Since I’m at the age now that starting a family has become a frequent topic of conversation, having a sound financial plan to make sure one’s child has the option and privilege to get an education, seems like a wise thing to consider. We are going to discuss real estate (surprise coming from me I know) as a viable alternative to RESPs for funding your children’s education. This strategy I stole from one of my best mortgage professionals Jason Henneberry, Owner of Mortgage Pal. A few months back he had this exact strategy featured in “Canadian Real Estate Wealth Magazine”.
You may or may not be aware, the Canadian Education Savings Grant was initiated to help families save for their children's post secondary education. The federal government “tops up” your contributions to a maximum of $500 ($2,500 x 20%) per child per calendar year, to a lifetime maximum of $7,200.
On the surface, this sounds like a great deal, and it’s hard to pass up an immediate 20% return on your money. But it’s up to you to make ongoing investment decisions that will affect the long term performance of the portfolio. If we assume a 6% annual rate of return and you invest $2,500 per year and take full advantage of the CESG program, your child’s education fund will be worth approximately $83,000 in 17 years.
And as with most government initiatives, there are a lot of rules that dictate under what circumstances, in what amounts and for what purpose the money can be used. What happens if your child decides not to attend post secondary education? What if they have a brilliant idea and prefer to use the money to start a small business instead?
Perhaps there is a better way to spend your $2,500 per year and give your child more options and better control over their financial future.
The best student loan that money can buy…
Now let’s take a look at what would happen if you chose to forego the government grant of $500 and invest the $2,500 per year (or $208/month) to service a small equity loan on your primary residence in the amount of $39,195 based on 6% interest. Many people have access to much cheaper money against their home currently but this gives us a nice, long range cushion.
You decide to use the equity loan as the source of your 20% down payment for the purchase of a one-bedroom condo near UBCO valued at $189,900. The condo is new construction and comes with a waiting list of students willing to sign a one year lease at $1200 per month in gross rental income. After property taxes, condo fees and management expenses, you net $125 per month which covers the payments on the $156,782 mortgage that you obtained to buy the property. Use the positive cash flow to make two additional payments per year and at the end of 17 years, assuming an average interest rate of 4.50%, the mortgage will be free and clear!
The 80 year real estate price index tells us that Canadian real estate historically appreciates at a rate of about 6% per year. But even if we half that number and assume an average growth rate of 3%, the property will have increased in value to $323,920 by the end of the 17th year. And you own it free and clear (400% more than the $83,000 RESP).
Your child now has the option to sell the property and use the cash to pay for school, or take over ownership and refinance to create a self funding student loan which their tenant will pay off for them while they complete their education and eventually enter the work force. This second option has the added benefit of “staying invested” during those years and allowing the property to continue to appreciate. Remember, the RESP would have to be liquidated to pay for school and your child loses out on potential growth of the asset over time.
The gift that keeps on giving…
It’s important to remember that the rental income from the property should more or less keep pace with inflation over the years as well. Assuming an average inflation rate of 3% per year, the rental income will have increased from $1200 to $1925 per month.
Let’s assume that your child decides to go to school and refinances the property to $210,500 to access the same $83,000 that would otherwise have been available in the RESP. At an average rate of 6% and monthly payments of $1,052, using the positive cash flow to accelerate the mortgage, it will be fully paid off in 11.2 years. That includes 4-5 years for school and a half dozen years getting their career of the ground.
Provided our assumptions hold true over the course of time, your child (now 28 years of age) will be the proud owner of a clear title property worth approximately $448,381 which generates NET cash flow of over $21,000 per year. Show me the RESP that even comes close to delivering that kind of long term performance!
And in terms of education, your child not only has a degree (hopefully!), but they might also have learned a thing or two about how to manage real estate during their formative years. And now they can leverage their asset as they move into the next phase of their lives, perhaps to pay for a wedding, or to help them with the down payment for their own home, or maybe even to do the same for their kids and pass the knowledge along to the next generation.
