If you’re thinking of investing in property, the #1 factor that can ensure your success is detailed preparation. Extensive research and critical self-assessment of your finances are paramount to achieving your investment goals. In the first part of Understanding Your Investment Goals, we discussed setting your specific investment goals and determining the type of property investment you should make (there are various kinds). In this post, we’ll get into the numbers: how to understand your regular expenses and income (cash flow), the overall profits you can expect (return on investment), and the importance of understanding financing, interest rates, and down payments.
Getting a mortgage for a second (or tertiary) property is more difficult than for a primary property, as the risk is higher for lenders and mortgage insurance will normally not cover investment properties. You may need at least 20% of the purchase price for a down payment on an investment property (and as much as 50% if you’re investing in a commercial property).
Your cash flow is the total amount of money being transferred into and out of your investment, especially as it affects liquidity. (Liquidity refers to how quickly or easily your assets can be bought or sold in a given marketplace; essentially, liquidity is a measure of how easily your assets can be transformed into cold, hard cash).
Negative cash flow (money going out) could be made up of: mortgage payments, taxes, insurance, property management fees, and maintenance costs. Positive cash flow (money coming in) would most likely be rental income, if you have secured tenants for your property.
Remember: just because the rental income you’re taking in is slightly more than your mortgage payments, this does not necessarily mean you’ll be making money.
Your equity is the market value of your property minus any outstanding debts. If you’re actively holding a mortgage on a property that you’re renting out, your tenant’s rent payments are effectively contributing to your equity—that is, if you apply rent payments to mortgage paydown, you’ll eventually have a mortgage-free property with built-up equity if and when you decide to sell the property.
A simple calculation of equity is: [value of home] – [amount owing on mortgage] = [equity]
For example, say a home’s market value is $489,500, but the owners still owe $412,300 on the mortgage.
$489,500 – $412,300 = $77,200
The equity the owners currently hold is $77,200. (If a tenant makes rental payments, these contribute to paying off the mortgage, which increases the owners’ equity.) It’s important to keep in mind that equity is never constant, since property market values fluctuate constantly.
Return on Investment
The total returns on your investment are all of the ways in which you can bring money in to offset your initial expense. ROI is calculated by adding up all sources of return, including cash flow, mortgage paydown (increased equity) and market appreciation (value growth). ROI is an important factor to consider in your calculations because it’s a good measure of the efficiency of an investment (greater efficiency means you get more out of what you’ve put in, per unit of time).
Interest rates remain low and therefore attractive to borrowers, but there are a number of factors that can determine the specific interest rate applied to your mortgage. Here are some tips on getting to know interest rates, and making sure you secure a rate that is beneficial to you:
- Check your credit score before requesting a loan. This factor is one of the most significant ones in impacting a loan’s terms and conditions.
- Some lenders will lower an interest rate based on how large your down payment is; if you can afford a 25% or even 30% down payment, you may qualify for a more favourable loan rate.
- What percentage of your payments will go towards interest and what percentage will pay down the principal debt? This is an important ratio; a higher percentage towards principal payoff means you’re eliminating your mortgage faster and more efficiently.
- Learn about Fixed Rate Mortgages (FRM) vs. Adjustable Rate Mortgages (ARM). In a FRM, your interest payments and monthly principal will stay constant for the duration of the loan. Prior to the end of the fixed rate, you’ll refinance and renegotiate your rates. The new rate can go up or down based on the status of the market. In an ARM, your interest payments and monthly principal stay constant only for an agreed-upon amount of time (say, 5 years). An ARM carries higher risk, but also has the potential to be more rewarding if the housing market and interest rates take a downturn after your initial phase of financing.
There you have it! The above are the most significant quantitative factors in calculating the resources you’ll need and the returns you can expect in a property investment. Take a close look at your financial health and make sure to research both the rental and resale property markets in your area so you’ll exactly what you’re getting into. With the right amount of preparation, and armed with knowledge, your property investment is sure to be a success.