Should I Buy an Investment Property? A 12-step guide to calculate your returns (ROI).

Introduction to the Guide and Calculator

Many people still want to buy an investment property to grow their wealth, but it’s essential to consider all the factors before deciding. This comprehensive guide will help you evaluate whether investing in real estate aligns with your financial goals and aspirations.

Understanding theory is helpful, but numbers matter. The calculator takes as much actual data as you can source from property listings, then allows you to enter estimates for 10-year impacts that include interest rates, expenses, and rental income. By researching these factors, you can make a more informed decision when purchasing an investment property.

To make this guide more tangible, we will dive into a real-world example using the businesscaseguy.com calculator: Should I buy an Investment Property? Open up the calculator if you want to follow along in more depth.

1. Compare the differences between a House versus a Condo investment

Understanding the benefits and drawbacks of managing a house versus a condo is important. Below are some factors to compare, such as maintenance obligations and investment growth potential.

When comparing the same area and market, a house generally provides higher returns over time, but they are more work to manage. By thoroughly examining both types of properties, you can make an educated decision that aligns with your investment objectives and lifestyle preferences.

Factor	House Investment	Condo Investment
(1)Financial Entry Costs	When comparing in the same market or local area, a house will usually cost more than a condo. So if you have a fixed budget, you must compare what’s affordable.	If you have a fixed budget and house prices are out of reach, then a condo is more like to be in your price range.
(2)Upfront Renovation and Repairs Costs	It’s common to encounter properties of various ages and conditions, ranging from new constructions to older homes needing significant repairs. This can impact areas like the roof, heating, cooling, foundation, and more. A thorough home inspection can help you mitigate these financial risks.	While you may come across some repairs that need to be addressed, it is important to note that any major repairs to the utility systems, roofing, and foundation are the responsibility of the condo association.
(3)Planned Recurring Expenses	If your tenant is in charge of all outdoor maintenance and utilities, then homes will have fewer types of recurring expenses other than your mortgage, property taxes, and home insurance.	Condos will have the same expenses, but you must add the condo association or maintenance fee. Although it gets tacked on for services you may not use, it does save you time and effort in dealing with those issues.
(4)Unexpected Expenses	Investment properties can come with unforeseen costs, such as broken appliances or leaky faucets. It’s essential to budget for emergency repairs just like you would for increases in recurring costs.	Given the smaller size of a condo and your responsibility for the unit interior, you are unlikely to have major unexpected expenses. However, a neighbouring unit causing damage is more likely in a condo. The only time major building repairs impact you is if the condo board makes a special assessment. Click here to read an Ontario-based summary.
Factor	House Investment	Condo Investment
(5)Outdoor Maintenance	Owning a house entails more duties, including caring for the yard, maintaining the exterior, and occasionally removing snow. These ongoing costs necessitate a clear understanding between the landlord and tenant regarding who is responsible for which upkeep tasks.	When living in a condo, the association usually handles outdoor maintenance tasks as part of your maintenance fees.
(6)Appreciation or Growth	Numerous factors influence the growth rate of a city and its surrounding area. Although houses have a greater chance of increasing in absolute dollar value because of their size and land ownership, the percentage of appreciation may differ.	Although condos may have a lower absolute dollar value appreciation because of their lower price, they can still offer promising returns on investment. This is often due to factors like their location, available amenities, and demand.
(7)Time and Effort	As a homeowner, you are responsible for the maintenance and upkeep of your property, both inside and out. This includes the building structure, utilities, landscaping, and all other elements. The size and age of your home can also affect the level of maintenance required. Even with a tenant agreement, you may still be accountable for addressing any problems. If you don’t have the skills or time to handle these tasks yourself, you may need to hire professionals and pay for their services.	When you own a condo, your ownership is limited to the interior of your unit. Tenants are less likely to need frequent assistance with significant issues. While such issues may still arise, condos typically require less time and effort than owning a house.

2. Find out the actual ‘sold’ and ‘leased’ prices

Knowing the actual vs listed prices will help you save a lot of time and energy instead of using unrealistic property values that may not rent well. You may find a listed property for $400k and think it’s great. However, once you compare the ‘sold’ history for comparable locations and features, you may find out it will sell closer to $500k, and this price is used to build demand.

The same applies to rental listings. You want to know what properties are rented for, not just the listed estimate. It may ‘list’ for $2800; however, most comparables lease for $2500. Using $2500 versus $2800 in the calculator will help produce a more realistic analysis.

