Investing in real estate is a very effective way to build intergenerational wealth. Return on investment in real estate is from rental income, capital gains or a combination of the two. As with any other investment, there is risk involved in investing, and a successful investment requires either luck or very well-thought-out investment decisions.
The easy and convenient way to invest in real estate is to give your money to professionals to do the investment. You can do this by buying shares in real estate investment trusts (REITs). You can even further reduce your investment risk by investing in REIT ETFs.
The real estate market is a market with relatively low liquidity; it is also very local. These lower levels of liquidity combined with locality would result in a less efficient market. In an efficient market, almost all trades occur close to fair market value. Inefficiency in the real estate markets means that some buyers are paying too much while some sellers are asking for too little. Those who are willing to put time and energy into their real estate investment can exploit such inefficiencies and produce much higher returns compared with passive investment in REITs or REIT ETFs.
Real estate investment offers the potential for two types of gains: rental income and price appreciation. To generate rental income, one would purchase a property and lease it out. On the other hand, to pursue capital gain, the strategy is to purchase property at a low cost and sell it at a higher price, a process commonly known as flipping. There are three strategies for achieving this: purchasing properties significantly below market value, timing the market correctly, and making improvements to the property post-purchase.
Acquiring properties at a price that is significantly below their market value is commonly referred to as Distressed or Wholesale Real Estate Investing. The latter often entails making an offer to purchase a property and then transferring the right to purchase to another buyer. Wholesalers may utilize the inspection clause to back out of the deal if they are unable to find a buyer for the property.
Distressed real estate investing also includes cash purchases, with some real estate investors offering fast and secure closing in exchange for a reduced price. Timing the market is tough, but short selling is not an option for real estate investors, and real estate prices go up more often than they go down. So many real estate investors feel smart and gain financial rewards without having any ability to time the market.
Considering monthly changes since 2005, the Canadian home price benchmark has increased 150 times while it has decreased 61 times. In other words, over the past 17 years, benchmark home prices have increased 70% of the time while they have decreased 28% of the time. It is also informative to note that the average monthly price change has been 1.11% when prices increased and -0.74% when prices declined. Despite the favourable odds for real estate investors, there is still a significant chance that the market may decline.
A homebuyer's decision to purchase a property often hinges on their emotional connection with the house. This connection can be formed when the potential buyer can envision themselves settling into the house and experiencing a comfortable lifestyle there.
However, if the property is not well-maintained and appears untidy or dirty, or if there are issues such as poor lighting or leaky taps, it can be challenging for a buyer to develop an emotional connection with the house. In these cases, the seller may need to offer larger discounts to compensate for these shortcomings, surpassing the cost of fixing the problems.
As such, an investor can take advantage of purchasing a poorly maintained property at a discounted price and then selling it at a higher price after making necessary repairs and improvements, such as updating lighting fixtures, giving the walls a fresh coat of paint, fixing broken structural components, replacing outdated windows and plumbing, and upgrading heating and air conditioning systems.
This strategy can be profitable if the investor is handy and has established relationships with reliable contractors or handymen. However, if the investor plans to find contractors after the property has been purchased, they may face cost overruns and experience delays, which can impact the overall profitability of the investment.
Because of high home prices, real estate investment often uses leverage. But it is very important not to over-stretch yourself and keep your ability to absorb some negative shocks.
If you are starting your real estate investment and do not mind some proximity between your life and investment, you can use either an insured mortgage or a conventional mortgage to purchase a multi-unit property (up to 4 units) where you live in one of the units while renting the rest.
If you do not want to live in your investment property, you can use an investment property mortgage to fund up to 80% of the purchase price. Investment property down payment needs to be a minimum of 20% of the property price. If your property has more than five units, it is considered a commercial property, and you should use a commercial mortgage.
A rental property investor would look for a location with low vacancy rates. A recent report by Canada Mortgage and Housing Corporation (CMHC) shows that current vacancy rates are historically low across Canada. Namely, in 2022, purpose-built rental houses had a vacancy rate of 1.9% with an average monthly rent of $1,258 for two-bedroom units, while the vacancy rate for condominium apartments was 1.6% and the average rent for two-bedroom units was $1,930.
