Benefits & Pitfalls of Investing in Real Estate

Given improving employment conditions, an increasing population, low vacancy rates, and the appreciation of real estate over the past decade, Toronto residential real estate investment has never been quite this attractive. With housing prices still high, people won’t stop renting anytime soon. In fact, the percentage of private dwellings that are rented in the City of Toronto is hovering around 33.5%; the highest level since 2001. Conversely, the rate of ownership has shrunk to 66.5% from a two-decade high of 67.6% seen 2006. Investing in real estate may be beneficial whether you are considering looking to diversify your portfolio and grow your wealth, taking your first step into the real estate market, or preparing for your retirement when you downsize, otherwise known as smartsizing.

Benefits

Deduct certain expenses and reduce taxes you owe. The Canada Revenue Agency (CRA) permits that reasonable expenses can be categorized as current expenses or capital expenses. The former, otherwise known as operating expenses, are recurring expenses that provide a short-term benefit. For example, the cost of repairs you make to keep an asset in the same condition as it was when you acquired it, such as painting the interior each time a tenant vacates the property. You can deduct current expenses from your gross income in the year you incur them. The latter, provides a benefit that usually lasts for several years. For example, costs to buy or improve your property are capital expenses, such as a furnace you are renting with the property. Typically, the full amount of these expenses cannot be deducted in the year you incur them. Instead, you can deduct their cost over a period of several years. This may include but are not limited to: the purchase price of the rental property, legal fees and other costs connected with buying the property, and furniture or equipment you are renting with the property.

The following is a list of other expenses that are deductible:

o   Advertising

o   Insurance

o   Interest

o   Professional fees

o   Repairs and maintenance

o   Motor vehicle expenses

o   Office expenses

o   Property taxes

o   Prepaid expenses

o   Salaries, wages, and benefits

o   Travel

o   Utilities

o   Management and administration fees.

What is one of the most significant expenses on the list above? If you guessed interest, you're correct! Even though mortgage interest rates have been rising over the past year, we are still in a historically low interest rate environment. The interest you pay on your principal amount; however, can add up over the years. You can deduct the interest charge on money you borrow to buy or improve your rental property. So, even if the rent you earn on the property in the first year leaves you a couple of thousand dollars short, you can save money off your tax bill by deducting the interest spent from your total earnings (i.e., salary, wage, or rental income). This reduces your overall tax debt as it reduces your taxable income.

Negative gearing or purposely purchasing and carrying real estate at a loss. Real estate is great when it comes to tax benefits. A negatively geared investment property can offer immediate tax benefits while also offering the prospect of capital appreciation over the long-term. Perhaps for this reason, negative gearing is often used by higher income earners to reduce their actual taxable income in the short term in order to, theoretically, earn more money over time.

Earn passive monthly income. One of the benefits of owning an investment property is that you can rent it out. If you can get enough rent to cover your expenses you are effectively getting someone else to pay down the principal loan you borrowed and the interest on the loan. You come up with twenty percent of the purchase price as your down payment and the people renting the property pay for the mortgage and the expenses. If you are smart you will even have some money left over which is positive cash flow and passive income. Over time, as you pay off your mortgage you gain even more positive cash flow and accrue a greater amount of equity. With enough time, a healthy portfolio of properties can eventually fund your lifestyle and your long-term goals.

Asset leveraging as an investment strategy. Being able to leverage your investment means you can purchase more with less. Can you recall one of the Five Cs of Credit lenders analyze from our previous entry? You guessed it—collateral. With real property this happens when you come up with the minimum twenty percent of the purchase price of the property and secures the loan of the rest of the purchase price against the property. Investment properties can be purchased at eighty percent loan-to-value ratio (LVR). The LVR is calculated by taking the amount of the loan and dividing it by the value of the property, as determined by the lender. This high leverage capacity results in a higher return for you at a lower risk due to having less of your own capital tied up in the property, since eighty percent of the purchase price is provided by the mortgagee (lender). Instead of taking $70,000 and investing it in the stock market, you can take your $70,000 with the bank’s money and purchase a $350,000 condo. Leverage helps to maximize your return on investment when you experience growth. A 10% return on $70,000 in the stock market gives you $7,000. A 10% return on that $350,000 condo, with the $70,000 down payment, gives you $35,000 return on investment—a fifty percent return. Much higher because of the leverage you have.

