asset. And it's either on your own or using a company like RPM.

Carla Browne:

Right. Thanks for that, Adrian. I think that those are great considerations all along the board for an investor or someone who's getting to investment real estate. So, like anything there's pros and cons, and you do need to go through this process of weighing all those out to make sure what's right for you.

Carla Browne:

And then also remember that what's right today might change tomorrow. So, it's okay. And I always say that to investors, especially because with my services, you might be self-managing today, but you should know what are services are and how that works, so that if you ever want to look at it, your portfolio grows your life changes, kids come along, life gets busy, you're moving, you want to invest outside of your backyard, all of those things might change the optics of that.

Carla Browne:

Okay, thanks. That was a lot of great information. A little bit longer than what we usually go, but I think well worth it. So, I think we're going to wrap it up if that's okay. And yeah, until next time. Now, that's Real Property Management.

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