Real Estate

Many people assume someone who owns 3 individual condo apartments in Toronto is getting a free lunch, but the truth is, owning apartments has pros and cons, risks and rewards, just like any other investment. Its difficult to explain how the returns of real estate investing actually work over a conversation at a cocktail party. This post will show real life examples of the returns of 3 individual 1 bedroom apartment condos in Toronto for 2016. I hope this post gives the layperson more knowledge about the actual results of owning condos on Toronto. The rates of return might not be as high as you’d expect!

Below is a table listing the income and expenses of 3 apartments in Toronto. Each of these apartments are located in downtown Toronto. Condo 1 was purchased 10 years ago, Condo 2 was purchased 8 years ago, and Condo 3 was purchased 6 years ago. Condo 1 and Condo 2 are proper 1 bedroom apartments where the bedroom is a separate room from the kitchen and living area. Condo 3 is a bachelor apartment where the living space is contained in a single room with only a separate bathroom. Each building has 24 hour concierge, Condo 1 and Condo 2 have modest rooftop terraces, whereas Condo 3 has extensive amenities including indoor and outdoor pools, a large fitness center, and meeting space. Condo 1 and Condo 2 are rented unfurnished to long term tenants. Condo 3 is rented furnished with term leases. Each unit includes utilities, and Condo 3 also includes unlimited internet. The rent is $1,600 per month for each unit.

The additional insurance expense listed is required because although each building has insurance to protect damage caused by common elements, there are gaps in the policies so individual units need to also have insurance for damage caused by the resident or elements exclusive to the unit, such as if there is a flood caused by the resident of the unit causing damage to the building, this risk is covered in the unit specific policy. Also, damage to articles of the resident are also covered under the unit specific policy regardless of fault.

Interest expenses are associated with the mortgages held on each unit. At the time each unit was purchased, a 20% down-payment was invested, and the balance of funding was provided by mortgages.

Condo 2 suffered legal expenses in 2016 because of an error made by the property manager who was subsequently terminated by the condo board. The legal expenses were associated with adjudicating the dispute resulting from the error by management. This impacted the returns of Condo 2 for this particular year.

Maintenance expenses are related to tasks such as appliance repair. The utilities expense on Condo 3 is the cost of providing internet to the resident.

The total annual income provided after expenses for all three units is $16,829 or $1,402 per month.

What is the rate of return these condos produce?  This can be determined by dividing the income of each property by an estimate of their market value. I estimate Condo 1 to be worth $450,000, Condo 2 to be worth $425,000, and Condo 3 to be worth $325,000. The estimated rates of return are provided in the table below.

As the table illustrates, each property has a bit of financial leverage. Its been a number of years since these condos have been owned as described above, so a portion of the mortgage debt has been paid down, and the properties have appreciated in value, so they carry more equity with a lower leverage rate than when they were each initially purchased.

Readers might be surprised to see the low rates of return. Higher cash yields can be obtained in many other liquid investments such as many blue chip stocks, and some bonds. I’m not going to argue that real estate (in particular condos in Toronto) is the best investment. Many investments are good ones, and from time to time certain asset classes will outperform others. There are many factors to consider when investing in stocks, bonds, and real estate, and its impossible for the individual investor to know which one will be the best. Individual investors can only assume that the market price has accounted for all the relevant factors. I think its more important for the individual investor to maintain a diversified portfolio rather than attempt to dramatically outperform the market. The individual who wants to create wealth should focus their energy on business activities where a financial investment is limited and operational success is far more important. With those thoughts in mind, a low rate of return in the short term should not cause an investor to sell their real estate today.

The % return on equity row describes the rate of return based on the equity invested = profit / (value – mortgage). The % return on cash row describes the rate of return based on the market value of the property = profit / value. The difference between the two rates is the impact of leverage. If the rate of return on the apartment is higher than the interest rate paid, then its profitable to borrow, otherwise, its better to invest without borrowing, or to mortgage the property but use the cash generated to invest in some other higher rate of return. Its also important to note that without the one-time legal expense associated with Condo 2 in the current year, the % rate of return on equity would have been 3.52%.

How does the rate of return on these properties compare to publicly traded REITs?  An investor could probably obtain similar rates of return by investing in REITs, without the hassle and risk of managing individual assets. The leverage rates of residential REITs compared to the current leverage of these three apartments is similar. Some REITs have higher leverage, some have lower. The other benefit of owning a REIT, besides the passive nature and less work, is the benefit of liquidity and diversification. Shares of a liquid REIT can be sold at any time with very low transaction costs, whereas individual properties are expensive to sell if a broker is used.

From a tax perspective, the individual properties are probably a better investment. The expense categories that CRA allows for real estate investments are pretty broad, and can include transportation and administrative expenses. The individual property investor can also make CCA deductions to reduce any other current year’s tax owed, but this comes with the caveat that if/when the properties are sold this CCA is clawed back in the form of capital gains tax. With REITs, the distributions are mostly taxed at the holder’s marginal rate in the year they are received. REIT distributions are not dividends, but are considered passive income to CRA. If its possible, try and hold REITs and bonds inside registered accounts (RSPs, TFSAs, RESPs, RDSPs, etc) and hold dividend paying stocks in non-registered accounts since the tax rate on eligible dividends is relatively low.

Another element that should be considered when analyzing the rate of return of condos in Toronto is the potential for their value to appreciate. This is one of the main drivers behind many real estate investments, the idea that the property will become more valuable over time, regardless of the annual yield %. This has certainly been the case in Toronto throughout its history, but who knows what the future will bring. If we consider urbanization will continue, major cities around the world will to grow and the added population will continue putting pressure on real estate prices. With leverage, the returns from appreciating real estate prices are magnified.