An increase in the value of your asset. Over time real estate has proven to be a very stable investment when compared to other markets. Yes, it has its ups and downs, but the real estate market as a whole tends to be a lot less volatile than other investments, such as the stock market. This may be due to the fact that property takes a longer time to sell and the fact that there is always a demand for homes. Moreover, in an appreciating market, your asset can provide you with opportunities to leverage equity you have gained in order to fund further investment activities.

Diversification. Institutional investors do it, so why should you not do the same? Diversification reduces the overall volatility and risk of your portfolio. Furthermore, it can keep your money working for you at all times. For example, when the stock market is doing poorly, something else should be doing well, and vice versa. 

A house to live in if necessary. Shelter is a human necessity and whether the times are positive or negative, an investment property can provide you and your family a place to live when required.

Pitfalls

Wherever you find rewards like the ones described above, the risks associated with any investment are not far behind.

Barriers of entry. Shares in a company on the stock market can be purchased at a wide range of price points. Conversely, real estate is going to cost you tens and sometimes hundreds of thousands of dollars just to get into the market. With property prices constantly on the rise it continually becomes increasingly difficult to get into the market. This high cost of entry keeps a lot of investors out and makes it hard to begin investing if you do not have a lot of money behind you.

Once you have skin in the game, the responsibilities, obligations, and challenges of being a landlord begin:

Vacancy rates. Since real estate is such a large investment you will often have a mortgage you have to pay for. Sudden changes like rental vacancies or rising interest rates can put a strain on your cash flow. If you are relying on the monthly rent from your tenant and, suddenly they move out or stop paying, ask yourself, “Can I afford to continue to make cover my monthly expenses?”

Tenant risk. Not only can bad tenants impact your cash flow if they do not pay their rent, but they can also be a real nightmare at times. In addition to the financial stress bad tenants can impose on you, bad tenants may cause you emotional stress. Again, real estate is not always exemplary of Ron Popeil’s catch phrase “set it and forget it.” You can always hire a property manager to further relieve you of various risks associated with being a landlord, but make sure that the rent you receive can cover that additional expense. If you choose to do it on your own, understand that rewards and benefits that you pursue do not come without their risks.

Associated costs. Real estate is accompanied by ongoing costs that you may not experience with other investments. Insurance, legal and accounting fees, mortgage payments, maintenance, renovations, and so on. Surely items can be expensed, but these ongoing costs may be regular or may come as a surprise when you least expect it and must be covered by you at the time they occur. With proper planning and an investment that meets your risk tolerance, you could land a property where the rental income outweighs all of the expenses and puts you in a position of net positive cash flow.

Traditionally, real estate is an illiquid asset meaning that it takes time to sell real estate. In a quickly appreciating real estate market, this risk is minimized; however, it is further emphasized in a moderately appreciating or depreciating market. Shares you hold in a company can be sold at a moment’s notice, conversely, real property takes longer to sell. Depending on the area, economic conditions, type of property, and price point it could take weeks or even months to sell your property. This lack of liquidity can be a pitfall if you need to access your money quickly for use in other areas of your life.

Putting all your eggs in one basket. If the market begins to change due to overall economic conditions or government policy, all your effort and resources that have been placed in one investment can leave you with no alternatives to weather the storm especially when, as noted above, real estate traditionally takes longer to sell.

Investing in real estate can prove to be extremely rewarding when property values are appreciating and the monthly rent you receive puts you in a position of positive cash flow. If you want to pursue the benefits and you can stomach the risks associated with investing real estate, you will have to be mindful of the following: your budget inclusive of the purchase price, taxes, legal and accounting fees, and utilities; legal obligations as a landlord, market rent for the type of property you are purchasing, what is required by you to manage the type of property you are purchasing, and what is involved in managing the property. All of this information may be difficult to digest at the outset, so take advantage of a knowledgeable real estate sales representative to guide you through the market. If real estate investment is right for you, stay tuned for our next entry on what to look for when shopping for an investment property.