At some point in life you’ve probably been faced with the difficult decision to rent or buy your home. In many cases the decision isn’t so clear. With owning your own home, you’re building equity instead of lining the pockets of a landlord, but at the same time you’re making a decision that’s a lot harder to reverse, as well as burdening yourself with a significant downpayment and significant debt. With renting you’re missing out on what has arguably been the greatest source of wealth creation for the middle class in the last 50 years, but you’re obviously not tied down, financially or locationally.

If you talk to a financially minded person, they’ll likely tell you that you can crunch the numbers to determine if it makes more sense to rent or buy. What’s the monthly rent vs monthly mortgage payment and costs of ownership (taxes, maintenance, utilities, and insurance)? Maybe factor in a view on property prices down the line and you’ve arrived at two numbers you can compare. This approach, while simplistic does provide many with an answer. But I’ll argue that in many cases, there’s actually a third option that would make the most financial sense – buying and renting at the same time.

Now when I say buying and renting, I’m not referring to buying and renting the same property. What I’m talking about is a sort of market arbitrage where you rent in the market that you want to live in and buy in a market that offers higher rental income potential. This strategy tends to work if you live in bigger cities where properties are often more expensive and rental yields often lower. Let me illustrate with my own personal example of how I pursued this rent and buy strategy and walk you through the pros and cons.

In 2011, I was working in downtown Toronto and I wanted to live close to the office. My budget meant that I was looking at renting or buying a small one bedroom apartment. It would have cost in the neighborhood of $300,000 to buy the apartment I was considering or about $1,350 per month to rent. Given interest rates at the time of roughly 3% for a fixed 5 year mortgage, I was looking at about $1,150 a month in mortgage payments. Add in the condo fees, taxes and insurance and I was at about $1,600 cash out of pocket each and every month. If you look at an amortization table, I would have been paying down the mortgage by about $550 per month in the first year, so on the surface it would seem I would have been better off buying ($1,050 per month vs the $1,350 had I been renting). But this obviously neglects to consider the downpayment plus closing costs (estimated at $70,000) that I would have needed to buy the property. Assuming I could have made 5% a year on this investment, that equates to almost $300 per month in lost opportunity cost. So now it would appear that from a financial perspective these options were similar (ignoring property appreciation – more on that below).

Now this simplistic analysis ignored appreciation. The reality is that looking at the Toronto market, that same apartment probably appreciated close to 15% over the last 4 years. Since that’s all upside on the equity, that would have meant an increase of $45,000 over the 4 year period, or just over $900 per month. There are a couple of reasons I don’t factor in price appreciation in my analysis. For one, that price appreciation has also likely impacted the next property you plan to buy in that market (unless you’re moving cities), so it’s not something you’ll likely pocket – especially once you factor in the buying and selling costs which can easily wipe out any gain. Also, nobody knows for sure where the market is going, so while it went up in this case, the housing crash in 2008 highlights that’s not a foregone conclusion.

So from this simple analysis, it seemed I should be relatively indifferent to buying or renting (although less tied down with renting). So what did I do? Instead, I invested in a property in Windsor, Ontario. Prior to buying this property, I had never been to Windsor (about a 4 hour drive from Toronto), nor did I have any real reason to. The property in question was a nice single family home in downtown Windsor – the equivalent of which in downtown Toronto would have probably cost somewhere in the neighborhood of $2-3 million. So I was shocked to find that this particular property was being sold for $105,000. What’s more, with a little bit of investment ($3,000) to fix a few things up, I was able to rent the property for $2,450 per month (inclusive of utilities)! Now if you do the math on that, I was actually making roughly $1,000 in cash flow after costs (and mortgage payments) each month!

Now, my analysis would not be complete without factoring in taxes. The reality is that the income from my property would be taxed at my marginal income tax rate, so that $1,200 per month in income ($1,000 net pre-tax cash flow plus $200 debt paydown) was actually more like $525 post-tax (or $600 considering the opportunity cost). If I was able to scale my Windsor investment up to the same $70,000 that I would have invested in the Toronto apartment, I would have roughly offset the cost of renting in Toronto! Put another way, instead of my post-tax cash-flow being negative $1,350 or $1,600, it would have been roughly 0.

