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Rental real estate has been a great investment for many Canadians. But how do you assess whether yours is likely to work out?
After a strong rise in real estate prices in 2021 and in early 2022, many markets are now seeing weakening home prices. Current rental property owners, as well as new potential investors looking to buy, may be wondering how to determine if a rental property is a good strategy for them.
If you are thinking about becoming a landlord, you need to consider not only the purchase price and mortgage repayment costs of your property, but other financial considerations as well.
When purchasing a rental property, the typical down payment requirement is 20% of the purchase price. If the owner is going to occupy one of the units in a multi-unit property, there is a lower minimum.
For one- or two-unit properties, a buyer needs only 5% of the purchase price and can borrow the other 95%. However, if the property is worth more than $500,000, the minimum down payment is 5% on the first $500,000 plus 10% of the excess. A three- or four-unit rental property that will be owner-occupied has a minimum 10% down payment requirement.
Buyers need to consider land transfer taxes and mortgage default insurance as part of their closing costs as well. All provinces—other than Alberta and Saskatchewan—charge land transfer tax to buyers; in Toronto, municipal land transfer tax is charged as well. Mortgage default insurance applies to mortgages that exceed 80% loan to home value. But some lenders may require insurance for a property you intend to rent out even if your down payment is more than 20%.
Mortgage rates for a rental property purchase may be slightly higher than the best rates you can expect for an owner-occupied property. Rental property mortgages can be amortized over 25 years, or possibly as long as 35 years with a down payment of more than 20%.
So, how do you assess a rental property purchase? One thing to consider is whether or not the property could generate a good return. Here is how I would crunch the numbers.
For the record, I do not sell investments or real estate, so my intention is not to encourage or discourage buying rental real estate. I think it makes sense in some circumstances.
Consider the following scenario of a condo purchase in Ontario (outside Toronto). Some of the numbers below may seem high or low depending upon where you live; they are just for the purpose of discussion.
| Expense | Amount |
|---|---|
| Purchase price | $500,000 |
| Land transfer tax | $6,475 |
| Legal fees | $1,695 |
| Down payment (20%) | $100,000 |
| Mortgage amount (amortized over 25 years) | $400,000 |
| Mortgage rate | 4.5% fixed |
| Total mortgage interest over 25 years | $264,168 |
| Property value appreciation (annual average) | 3% |
| Monthly rental income (rising at 2% annually) | $2,000 |
| Annual property tax | $3,000 |
| Monthly condo fees | $250 |
| Average miscellaneous annual costs (insurance, realtor fee to find a tenant, occasional vacancy; these could significantly vary from year to year) | $2,000 |
The rental income comes to $24,000 in the next year, while the mortgage payments are $26,567 and the other expenses total $8,000.
Do the math and you can see this property runs cash-flow negative by $10,567 over the next year (about $881 per month). Sounds brutal, right?
If we assume the investor does not claim depreciation on the property, there is also tax payable on the net rental income each year. Depreciation—called capital cost allowance (CCA)—can be used to bring your net rental income down to $0, but not to create a loss. However, upon sale of the property, your previously claimed CCA is brought into income and typically taxed at a high tax rate.
The mortgage principal payments of $8,914, over the first year of the mortgage, are not tax deductible. Only rental property interest can be claimed on your tax return. So, the property has a small loss of $1,653 for the year for tax purposes.
A rental loss can reduce your other income and result in a tax refund. Tax savings based on a 35% tax bracket (about average at $75,000 of income across the country) would be $579. That means the owner has a net cash-flow outlay of $9,988 for the year to carry the rental property after the tax refund.
For this property to be cash-flow neutral, with rental income covering the expenses and the mortgage payments (assuming a 25-year amortization), an investor would need a down payment of about $259,000 or 52%.
There are other considerations. Cash flow alone is not necessarily the best way to assess the numbers. Here is how I would evaluate the property as an investment.
With a purchase price of $500,000, the property actually costs $508,170 including land transfer tax and legal fees. If the property’s value grows, at 3%, to $515,000 after the first year, and the $400,000 mortgage is paid down to $390,325, that means $124,675 of net equity.
