A common question when it comes to building income streams, is how to adequately include real estate in your investment portfolio. Is owning your own home sufficient diversification? Would investing in additional properties over expose you to the real estate market? If I invest in real estate will I make as much money as they show on TV?
I believe an excellent rule when it comes to investing, is to stick with what you know. Investing your money in products or businesses you don’t understand is never a smart move. Warren Buffet follows this rule of thumb, and if its good enough for him, it’s definitely good enough for me. For the average person Buffet warns against investing in individual stocks, recommending instead to invest in a low fee ETF that mirrors the S&P 500.
Unless you have some genius level analysis abilities, an above average understanding of market economics, or are willing to dedicate some significant time, focus and energy to understanding the stock market, and each individual company you are investing in, you are much better served investing in a low fee fund that essentially follows the market as a whole. Because, if you are Joe Blow, 9.9999 times out of 10, you’re not going to beat the market (or all the people working in that field that have dedicated their lives, education and full time workings hours to being the absolute best at it!).
Real estate is absolutely no different. Although more people have a generally broader understanding of real estate as a result of purchasing their own homes, or renting themselves, it still doesn’t mean you are prepared as an investor. Building knowledge BEFORE investing not only helps to manage your risk, it will also help you decide if investing in real estate is right for YOU.
For instance, many financially savvy people I know absolutely hate being landlords. Some who have tried it and run into difficulty swear they will never do it again. They don’t see the return as being worth their time or effort.
And although HGTV has made flipping houses look easy; 30 minutes, minimal sweat, a brief hiccup in the job that is miraculously resolved, and then boom, you have a beautiful property ready for the market and you make tens of thousands of dollars. Same story…..every…… single……. time. (I won’t lie….I still used to watch them though!) There’s a lot that goes into flipping a property, from the purchase, to the reno, to the eventual sale. Maintaining a constant understanding your market, having an excellent contact list, and being equipped with at least some basic knowledge of contracting and renovating are highly recommended if you want to be consistently successful.
Commercial investing is a whole other ball of wax. Different lending rules, generally bigger stakes, higher liability and drastically different leasing contracts than a typical residential rental. A strong network of contacts is also extremely important.
All of which to say, doing your homework and complimenting skills or an area of knowledge you ALREADY have, is likely the best and most efficient route to take. IE: if you are an experienced contractor, married to a real estate agent, than perhaps flipping houses is exactly the place for you to invest your time.
But if after examining your local market, and assessing the skills you bring to the table you are still unsure what route is the best place to start, buying to rent is for most people is a nice way to ease in. (Even better is than purchasing to rent is to start by renting out a portion of your own home (basement suite, renting a room etc). This helps you build familiarity as a landlord, and understanding of the laws that apply to your area.)
Overall, buying a property with the intention of renting it for a longer period of time has a lot more room for “mistakes” than other methods of real estate investing. Firstly, you don’t have to get everything right in order to win financially in the end. This is in large part because fo the long term nature of the purchase. You’re not trying to make a quick sale, or time a market downturn/upswing, which means (for the most part) you can ignore the peaks and valley’s of the market.
In the ideal world we would all purchase properties in a down market, but if you’re planning to hold a property for 10-20 years, much like the stock market, minor fluctuations in price become irrelevant to the long game.
One of the best things you can do anytime you are looking at investing in real estate is to start watching the market. Start months before you are ever thinking of actually making a purchase. This will help you understand the price point of the market you are buying into, and also help you identify and move quickly when an ideal property does come onto the market.
Location, location, location is an age old saying for a reason. Think about the type of tenant you would feel comfortable having. If you want to appeal to students, look for something close to a post secondary school. If you want single professionals, consider a dense urban centre. If you are looking for family tenants, check out the top schools in your desired city/town, then determine where their catchment boundaries are. Are grocery stores, transit, community centres easily accessible? Are there up and coming areas that are slated for substantial development where property values are likely to rise over the coming years? Use all this information, and what you’ve observed in your overall market evaluations, to narrow down the exact neighbourhoods you want to buy in. Then learn those specific market trends inside and out.