The math behind analyzing this strategy of buying in your home market or in another market is relatively straightforward. Ignoring home appreciation (it also seems everybody has their own views of home prices in their own markets), it becomes simply a matter of comparing capitalization rates between markets. The capitalization rate is the ratio of pre-financing income to the cost of the property. For the property in the other market, you need to make sure to consider vacancy rates, but you can ignore this for the property you would plan to live (since your own vacancy is 0). In my example, the capitalization rate for my Windsor property would be roughly:

($1,000 cash flow + $200 mortgage payment) * (1 – a vacancy rate of ~10% for Windsor) * 12 months / ($105,000 purchase price + $3,000 improvements) = 12.0%

The apartment in Toronto would have had a capitalization rate of:

($1,350 gross rent – $450 in costs such as condo fees and taxes) * 12 months/ $300,000 purchase price = 3.6%

To compare which provides a better deal, simply multiply the capitalization rate of the more lucrative market by 1 – your marginal tax rate (so in my example, 12.0% * 0.61 = 7.3%), and if this is greater than the capitalization rate in your home market (in my case the 3.6%) then you may want to seriously consider this buy and rent strategy (in this case there is obviously a big difference).

I do want to caution, however, that there are a lot of things to consider that I may have skimmed over or not mentioned. For one, it can be difficult to manage a property remotely and so a good property manager is vital (but is also a cost that needs to be considered). Also as mentioned, appreciation is something that can dramatically alter total returns, but for reasons mentioned aren’t considered in this analysis. You should take the time to develop a good understanding of the market you’re considering investing in as general market and rental dynamics can change significantly over time. Furthermore, there may be other tax incentives to owning your own home.

Lastly, I do want to highlight that although a 12% cap rate property is not terribly common, it is still relatively common to find very attractive cap rates in smaller markets that can make this strategy pay off. For Canadian investors, take a look at our recent 5 Year Canadian Residential Real Estate Returns (2010-2015) report for an idea of cap rates in different markets. If you do decide to invest in real estate, I also encourage you to give our real estate analysis software a try. It’s free for up to 3 reports on any properties in North America and can help set return expectations.

Our study considered a hypothetical investment made in each of 34 markets in 2010 and exited in 2015. Returns assumed each investment carried a mortgage representing 80% of the purchase price at an interest rate of 3.5% and amortized over 25 years. Returns were considered on a pre-tax basis.

1) Thunder Bay, Ontario

Thunder Bay, a city in NorthWestern Ontario with 121,596 in the Census Metropolitan Area topped our analysis of residential investment returns from 2010-2015. Thunder Bay saw both strong price appreciation, as well as high cap rates over the 5 year period.

Oshawa, a city East of Toronto with a population of 356,177 in the Census Metropolitan Area, came in 2nd in our study primarily based on price appreciation over the 5 year period. Cap rates (and income) were better than in larger Canadian cities such as Toronto, Calgary, and Vancouver but were considerably less than in cities like Thunder Bay and Windsor.

Windsor, a city in SouthWestern Ontario directly south of Detroit with a population of 319,246 in the Census Metropolitan Area, took 3rd place in our analysis of 5 year investment returns. Windsor exhibited strong income generation potential over the study period, and relatively good growth in home prices, but not to the same levels of appreciation in both Thunder Bay and Oshawa.

Full study results for 34 cities and methodology are provided in the report. Download a copy of the report: SpendTree Report – 5 Year Canadian Residential Real Estate Returns (2010-2015)

About SpendTree

SpendTree aims to change North American residential real estate investing by empowering individual investors with an easy to understand online tool that provides the relevant analyses to make better investment decisions. Utlizing a combination of user-generated and external data, the SpendTree tool can provide a more thorough analysis of investment properties than what most individual investors are used to. This includes metrics that most real estate investors are familiar with, but also provides capabilities that have generally been the domain of professional and more sophisticated investors such as detailed sensitivities, hold period analyses, pro-formas, and market benchmarking.