Estimating a realistic market value for purchase and rental prices can be done through real estate agents, bank appraisals, or by researching other recent and comparable sold listings. Tools like Zillow (US) or House Sigma (Canada) are great research tools because they show you the actual sold and leased prices.

3. The importance of location

Using the Toronto (Canada) Real Estate market as an example, I searched for a 1 bedroom, 1 bathroom unit that was <$500k, with parking. I wanted to ensure it was on the subway line, which provides a larger rental applicant pool. This means I expect to keep it occupied 100% of the time for the market price or greater.

If I were targeting families, I would research school ratings as well. Given this is a smaller unit, the renters will likely care more about subway access and distance to major employment centers.

I found this 1 bed, 1 bath, 1 garage condo unit at Yonge and Sheppard listed for $499k. It’s within walking distance of the subway line and a 20-minute ride directly to the downtown core. When I check the ‘sold’ listings in the last 90 days, I find that comparable units sell for around $560k.

Next, I checked the ‘leased’ listing in the previous 90 days and found comparables in the same building. Other 1 bed, 1 bath, and 1 garage units are leased for around $2300.

Location is also a factor in deciding how to manage the property. If your investment property is not within a short driving distance of your home, you may have to pay a person or company to manage your property.

As a landlord, you have several essential duties and tasks to fulfill. These obligations include property showings, tenant background checks, maintaining the property, fixing or repairing minor issues, complying with legal requirements, and resolving disputes. Outsourcing these services will impact your return on investment.

4. What upfront and recurring expenses will I incur?

When considering a real estate investment, I dive into the three spending categories.

1. Start-up funds: This includes your down payment, land transfer taxes, legal and regulatory fees, renovations and repairs, and home inspections. Consider these the costs you have to get through before you can rent the unit.

2. Mortgage Payments (Principal and Interest)

For a 10-year return on investment calculation, you need to estimate a 10-year mortgage interest rate. Regardless if rates are high or low at the current time, enter your best estimate into the calculator. I used the average Canadian prime rate over the past 20 years and added 1% for this example. This calculation is 3.7% + 1% = 4.7%.

3. Recurring and One-time Expenses: These are your recurring monthly and annual expenses to operate the unit. This includes mandatory expenses such as mortgage payments, property taxes, and maintenance (or condo association) fees.

Optional expenses include property management fees and realtor fees to find tenants. They are optional because if you manage these tasks yourself, you won’t have to pay for these services.

Capturing an allocation for general repairs should be saved monthly. Although you are not spending it each month, set aside this money for future one-time repairs.

Based on the property listing, I pulled the figures below and added my estimates where required. Also, I do not have to capture utility expenses against my budget because the tenants pay for them.

5.  Understand where you profit from an income property

Now that the various costs and expenses are captured, let’s start looking at how the investment property builds wealth. In most cases, you can earn money in three ways once the property is up and running.

1. Operations Cash Flow
2. Mortgage Principal Repayment
3. Price Appreciation

In this snippet from the ‘Business Case Summary’, your equity position is estimated at $393k by year ten. Given you started with a down payment of $112k, the equity growth works out to $281k ($393k – 112k).

Let’s dive further into how the $393k equity position is broken down at year 10.

1. Down payment: The $112k you invested out of pocket to purchase the property. This is your starting equity position.

2. Start-up Fees and Expenses: The $18k in transaction-related fees, taxes, and expenses estimated to close the transaction.

3. Operations Cash Flow: The difference between your rental income collected from the tenants, less your expenses in operating the property. It’s always great to be net positive. If it is negative, you’ll have to contribute some extra money out of pocket each month. Although some early years are negative to get started, by year 10, the net growth was $20k.

4. Mortgage Principal Repayment: Your mortgage payment is part of your monthly costs. The mortgage payment is comprised of your principal and interest. The principal portion helps your wealth grow, given you keep that portion as the property is paid off. The interest portion is considered an expense paid to the bank. Over 10 years, the principal is expected to grow by $86k.

5. Price Appreciation: Over the long term, properties in growing cities appreciate in value. In this example, the property value is estimated at $560k. With a 3% annual growth estimate, the property value after 10 years will be $752k, resulting in $192k in price gains. This is the most significant contributor (49%) to your equity position at year 10.

6. What will be my first-year income and cash flow results?

Once your down payment is paid and all your transaction fees and taxes are out of the way, it’s time to start operating your property. Forecasting the first year of revenue, expenses, and cash flow can help you decide and plan your budget accordingly.

Below are the results showing your monthly and annual results side by side. For this example property, it’s clear that the year monthly and annual cash flow will be negative, $-730 and $-8766, respectively.