Start watching rental ads in the exact neighbourhoods you are hoping to invest in. How does the current purchase price of a home compare to the rent you could reasonably expect to obtain? Once you factor in property taxes, HOA or strata fee’s, maintenance/repair budgeting and insurance, does the property provide you with cash flow? IE does it give you a monthly/annual return on the downpayment you have made to buy the property?
The amount of cash flow you should be looking for will depend heavily on the market in your specific area. There are many investors that would never consider purchasing a property unless they could get a minimum 8% annual return on their capital investment after all expenses. I dream of that number being a reality in the Lower Mainland!
Frankly if I could pick up a property that would return that kind of cash flow in it’s first year of operations here in Vancouver, I would buy it IMMEDIATELY. Sadly, that’s not a reality for this market. A 4-5% return on capital investment is much more accurate, and that’s IF you can find a particularly good deal. The reality is that most homes for sale in this market are much more likely to hit a break even on their first 2 years of ownership, and then as rental prices increase year over year, you start to see a minimal cash flow that steadily builds over time.
In hot real estate markets (Toronto, Vancouver etc) the rental money is made in the long term hold, as well as the building of equity in the property. So sometimes taking a break even and holding for the future profit is the right choice. All to say, knowing your market is ESSENTIAL.
As you are watching the market, simultaneously educate yourself on the Rental Tenancy laws in your area. Here in British Columbia (BC) we have the Rental Tenancy Act. I have probably read this Act at least a dozen times since becoming a landlord, and further reference it during every single tenancy I have. I use it as my guide to make sure I am fully in adherence with every rule governing my rights, as well as the rights of my tenant.
For instance, at the start of every tenancy I review the act and make sure I have complied with every step required when initiating a new tenancy. Here in BC that includes completing a Condition Inspection report with the tenant present, and ensuring they sign off on the document detailing what damage or wear (if any) exists in the property prior to they move-in. A copy of the inspection report must then be provided to the tenant. You then use this form to inspect the property at the end of tenancy and determine if any damages have been caused by the existing tenant. The consequence of not completing this document properly at the beginning of the tenancy? Or not giving a copy to the tenant? You lose any right as a landlord to make a claim for damages at the conclusion of the tenancy. Zip, zero, nada. Doesn’t matter what they do to it. Kinda makes it seem like an important thing to do, right?
Guess how many landlords I know that have NEVER completed this document with any of their tenants. A LOT. Seriously, the vast majority don’t bother. In fact, 100% of the tenants I have ever had have told me that they’ve NEVER completed that document with any other landlord. ***Mind – blown*** It seriously amazes me.
It’s reasons like that there are so many horror stories about being a landlord. But making sure you are in compliance with your legal obligations as a landlord will ensure that vast majority of the problems you are likely to experience can be resolved in a way that doesn’t cause you to lose money. Because you will have problems. I’ve had tenants that don’t pay, are late on rent, damage the suite, break contracts. That’s part of the landlord business, BUT, because I followed my obligations to the letter, Mike and I have successfully obtained payment for almost EVERYTHING that has ever been damaged or owed. We’ve lost out on small amounts here and there where we haven’t felt it was worth our time to pursue, but that is the cost of doing business.
It also means, don’t expect this business to be truly passive income. It’s not, you will still need to put in the work. But, when I break down the money we’ve made over the years from rental properties and divide it by the hours Mike and I have put it, in comes out to a substantially higher per hour wage than either of us have ever made at any job. So from that perspective, it’s definitely worth the effort.
Bottom line, do your homework first. Then if you think this business is a good fit for your personality, skills and existing knowledge, be sure to read next week’s post where I’ll talk about how to make your real estate investment an reality that not only fits, but contributes to your plan for Financial Freedom.