• Investor 1: Holds 100% stocks that are expected to return 8%
• Investor 2: 50% stocks and 50% real estate – both assets expected to return 8%

Both these investors are expected to achieve an 8% return, but what if the stock market actually returns 0% or 16%. The returns of Investor 1 are far more volatile. Because the stock market and real estate are not terribly correlated (A 2010 study by CXO Financial Advisory Group actually found a slight negative correlation), we can say that Investor 2 is more likely to achieve a return closer to 8%. On a risk-adjusted basis, Investor 2 is in a better position and because investors demand higher returns for greater risk, Investor 2 acutally has a BETTER portfolio than Investor 1.

Hopefully you’re convinced that a diversified portfolio is better. And the more diversified the portfolio, the lower the risk. So yes, holding stocks AND bonds is better than just stocks or bonds, but holding stocks, bonds, AND real estate is even better. At some point you do need to factor in the costs of diversification (e.g. transaction costs, etc), especially if your portfolio is not large, but for the vast majority of investors, adding more asset types is better.

But you may be thinking that’s it’s fairly straightforward to buy and hold stocks and bonds, but it’s challenging to buy and hold real estate. There are options like publicly-traded REITS, but we’re strong believers in direct ownership since you’re cutting out the middlemen. Direct ownership isn’t for everyone as it’s more complicated and demanding, but the returns are generally significantly higher. And that’s where SpendTree comes in. We’re here to help make finding, analyzing, and buying direct real estate relatively easy. Take a look at some of our other posts for how to get started in real estate and with SpendTree, and make sure to give the tool a try!

1. Net Operating Income – NOI

This is the one number that every income property owner should know as it’s an estimate of the annual income generated by a property. Although the formula is pretty straightforward, the devil’s in the details.

NOI = Gross rent*(1 – Vacancy Rate) – Operating Expenses (such as Property Management, Maintenance, Insurance, Property Taxes, HOA Fees, etc.)

Gross Rent: This should be a realistic assumption of the rent potential of a property. If the property is rented out, then this number is known with greater certainty. Otherwise, a smart investor should look at the rents charged for similar properties – SpendTree provides an estimate, but also consider checking listings on sites for renters.

Vacancy Rate: This is often overlooked by new investors, but needs to be considered. It’s unlikely that a property is going to be rented out consistently, so an appropriate vacancy rate greater than 0 needs to be incorporated. SpendTree provides vacancy rate estimates at the local, state/provincial, and national level.

Operating Expenses: This is generally the area of greatest variability. A shrewd investor will be sure to account for all known expenses, as well as an allowance for general repairs & maintenance. Note that financing costs (e.g. mortgage principal & interest payments), income taxes, capital expenditures (e.g. upgrades to the property), as well as depreciation of capital assets are NOT included in operating expenses for the purposes of NOI. This is because NOI is an estimate of the current annual profitability of a property regardless of future improvements, how the property is financed, or the owner’s personal tax situation.

NOI should NOT be considered an estimate of a property’s cash flow since it neglects to consider financing, personal taxes, and capital expenditures. It is, however, a relatively reliable way to compare the profitability of similar properties. All else equal, a property with a higher NOI suggests a better investment. When comparing properties, however, be sure to consider the cost of upgrades. Two properties that cost the same and yield different NOI’s may not mean that the higher NOI property is a better investment. The higher NOI property may require significantly more capital investment which may mean the total return may not be as great.

2. Cap Rate

An abbreviation for capitalization rate, the cap rate allows you to easily compare the annual profitability of different properties compared to their costs without considering financing.