For a full PDF analysis showing the performance of the one bedroom units under construction right now at UBCO over time just drop me a quick line to [email protected]
Strategy and much of this content provided by Jason Henneberry of Mortgage Pal.
What you are about to read is a true story about a frustrated investor, who for the sake of privacy I will change his name to Tom. Tom had always been very risk averse and being this way had allowed him to put together a nice nest egg of about $500,000. Half of this was in Registered Retirement funds (RRSPs) and the other half was in low risk stocks, bonds and GICs. He was about three years away from retirement from his job where he earned a nice salary of 75,000 per year and he had kept his credit clean. Following the conventional "wisdom" he had diligently paid off nearly his entire mortgage on his $500,000 home. He had only $100,000 still remaining.
By most people's standards, Tom had done it, he had secured a safe future for himself. The thing keeping Tom up at night was the fact that he had busted his hump his whole life to get to this point, but was now confronted with the reality of soon being on a fixed income of less than $30,000 per year...for the next 20-40 years! The $30,000 is a combination of his 4% return on his portfolio ($20,000 annually and his pension of $10,000). Tom and his wife want to travel, they want to spoil their grand kids and have the freedom to start crossing items off their bucket list. Tom wondered if there was anything he could do over the next three years that would change the outcome of his golden years.
Tom came into my office after reading various articles I'd written in this column and asked if I had any bright ideas that could help him on his quest to avoid his fear of being trapped inside a fixed income barely adequate to stay in Kelowna, let alone travel. He shared with me that he had always been afraid of buying rental property because of the risks. He had heard horror stories of tenants doing the midnight dash and leaving the property in bad shape. Also because Tom still works full time, he didn't have time to be running ads, screening tenants, handling maintenance items or chasing people for rent. What he did like about his current portfolio was that it was hands off.
We spent the next hour going over his finances and I explained an investment vehicle to him that we have been using that not only removes all of the risks associated with buying a rental property but actually gave Tom a totally hands off investment with a predictable rate of return more than five times what he was getting now. Tom asked me to sketch up a plan for him over the next couple of days and present it to him and his wife. I welcomed the challenge.
With Tom still working and earning his nice salary, banks like him. We will take advantage of this for the next three years while Tom still has the income to qualify for mortgages. With Tom's cash, the plan is to buy three properties through the Empowered Renter Program in the 350-400k range. This is using a rent to own strategy to maximize the cash-flow, eliminate management and mutually agree on a fair rate of appreciation for the property, in this example it's 4%.
Each of these properties will be positive cash-flow of $10,000 per year and each will have a pre-determined rate of appreciation of approximately $15,000 as well as a mortgage pay down of approximately $7,000 per year with each deal representing $32,000 per year in total upside. When the properties sell he has to pay real estate fees that give him an annual return of 22% on the roughly $80k in each property.
Over the next six months we will execute the plan to invest the liquid portion of his portfolio into three properties that have a cash on cash return of 20-22%. He now has his $250,000 spread out as down payments on his three properties; $400,000 x 20% = $80,000 (multiplied by 3 plus taxes).
This $250,000 is now earning $52,000 per year on the money that was returning $10,000 back when it was in a low risk stock portfolio. It is backed by real estate that he is the titled owner of - something he can see and touch. His tenant has provided a large deposit of fifteen to twenty thousand, and is caring for the home like it is their own. When these properties sell to the tenant buyer, Tom plans to empower other tenant buyers using the same strategy, and will continue to see 20-22% returns on his capital for another 3 year term.
The plan went beyond just the three rental properties. Tom conservatively has $250,000 in available equity in his existing home. He can have access to this on a line of credit for less than $8,000 per year. The plan with this equity is to purchase a long term multi-family holding property like an 8-plex. I showed him one he could buy for $930,000. He would need to invest his $232,500 for down payment and the property would return to him after all management cost and expenses, an annual net revenue of $25,000 including the interest on his credit line.
