The article “Will you make money on your rental property?” was originally published in MoneySense on September 7, 2022. Photo by Timur Saglambilek on Pexels.
Rental real estate has been a great investment for many Canadians. But how do you assess whether yours is likely to work out?
After a strong rise in real estate prices in 2021 and in early 2022, many markets are now seeing weakening home prices. Current rental property owners, as well as new potential investors looking to buy, may be wondering how to determine if a rental property is a good strategy for them.
If you are thinking about becoming a landlord, you need to consider not only the purchase price and mortgage repayment costs of your property, but other financial considerations as well.
How much does it cost to buy a rental property?
When purchasing a rental property, the typical down payment requirement is 20% of the purchase price. If the owner is going to occupy one of the units in a multi-unit property, there is a lower minimum.
For one- or two-unit properties, a buyer needs only 5% of the purchase price and can borrow the other 95%. However, if the property is worth more than $500,000, the minimum down payment is 5% on the first $500,000 plus 10% of the excess. A three- or four-unit rental property that will be owner-occupied has a minimum 10% down payment requirement.
Buyers need to consider land transfer taxes and mortgage default insurance as part of their closing costs as well. All provinces—other than Alberta and Saskatchewan—charge land transfer tax to buyers; in Toronto, municipal land transfer tax is charged as well. Mortgage default insurance applies to mortgages that exceed 80% loan to home value. But some lenders may require insurance for a property you intend to rent out even if your down payment is more than 20%.
Mortgage rates for a rental property purchase may be slightly higher than the best rates you can expect for an owner-occupied property. Rental property mortgages can be amortized over 25 years, or possibly as long as 35 years with a down payment of more than 20%.
Is your rental property generating a good return?
So, how do you assess a rental property purchase? One thing to consider is whether or not the property could generate a good return. Here is how I would crunch the numbers.
For the record, I do not sell investments or real estate, so my intention is not to encourage or discourage buying rental real estate. I think it makes sense in some circumstances.
Consider the following scenario of a condo purchase in Ontario (outside Toronto). Some of the numbers below may seem high or low depending upon where you live; they are just for the purpose of discussion.
| Expense | Amount |
|---|---|
| Purchase price | $500,000 |
| Land transfer tax | $6,475 |
| Legal fees | $1,695 |
| Down payment (20%) | $100,000 |
| Mortgage amount (amortized over 25 years) | $400,000 |
| Mortgage rate | 4.5% fixed |
| Total mortgage interest over 25 years | $264,168 |
| Property value appreciation (annual average) | 3% |
| Monthly rental income (rising at 2% annually) | $2,000 |
| Annual property tax | $3,000 |
| Monthly condo fees | $250 |
| Average miscellaneous annual costs (insurance, realtor fee to find a tenant, occasional vacancy; these could significantly vary from year to year) | $2,000 |
The rental income comes to $24,000 in the next year, while the mortgage payments are $26,567 and the other expenses total $8,000.
Do the math and you can see this property runs cash-flow negative by $10,567 over the next year (about $881 per month). Sounds brutal, right?
If we assume the investor does not claim depreciation on the property, there is also tax payable on the net rental income each year. Depreciation—called capital cost allowance (CCA)—can be used to bring your net rental income down to $0, but not to create a loss. However, upon sale of the property, your previously claimed CCA is brought into income and typically taxed at a high tax rate.
The mortgage principal payments of $8,914, over the first year of the mortgage, are not tax deductible. Only rental property interest can be claimed on your tax return. So, the property has a small loss of $1,653 for the year for tax purposes.
A rental loss can reduce your other income and result in a tax refund. Tax savings based on a 35% tax bracket (about average at $75,000 of income across the country) would be $579. That means the owner has a net cash-flow outlay of $9,988 for the year to carry the rental property after the tax refund.
For this property to be cash-flow neutral, with rental income covering the expenses and the mortgage payments (assuming a 25-year amortization), an investor would need a down payment of about $259,000 or 52%.
Other financial considerations besides cash flow
There are other considerations. Cash flow alone is not necessarily the best way to assess the numbers. Here is how I would evaluate the property as an investment.
With a purchase price of $500,000, the property actually costs $508,170 including land transfer tax and legal fees. If the property’s value grows, at 3%, to $515,000 after the first year, and the $400,000 mortgage is paid down to $390,325, that means $124,675 of net equity.
The buyer invested $108,170 ($100,000 down payment plus the land transfer tax and legal fees) upfront, plus the $9,988 net cash flow loss after tax refund. That is a cumulative investment of $118,158 that is now worth $124,675—representing a 6% return. Of course, that return is all just on paper because to sell there would be transaction costs of 4% to 5% of the property value, turning the gain into a loss in no time.
Accounting for changes in value and expenses
What do the numbers look like after 10 years assuming rent and expenses rise by 2% annually, and a continued 4.5% mortgage rate?
By this point, the buyer’s cumulative investment is $208,078 including initial down payment, initial land transfer tax and legal fees, and future annual cash-flow shortfalls. There would be $382,887 of net equity and an 8% tax-deferred annualized rate of return.
Over 25 years, the annual return would fall to about 6% due to the decreasing leverage and reduced mortgage interest deductions.
Are investment properties worth it?
I chose the numbers to use in this analysis at random. I am not trying to say that a rental property will result in a 6% long-run return. If we increase the condo fees, property tax, or miscellaneous costs, or decrease the rent—let alone increase the mortgage rate—those changes would all make the numbers look worse. The point is that even if a rental property runs at a loss, that does not make it a bad investment.
Your return is not based on your cash flow alone. It is based on your initial investment, your increased net equity each year and your cash flow.
Rental property vs. other forms of investing
If someone buys a rental property that will run at a loss, they can consider it to be like a monthly registered retirement savings plan (RRSP) contribution over the long run. But they need to make sure they can afford the cash flow requirements, an extended vacancy or an unexpected repair. Given the transaction costs to buy and sell real estate, it can be risky to try to make a short-term return on a real estate investment.
Going forward, a 6% to 8% return over the long run may be a reasonable expectation for stocks before investment fees. If you opt for purchasing a rental property over contributing to your RRSP or tax-free savings account (TFSA), you may earn a comparable return to what you could have in traditional investments, but you forgo the tax deduction and immediate refund of a RRSP contribution, or the tax-free growth of a TFSA account.
Should you invest in a rental property?
A rental property provides tax-deferred growth, with tax payable someday on the sale of that property. A landlord may be able to borrow against a rental property to access the equity instead of selling it, without triggering tax payable. However, getting a mortgage is always more difficult in retirement, when you are more likely to need the funds.
If an investor does not already have a significant portfolio of stocks and bonds, putting all their savings into a rental property down payment could leave them undiversified. This is especially so if buying a rental property in the same area the investor already owns their principal residence.
Obviously, a cash-flow positive rental property is better than a property that, at first glance, runs a negative return. But cash flow is not the way to assess a rental property.
More importantly, if high property value appreciation is required for your rental real estate numbers to make sense, there is a risk if prices go sideways for a while or drop further. Both are potential scenarios in this new higher rate environment, with lots of low interest mortgages coming up for renewal over the next few years at higher rates.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.