Cap Rate = Net Operating Income / Total Cost

Everybody in real estate investing loves to talk about cap rates. Obviously a higher cap rate is better than a lower one, but as discussed above with NOI, it’s important that you compare apples with apples. For one, make sure that NOI is calculated consistently – there tends to be a wide discrepancy in the expenses that investors / agents tend to include or neglect in their calculations. You may also want to consider taking a normalized cap rate over a 5 or 10 year period since NOI in year 1 tends to be lower, especially if a property is vacant when purchased (SpendTree gives you a cap rate analysis over several periods).

Also, cap rates don’t consider capital expenditures, depreciation, or financing, so it’s important that this be used in conjunction with other metrics when analyzing a property.

The question a lot of investors love to ask is, ‘What is a good cap rate?’. The answer is that it depends. In markets that have historically seen great appreciation in home prices, cap rates tend to be lower as appreciation makes up a bigger portion of overall return. In markets with more modest appreciation, it’s not uncommon for investors to talk about cap rates above 10%. Any good investor should get to know the local market and understand expectations for cap rates. If a property’s cap rates appears significantly higher than the market, an investor should explore why this is the case. It may just be a great opportunity, but could also be a warning sign that the numbers are too good to be true.

3. Annual Cash Flow

As mentioned above, NOI does not consider all cash expenditures. It does not include mortgage payments, nor does it include capital expenditures or income taxes. Serious investors will want to consider both the pre-tax and post-tax cash flows they should be expecting from a property. At the end of the day, an income oriented investor is most concerned about what they’ll actually be able to spend from the investment.

Pre-Tax Annual Cash Flow = NOI – Capital Expenditures – Mortgage Payments

Post-Tax Annual Cash Flow = (NOI – Mortgage Interest Payments – Depreciation) * (1 – Marginal Tax Rate) + Depreciation – Capital Expenditures – Mortgage Principal Payments

Depreciation: Note that depreciation is a non-cash charge, so it doesn’t affect pre-tax cash flow. It does affect post-tax cash flow as it’s deductible for tax calculation purposes. That’s why we have to add it back in the post-tax calculation (it reduced income taxes owed in a year).

Mortgage Payments: Mortgage interest is a cash expense that goes directly to the bank, and hence is deductible for tax purposes. While mortgage principal payments do affect cash flow, they go directly to paying down your mortgage and so you still benefit from this and need to be taxed on these payments.

Calculating a reasonably accurate cash flow projection can be challenging, but we’ve done our best at SpendTree to provide you with this analysis in our reports. It’s an important consideration all real estate investors should know.

4. Cash-on-cash return

This is an important ratio to evaluate the overall performance of a property. It compares the total cash returned to the investor with the cash invested in the property.

Cash-on-Cash Return = (All property cash flows + cash received on sale) / Total Cash Invested

Cash Flows: This is essentially a sum of the annual pre or post-tax (depending on whether you’re calculating a pre or post-tax cash-on-cash) cash flows as discussed above.

Cash Received on Sale: This is the selling price – closing costs – remaining mortgage balance (and any mortgage penalties if applicable). If you’re calculating the post-tax cash-on-cash return, then you need to factor in taxes on the capital gain (the excess over what you invested that you receive back).

One problem with Cash-on-cash returns is that it doesn’t factor in the time value of money. If I double my money in 4 years, it’s obviously better than if I double my money in 8 years and for that, investors also need to consider the IRR. In conjunction, these two metrics are powerful in giving an investor an idea of how a property will perform.

5. Internal Rate of Return  – IRR

The IRR is a number that uses the investment’s discounted cashflows against the initial cash investment. It is based on the idea that a dollar today is worth more than a dollar tomorrow. The IRR is the % that discounts all future cash flows so that its present value is equal to the total cash invested.

This is a tricky calculation to compute, and typically investors will use specialized software or excel to do this calculation. A simple illustration of this calculation would be a property that was purchased all in cash for $100k and then sold for $150k a year later. Assuming the property incurred no expenses and produced no income, the IRR would be 50% (150/(1 + 50%) = 100). Without getting too into the math, the IRR is often the number that professional investors will use to benchmark an investment’s returns since it considers time and absolute value of returns.