The last piece of the puzzle in Tom's quest to move from non existing returns into the land of double digits and possibility, is to put his RRSPs on steroids as well. I shared with Tom that he could invest his RRSPs into a self directed RRSP account and become his own bank. With this he would be free to lend his money against real estate and again expect a 10-12 percent ROI. There are many successful Real Estate Investment Trusts that will pay a 10% dividend and allow you to be totally hands off. With Tom's new plan, he can expect to earn $25,000 per year on his registered funds.
So now let's take a look at what Tom will have three years down the road when he decides to pull the plug on work and set his sights on that bucket list.
- His Rent to Own investments produce $52,500
- 8-plex from equity in his home makes $ 32,000
- RRSP's in a well managed REIT makes $25,000
- Canada Pension Plan max amount is $10,500
Tom's Total Earnings = $120,000 per year
This is more than Tom has ever made, and the best part of it is he doesn't have to trade his time to earn it. All of his hard earned equity that he worked so hard to get over the years is doing the heavy lifting. Each of those dollars has been given a healthy quota of returning an average of 14.6% per annum. He has $750,000 of his cash in the real estate market to earn him his dream income. To replicate that in what he was doing before, he would need close to three million dollars!
In addition to the amazing cash-flow, Tom's properties are appreciating further adding to his returns. The best part of this entire process was helping Tom see what's possible for his retirement years. He left my office filled with hope and excitement for the future. That was a good day for everyone involved.
For a Free E-book that illustrates in great detail each of the deals we did for Tom, explaining the Empowered Renter Program, Self Directed RRSP and Multi Family investment pro forma, just drop me a quick email to [email protected] and we will send it off.
Anyone that has been reading my articles knows I love a regular home with a suite or a duplex property, and for over a decade I've been pretty faithful to these residential investments, but recently I have had my attention fixated on a more alluring beast, and that is multi-family investing (apartment buildings) and I have to say, I have a new obsession. It combines my favourite two aspects of real estate, Cash-flow and Value-adding, except it puts both on steroids.
Now before I start, many people may have already checked out after reading the headline. Apartment buildings? That's out of our league, or that's too risky! I'm here to challenge that limiting belief. For starters, obtaining a mortgage on a building that has been run like a business for years is surprisingly less challenging to finance with banks than a residential property. With residential they focus on the strength of the applicant. In multi-family lending they look at the strength of the building's financials.
In terms of risk, it may seem like because the numbers are higher that the risk is higher, but that couldn't be further from the truth. In an apartment building you have only one roof to worry about, one heating system, one property tax bill etc. There's an economy of scale here. For example, a roof for an apartment building is worth approximately $20,000. If you had 10 duplexes and had to do all 10 roofs you would be looking at closer to $100,000 in costs.
What about the risk of vacancy putting strain on your cash-flow? Consider that 5 of your 20 apartment units could suddenly vacate, and you would still be cash flow positive. If one side of your duplex vacates you are faced with an ugly negative cash-flow situation.
Risk aside, my favourite part about apartment buildings is that their value is based on the Net Income. More technically speaking, it is the Net Operating Income divided by the local, current CAP rate. A CAP rate is the expected return on investment for banks and investors. In the Okanagan Valley in 2014, banks are lending against a value that is based on a CAP rate of 6%. This is a fairly high overall yield as compared with larger centers like Vancouver, that only offer 2-3% CAP rates.
For example a building with a net operating income of $120,000/yr divided by a CAP of 6% is worth $2,000,000. Another way of putting this would be that an investor would have to invest 2 million of their own and the bank's capital for an income stream of $120,000 or 10k per month. Typically you would require 25% of your own funds and 75% bank financing. Read all the way to the last paragraph for a free e-book on raising money for a down payment.