Over the 10-year horizon of this business case, if your rental income grows faster than your expense, your cash flow may shift positively.

7. Know the difference between Cash Flow and Equity

Now that you understand the methods to generate revenue from an income property and what your first-year estimate results will be, let’s take a moment to understand cash flow vs equity growth.

Cash flow can be negative even though your equity keeps growing. If your equity growth exceeds your cash flow losses, the net return will be positive. This positive return can be misleading since you may assume you don’t have any out-of-pocket expenses each month. However, this is not always the case.

Continuing with this example, we can see how this is true.

• In section 6 above, you can see in year one that your annual cash flow is -$8,766 once you pay all expenses and your mortgage. You must cover that shortfall out of pocket.
• However, the -$8,766 includes the portion of your mortgage directed to principal repayment, $6,975, which goes toward your equity.

• Finally, the property price appreciation estimate of 3% per year will also be part of the equity calculation: 560k x 3% = $16,800. This is an unrealized gain, as you can only realize this benefit once you sell the property or use a line of credit to borrow against the property.

To summarize, your equity growth can be calculated as follows:

• Cash Flow + Mortgage Repayment + Price appreciation.
• This works out to $-8766 + $6975 + $16,800 = $14,829.

If you can afford to pay out $8,766 in out-of-pocket expenses annually, you can benefit from the equity growth of $23,755.

8. How can I break even on my monthly cash flow?

Continuing along the same thread as section 7 regarding negative annual cash flow of $8766, this may not sit well with investors, especially first-time investors in real estate. At this point, you have two options to make cash flow = $0 (break-even) or greater.

1. Look for another cash flow-positive property, or
2. Consider reducing your offer or increasing your rent.

Option 1 requires more research and maybe looking at properties in other areas. Option 2 may work if the offer you want to submit is fair and not significantly below market value.

The investment property calculator shows you the break-even estimate. Assuming all expenses remain the same, it shows how much your offer needs to be reduced or how much would your rent needs to increase to make your monthly cash flow = $0.

If breaking even each month is important, this property may not suit your investment priorities. Based on the estimates captured thus far, you would need to either offer $176k below the market value or check if getting an extra $730 monthly rent is realistic.

9. What will my Return on Investment (ROI) be in ten years?

The previous section showed the dollar value for each revenue area. A percentage to compare will allow you to compare this to other investment options, such as stocks. In this scenario, by year 10, the annual estimated ROI is 13.4%. These returns are calculated based on your down payment of $112k, your starting equity position.

10. Am I financially ready for the purchase?

Financial preparation before investing in a property will prevent many issues in the future. Considering factors such as creditworthiness, down payment obligations, debt-to-income ratio, cash reserves, and the overall impact on your financial stability. By conducting a comprehensive economic evaluation, you can determine if you’re ready to purchase an investment property.

11. Can I handle the worst-case scenario?

When considering investment properties, it is essential to recognize the possible risks involved. Worst-case scenarios can include extended vacancy periods, legal disputes, economic downturns, increased interest rates, reduced rental rates, and increased expenses.

To minimize financial loss and avoid a forced sales situation, it is crucial to have risk mitigation strategies, contingency plans, and adequate cash reserves.

This section of the investment property calculator helps you understand your annual impacts if all your rent is lower and all your expenses are higher. In this scenario, you must cover $5k per year in additional costs if rented at 100% occupancy.

However, each month the unit doesn’t have a tenant, whether due to the market, or a dispute,  you will have to cover close to $2500 in expenses. You must build a cash buffer to address gaps in rent or cost increases.

12. Should I consider buying stocks instead of an investment property?

If you made it this far in the article, you are leaning towards an investment property. If this is not the case, and you still want to compare other options, such as a stock index, read through the Ultimate Guide To Calculate Stock Market Vs Real Estate Returns (businesscaseguy.com).

Conclusion

When contemplating the purchase of an investment property, you need to know what you are getting into in terms of effort, risk, and returns. Creating a realistic estimate based on market conditions helps get you close to a decision.

It’s clear that real estate is more work to manage than other investments such as stocks, so you have to consider if there are better returns and if that increased margin is worth it.

Although real estate investment can be lucrative, it requires careful research, financial readiness, a long-term commitment, and a proactive attitude toward risk management. By educating yourself and making a well-informed decision, you can put yourself on the path to fulfilling your financial objectives through investment property ownership.

The business case guy calculator is a tool to help you understand factors you need to consider. It cannot predict the future or account for every possible scenario. You should review investment property decisions with your financial advisor, accountant, and real estate agent.