I am writing this as someone who has been evaluating the pros and cons of purchasing a second property. A lot of existing homeowners have potentially built significant equity in their primary residence. The pandemic has helped jack-up the prices of single-family homes exponentially over the last couple of years. Seeing this upside has me questioning on whether a rental does make sense in the long run?
The Hypotheticals
We will consider hypotheticals to be able to analyses this question better. Let’s consider that Alexa purchased her first home for $650K in a Toronto suburb prior to the pandemic. A similar home in her neighborhood is now appraised at $950K. Alexa has a pending mortgage of $550K on her home.
If Alexa chooses to refinance, she can available a maximum mortgage of 80% on $950K or about $760,000. Subtracting the current mortgage payable of $550,000, Alexa has about $210,000 available as cash if chooses to refinance.
Interest Rates Matter, really do !
The question to answer is whether that rental property purchase make overall sense given that Alexa’s mortgage now is $760K. Well, it depends on the rate of interest Alexa gets for her property. Given that the Bank of Canada has just increased key hike rate by 0.25%, Alexa will be now paying be paying a higher interest rate. Alexa had an interest rate of 2.35%. The best fixed interest rate that Alexa has access to now is 2.94% from the same lender. While Alexa paid a monthly mortgage amount of $2,650 previously, she will now pay $3,573 post refinancing.
Another hypothetical – the Property of Interest
This is hypothetical again. Alexa decides to jump in irrespective of the higher interest rates. She chooses a condo to invest. Going rates for a 1-bedroom condo is about $700,000 in her area of interest. Alexa purchases the condo and puts down $200K on the condo. Her mortgage rate for this purchase again is 2.94% resulting in a monthly mortgage payment of $2,350. Her maintenance cost will be about $350 a month and monthly property tax about $250 a month.
The total cost of carrying the apartment would be $2350+ $350 + $250 or about $2,950.
The Question of Cashflow and Vacancy
The suburb Alexa is considering has a vacancy rate of 3% but here purchased apartment is slighter larger and newer compared to the city average. We assume here that the vacancy rate in Alexa’s building is lower. A 1-bedroom apartment goes out for $1,900 in this suburb and about $2,100 in Alexa’s apartment complex.
Even if Alexa manages to secure renters for the entirety of her first year, she will have a negative cashflow of $850 a month and an overall negative cashflow of negative $10,200 for the year. We must also consider that Alexa is paying about $900 more on her primary mortgage each month. Overall, Alexa is paying about $21000 more than she did last year.
Should she have done it then ?
Well, it depends on the end goal. If an investor has the income to sustain an additional $20K for the year, then they are maybe able to manage. The upside is of-course the Capital appreciation on the rental unit. If capital appreciation normalizes to say 5% per annum from this point on, the rental property still appreciates by $35K by end of rental year 1. You don’t realize the money from the cashflow but there is opportunity if you’re able to sustain for the initial years.
Another upside is the opportunity to increase the rent should the tenant choose to move out. But maintenance of this condo will also likely increase each year.
Would I do it ?
If our annual income were to net up by $10K, I would consider it. To be honest, I would also be concerned about paying the entire mortgage amount should a renter not be found. I would do it, but I would focus on purchasing a property outside of the areas where the craziest appreciation have already happened. And that might be many miles away from the areas where this example is based. It would also help if the difference in the primary mortgage rates after refinancing were closer to what they were before.
This continues to be a difficult decision. Where you’re looking to buy geographically, what interest rate can you secure and how much can you pay down are critical to deciding. A negative cashflowing property may not cut it for us.