So with that knowledge, how does an investor take something from being a solid investment and really turn it into a gold mine? I'm talking raising the value by as much as a million dollars in 2-3 years through a process called normalization. In simple terms, get the rents up to maximum market price and the expenses down as low as one can negotiate them. What happens once you start down this rabbit hole is about as exciting as anything you will find in the world of investment, period. Are you ready for it?
Here's the basic principal. $50 dollars added to the bottom line monthly, equals $10,000 in increased value. Pretty cool right? But don't forget that when you have 20 units that multiplies into $200,000!
So if $50 dollars/month equates to a $200,000 gain, then let's explore how an ordinary investor could profit $1,000,000 (tax free) by systematically going after the lowest hanging fruit over a 2-3 year period.
This is a case study of an average 20-unit apartment building in the Okanagan Valley. I prefer something built in the 1970's as many were built in that era. The reason this era provides for the best opportunity is that due to its age, you can count on the majority of the big ticket items like roof, windows and boiler systems having been upgraded in the past decade. Also, it is very likely that its current owner has not kept up with rental increases over the years and because they don't have debt on the building typically, they are not overly concerned with maxing out the rents. Often they are happy making their 100-120k per year off the building. Now in their 70s, they are ready to sell this investment and exit the landlord business. Here in lies the opportunity!
Our buying Criteria is a building where the current rents are approximately 100-150/mo low for an average unit compared to the market. You would be surprised at how often this is the case. When looking at the financials of a building look for things like utilities being included, which once eliminated can provide an instant increase in cash-flow of about $75/month per unit. That move alone adds $300,000 to the valuation. The other item we are looking for is a high expense ratio. This means that the expenses are high in relation to the Gross income. Anything 40% or higher is the sweet spot. Our job will be to lower expenses by at least 5%.
So here is a basic Income and Expense scenario for our hypothetical 2 million dollar, 20-unit apartment building:
- 20 Units with an average rent of 800/mo
- $192,000 Gross revenue
- $76,800 In expenses including utilities (40% expense ratio)
- Net operating Income $115,200
- Market Value based on 6 CAP equals $1,920,000
- Raise average rents to 950/mo
- Stop including utilities in rent
- Reduce remaining expenses by 5%
These objectives will take some time to complete (allow for 2 to 3 years to fully normalize a building) but trust me, it's well worth the investment of your time and energy. Now let's look at our investment after we've accomplished our three missions.
- 20 units at an average rent of $950/mo
- $228,000 Gross Revenue
- $55,860 Expenses (After utilities removed and 5% reductions on all contracts)
- $172,140 Net Operating Income
- Market Value based on 6 CAP is now $2,870,000
- Net Gain $950,000
Obviously this is a staggering profit, and anyone would kill to be part of something like this. The simple fact is, very few people will ever make the leap. I consult a very small group of investors on how to acquire, normalize and sometimes even further develop multi-family property. It's something I am deeply passionate about and have begun investing in myself. A few months ago I closed on my first apartment building and have another one pending as I write this.
The deal in the case study is only an example. You can find small 5-plexes for as low as $500,000. An 8-plex will run you about $900,000. A 12 unit building will be about $1,200,000.
A general rule of thumb for buildings with 10 units or more suggests you can expect to pay about $100,000 per unit. Slightly less as you go up in price (more economy of scale).
In closing I just want to point out that you should not let a lack of capital stop you from pursuing this dream. Raising investment money from people in your inner circle is very doable. Partnering with people to do multiple deals is as profitable and fun as any business venture.
If you reach out to me via email I will send you a free e-book titled "The Secret To Raising Money To Buy Your First Apartment Building". A great 27 page PDF that will get the ball rolling for you!
Just drop me a line at [email protected]
We all know someone who became a first generation millionaire during the last market cycle from 2001 through 2008. It doesn’t take impeccable timing, mountains of cash, or any uncanny business acumen. All it takes is a simple plan to follow and the discipline and guts to see the plan through. That’s it, there’s no magic here. Thousands of millionaires will be made right here in the valley in the next seven years, so let's make sure we’re on that list! So how do we ensure we aren’t on the sidelines this time around the merry-go-round?