The buyer invested $108,170 ($100,000 down payment plus the land transfer tax and legal fees) upfront, plus the $9,988 net cash flow loss after tax refund. That is a cumulative investment of $118,158 that is now worth $124,675—representing a 6% return. Of course, that return is all just on paper because to sell there would be transaction costs of 4% to 5% of the property value, turning the gain into a loss in no time.
What do the numbers look like after 10 years assuming rent and expenses rise by 2% annually, and a continued 4.5% mortgage rate?
By this point, the buyer’s cumulative investment is $208,078 including initial down payment, initial land transfer tax and legal fees, and future annual cash-flow shortfalls. There would be $382,887 of net equity and an 8% tax-deferred annualized rate of return.
Over 25 years, the annual return would fall to about 6% due to the decreasing leverage and reduced mortgage interest deductions.
I chose the numbers to use in this analysis at random. I am not trying to say that a rental property will result in a 6% long-run return. If we increase the condo fees, property tax, or miscellaneous costs, or decrease the rent—let alone increase the mortgage rate—those changes would all make the numbers look worse. The point is that even if a rental property runs at a loss, that does not make it a bad investment.
Your return is not based on your cash flow alone. It is based on your initial investment, your increased net equity each year and your cash flow.
If someone buys a rental property that will run at a loss, they can consider it to be like a monthly registered retirement savings plan (RRSP) contribution over the long run. But they need to make sure they can afford the cash flow requirements, an extended vacancy or an unexpected repair. Given the transaction costs to buy and sell real estate, it can be risky to try to make a short-term return on a real estate investment.
Going forward, a 6% to 8% return over the long run may be a reasonable expectation for stocks before investment fees. If you opt for purchasing a rental property over contributing to your RRSP or tax-free savings account (TFSA), you may earn a comparable return to what you could have in traditional investments, but you forgo the tax deduction and immediate refund of a RRSP contribution, or the tax-free growth of a TFSA account.
A rental property provides tax-deferred growth, with tax payable someday on the sale of that property. A landlord may be able to borrow against a rental property to access the equity instead of selling it, without triggering tax payable. However, getting a mortgage is always more difficult in retirement, when you are more likely to need the funds.
If an investor does not already have a significant portfolio of stocks and bonds, putting all their savings into a rental property down payment could leave them undiversified. This is especially so if buying a rental property in the same area the investor already owns their principal residence.
Obviously, a cash-flow positive rental property is better than a property that, at first glance, runs a negative return. But cash flow is not the way to assess a rental property.
More importantly, if high property value appreciation is required for your rental real estate numbers to make sense, there is a risk if prices go sideways for a while or drop further. Both are potential scenarios in this new higher rate environment, with lots of low interest mortgages coming up for renewal over the next few years at higher rates.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.
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Not included in the mix are things like , months unit could possibly go unrented, rent controls and other rule changes by government and headaches caused by problem tenants etc.
I think you are missing maintenance costs … different then Condo Fees. This would be for things that break not covered by Condo Fees.
Not included in the expenses are the cost of hiring a property manager or spending your valuable time managing it yourself. Even if you price your time at a minimum wage rate per hour. It adds up. From time to time you will also have to evict a tenant and in Ontario particularly you can loose lots of rent, your own time and legal fees. Also cleaning and repairs when tenant moves out. Those “miscellaneous” costs should be much higher.
Spot on Suze. Renting is not a fully passive income. You have to put a value on your time as well and this can tip it to the negative very quickly. I’ve seen too many people get into the renting game without fully understanding what it is that they are taking on. It can be a great investment but don’t expect to throw a bunch of money at it, then sit back and cash in.
My investment condos all have home line plans. As I pay down the mortgage the line of credit increases. I withdraw the line of credit to pay negative cash flow. When the mortgage is renewed in 3-4 years the mortgage is increased to its original value minus one dollar. Banks will only give 4 mortgages at a residential rate. I am breaking even in my 3 rental condos over the last 4 years. A lot depends on the purchase price of the condos. At this stage purchasing a resale condo in Scarborough for rental makes economic sense but not in North York. I had the fortune of reliable tenants chosen by my real estate agent. The only unpredictable expense has been appliance replacement. Kitec plumbing was a cost in one condo which was bought in 2016 before the sudden rise in prices. I am retired for 4 years and the condos have kept my brain active. I have other sources of income. I only got into the condo game 4 years ago when purchasing a condo for my daughter to rent. If this had not occurred all my savings would be stocks. Buying a low-cost TSX indexed ETF and sitting tight is painless investing and may give long-term results similar to condo investments.