If you’re concerned at all about calculating these various metrics, you shouldn’t be. SpendTree’s software provides all these calculations and more at the click of a button. It’s free to sign up and should you have any questions about real estate metrics or the software, feel free to contact us at info@spendtree.com.

Happy hunting!

Register

If you haven’t done so already, go ahead and register a free account with SpendTree here. Once you have created your account, log in on the home page.

Create a Report

Once logged in, you will want to click on New Report. This will take you to the first page of the report creation process.

Report Tab 1 – General Info

We try to autofill as much information as we can, but you’re going to need to start with an address. Start typing and click on the property’s full address. The image to the right is the image that will be used as part of the report, use the controls beneath it to make sure the image has the property in full view.

The next few pieces of information are required

• Asking Price
• Square Footage
• Property Type
• Units

Then, for each unit, you will need to enter the number of:

• Bedrooms
• Bathrooms

Tip: You can give each unit a name: i.e. “Upper” and “Lower”

Once you’ve completed this tab, move onto the next page by clicking “Save & Continue”.

This is really where Spendtree Shines - On the top of the next page you can select “Generate Report” and we will autofill the rest of the data based on market estimates, or you can proceed and customize some or all of the values. If you select Generate Report skip down to the report section below.

Report Tab 2 – Sale Info

These contact fields are shown on the first page of the report – feel free to use this to promote yourself or the agent selling the property.

Report Tab 3 – Cash Flows

On this tab you will enter the cash flow details of the property. Most important is the rent for the individual units. Take a look at the numbers we’ve estimated and modify them as you see fit. Use the “Current Rent” field to input the rents currently in place. If a unit is vacant, leave this field blank. The “Market Rent” is an estimate of what the unit is expected to fetch on the open market (note, this is often higher than the “Current Rent”).

The field Other Income is an opportunity to capture any other income that the property generates such as laundry, parking, storage.

The rest of the fields are autofilled based on our best approximations of your property, update them as required.

You can make the reports as granular as you’d like. For example, you can add in detailed maintenance estimates or specific expectations for utilities.

Report Tab 4 – Improvements

If you are planning on performing any major work (HVAC upgrade, new roof, kitchen, etc.) input the values for the improvement and select Timing-Immediate, if you are running a report on a property that was previously purchased you would input the correct timing of the improvement.

Example: You purchase a property in 2010 and realize that the windows need to be replaced, you perform the work in 2013 and things are great. In the property report you would select Timing – 3 Years as it was done 3 years after purchase

Report Tab 5 – Financing

This tab is will be autofilled to represent a typical deal assuming it was done today, using prevailing interest rates and LTV estimates. If you have a better idea of the financing to be used, update the details of your first and second (if applicable) mortgages.

Report Tab 6 – Other

As can be seen, there are many other piece of information (19 to be exact) that are taken into consideration for each analysis. Each one of these data points has been estimated based on current market conditions for the property or general rules of thumbs. These can be updated or assumed as is. The references for each of these estimates is also provided in the report.

Example: The report shows “Market Basis” U.S. Census Bureau – San Francisco-Oakland-Hayward, CA. This means that the source of that data is the U.S. Census Bureau, and that the data is regarding the San Francisco-Oakland-Hayward,CA area.

Click Save and Generate Report once you’re done, don’t worry you can always come back and edit any of the values later.

Generate Report

Once you click “Generate Report” you should be presented with a full property analysis report containing the Assumptions, Sensitivities and Market Data that the report uses to ultimately calculate its Return Profile and associated 1-page summary. From this view you can either share the report or export as PDF. If any of the values need to be updated click on My Reports on the left, and then Edit Report in the list of your reports. Re-run the report once all of the numbers have been updated.

There’s plenty more that you can do with SpendTree, but hopefully this has given you a good idea and a starting point. Best of luck with your real estate endeavors!