The real estate market isn’t nearly as complex as we make it out to be. It does the same thing over and over, it goes Slump-Recovery-Boom! And then Slump-Recovery-Boom! And around and around we go. It’s also not hard to determine where we are in the cycle because we know what has already transpired. For example, we know that Kelowna Real Estate was in a slump from 2008 until 2013. We have all read the headlines by now that sales are up, inventory is down, and prices have started to head upwards. So what do you think might happen next?
So here is the plan, it involves purchasing five very ordinary houses in good areas that have legal suites. The suites are important, as without one, a house will rarely cover itself, let alone cash flow. The ideal property is three beds up and two down as these rent typically for $1500 up and $1,000 down in good areas bringing in a total of $2,500. The common two up, two down will work, it will just bring in about $2,100. Mortgage payments on a house like this will be $1,514 with 20% down, $1,703 with 10% down, and $1,798 with 5%. Each of these assumes a 25-year amortization and an interest rate of prime. As you can see, no matter how you finance these typical Okanagan homes, they will cover themselves and then some.
The additional cash-flow can be spent at your whim, used to pay down additional mortgage principal, or my favorite, wisely invested into the property to raise its value even more. I'm talking about new floors, paint, bathrooms, kitchens, this kind of thing. These little additional bonuses are not even considered in the chart below, neither are rental increases, but I don’t want to be too technical. So let's now take a look at a simple grid that shows what happens to our investments as we move through this next seven year recovery-boom phase.
So now it’s the year 2022, we’ve had a good run, factor in the down payments invested, we have a net worth in real estate in excess of 1.5 million. We could sell everything, pay some capital gains tax and be left with a little over a million dollars. Then we could sit on the sidelines and wait for a market correction, pick up great deals when no one else is buying, and put this whole plan on steroids when the market goes Slump-Recovery- Boom all over again. It would have been like having a million dollars cash back in 2009 and wisely buying up all the fire sales that were popping up all around you. Could you imagine what you would have done with a million in cash during the last big correction? Literally a fortune at your feet!
This article isn’t about hindsight however, it’s about foresight. Those that have it will be a millionaire seven years from now and a multi-millionaire 15-20 years from now. And all it takes is the first step.
If you’re a first time buyer, good news - you can start building your portfolio with 5 or 10% down. Those of you that are little more established will need 20% down. For this there are many options; borrow against your primary residence, or bring on a money partner, private mortgage, vendor take backs, the list goes on.
Now as an important side note, it’s crucial to choose a bank that will use rental income offsetting, so that each property you add to the portfolio doesn’t make the next more difficult to finance. I have found that TD is currently the most favorable to the investor when taking rental income into account.
I want to conclude this by noting that what you’ve just read is not inherently risky, anyone you know who has ever lost money in real estate, including myself, has done so by speculating on real estate. We are not speculators! We are investors, and we are hunting cash flow. It is this cash flow that recession proofs any portfolio, so that even if you decide not to sell off at the end of the next cycle, your investments will continue to be paid down and yield a return. I am speaking from experience on this. I followed this simple plan to create a seven figure net holdings in real estate the last time around, and I’m excited to do it all over again this time. It’s an exciting ride, I recommend being on it.
Read more Investment Real Estate articles
- Cash flow or flipper? Jul 15
- The power of 10 May 20
- 5 Deadly mistakes house flippers make Mar 21
- 2013 review: What worked...what didn't Feb 2
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- The 'L' word Mar 26
- Rent to own, good or bad? Feb 22
- Waking the Dead...Equity Jan 15
- Real estate - listen to the pros! Oct 19
- How does today's 30 year old retire at 55? Aug 13
- Flipping 101 - Is it time to quit your day job? Jul 20
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