Folks interested in real estate investing but who want their returns to be tax sheltered should consider using a Personal Pension Plan. That way, you get both access to an asset class that isn’t tightly correlated to stock markets and the interest or capital gains earned are not eroded by ongoing taxation….
This is very interesting. Thank you all for sharing. I am considering this as my retirement opportunity and downsize so I can transfer current home to my sons.
Hello, We have a question that we can’t seem to find an answer too.
We were hoping to start selling our rental properties as we are now retired.
The tenant in one of them has been there for 12 years and could possibly buy it! Is there a rule about working a cash deal in the price of the house so they have a down payment? They have been great tenants and would cost us a significant amount to even sell through a realtor so why give them those savings?
If you have an article in this regards ? Or have an answer for us
Thank you
Due to the large volume of comments we receive, we regret that we are unable to respond directly to each one. We invite you to email your question to [email protected], where it will be considered for a future response by one of our expert columnists. For personal advice, we suggest consulting with your financial institution or a qualified advisor.
Hello,
I wanted an advise if me and my brother buy a house which is in my province and I with my family will be living in it, my brother is in another province but he is in a rental appartment with family so this new home will be his principal residence also, but my brother don’t plan to live in the new house and continue to live in another province. To keep this new home his princapal residence how long he will have to live in the new home if thats needed I read somewhere that it has to be ordinarily inhabited so in that sense and if he lives only for some time in the new house but than goes back to live in his province, what proves he can give that he lived in the new house for some time. Also in case if CRA dont accept this as his principal residence what about the capital gains then if the property is sold in the future how will that be calculated. And if we buy the new home as Tenants in Common criteria, my share we set to 99% and my brother set to 1% does that mean if its not accepted as his principal residence then when the property is sold in the future he will have to only pay the capital gains on the 1% share of the property or how that works, really appreciate your good advice in this, thanks & regards.
Due to the large volume of comments we receive, we regret that we are unable to respond directly to each one. We invite you to email your question to [email protected], where it will be considered for a future response by one of our expert columnists. For personal advice, we suggest consulting with your financial institution or a qualified advisor.
Hello All. We recently got our home ready to put on the market. After reviewing the current selling prices, our home wouldn’t sell for the price we thought it would, because the decline in the market for March 2023. We are actually thinking about rental it out. It has 5 bedrooms and 3 bathroom, all 3 floor are finished. We’re considering about renting the main floor / upper bedroom and the basement as 2 rental options. I open to discussion and rental knowledge.
Hi I am 72 and my sister is 75 we had to sell our house out in the country since I was too old to pile 50 face cords of wood every year shovel lane and mail box lol plus my body was just wearing out . so we sold our home in the country and bought a condo . My sister would not rent since she loved to garden plus she loves to sit on the deck and read. But what no one told us how the rules went to keep it looking nice and well-kept. WRONG and I will mention the condo company was E & H Property Management just so you know what to watch out for. Well when we purchased the condo we were told that they kept up the outside work like grass, roofs, windows, and doors, Well at this moment our front lawn is dead, they supply no gardens even though you are told that anything past your front door and back deck they are to keep it up . So we are paying for gardens, the winter we are as old as we have to do our own shovelling since the plow at 2 am and buy the time you need to go out it is full of snow again. So shovelling just like I did when we left the country .our front door is the original door all bumps , bangs, paint coming off, lock does not work. and they tell me that they only repair a door if it is smashed in half, it is the original front door and it has taken a real beating. So when the thought of buying a condo crosses your mind give your head a shake and run the other way. They got you between a rock and a hard place. I do not know about other condos but where I am they are RUDE, uncaring, will not offer help to 2 old women when shoveling . Never heard of such people you could be doing on your driveway and they would just pass you by. We were better off in the country neighbours cared about each other and helped each other. This condo companies management charges do not even put lawn seed down just leave it dirt out rageous fees but do nothing to improve your condo . Tell the owners off if they ask for anything call you rude and will not take your calls there has to be some kind of government protection to save you from the vultures out there.