These data show that national vacancy rates are at a historic low in Canada. In other words, you can easily rent out residential units. Last year around 55,000 units were added to the stock of rental houses in Canada.
This is the largest addition to rental stocks over the last decade, but the growth in demand was much higher and pushed vacancy rates to a decade low. So national data suggest that you would have no problem renting out a residential unit in Canada. Yet it is important to note that rental markets are very local. Therefore, before making any investment decision, you should check the vacancy rate in the specific area of your interest. You can use the rental market data published by CMHC.
Statistics of Rental Condominium Apartments in Major Canadian Cities (October 2022)
|Rental Condo Apts.
|Percentage of Condo Apts in Rental
|Vacancy Rates (%)
|Average Rent Two Bedroom ($)
|Ottawa-Gatineau CMA (Ont. part)
|Ottawa-Gatineau CMA (Qué. part)
Source: Rental Market Survey (CMHC)
** Data Supressed
Rental property purchases are typically considered long-term investments, making it crucial to consider the future rental demand in your area. Generally, an increasing population leads to an increase in rental demand, while a declining population has the opposite effect. In many developed countries, low birth rates and an aging population result in a declining population.
However, Canada's relatively high levels of immigration more than makeup for its low birth rate, resulting in a growing population. At the end of 2022, Canada's population stood at 39,292,355, which represents a healthy annual growth rate of 2.25%. There are indications that immigration to Canada will continue, further driving population growth and housing demand.
It's important to note that international migrants do not distribute evenly across the country. Approximately 80% of international migrants go to three provinces: Ontario, British Columbia, and Quebec. Additionally, there is interprovincial migration taking place, such as the population shift from Ontario to Alberta.
There is also migration inside provinces. So it is essential to think about population changes that might happen where you are investing. To see how far the regional population can deviate from national levels, consider Wabana, a town in the province of Newfoundland and Labrador. At its peak around 1959, Wabana had a population of close to 12,000. Currently, its population is close to 2,000.
The most important driver of population growth is job creation, while job destruction is the most important driver of population decline. So to predict changes in the local population, you can study the local job market. Retirees and those who work remotely can choose their residence independent of the job market. Thus the quality of life in an area which includes security, weather and affordable housing, can also affect changes in the population.
If you would like to flip a property, you would be concerned with how easy it is to sell a home in your area. The most important metric to consider in this regard is days on the market (DOM). DOM is the average number of days a property takes to sell after it is listed. For example, at the time of writing, in the Toronto housing market, DOM=27 days, while in the Montreal housing market, DOM is close to two months. The smaller the DOM, the easier it is to sell a property in that area.
Another indicator that one can use to judge the ease of selling a property in a market is the months of sales. Months of sales measures how long it takes for the current number of houses advertised for sale to sell. It is calculated by dividing the number of homes for sale by the number of sales over the past month. For example, currently, there are 1.8 months of sales in the Calgary real estate market, while there are about 3.8 months of sales in the Ottawa real estate market. The smaller the number of months of sales on the market, the easier it is to sell a real estate property.
There is no reason for real estate investors to limit themself either to rental income or to capital appreciation, and they might want to maximize their return by gaining both rental income and capital appreciation. A popular and often profitable strategy which simultaneously aims to maximize capital gains and rent is called buy, rehab, rent, refinance, and repeat (BRRRR).
A good planner always has a plan B, and this is especially true in investing. The natural plan B for a rental investment is to flip, and the natural plan B for a flip is to rent out. So whether your strategy is to flip or to gather rent, it is best to find a property which is simultaneously suitable as a flip and as a rental.
The worst pitfall for a flipper is to buy when the real estate market is in the bubble territory, and the worst pitfall for a rental investor is to buy an undesirable property. When housing markets are in bubble territory, their prices are so high that their rent is insufficient for their mortgage payment.
So if a flipper considers his potential purchase as a rental, he would walk away from the great pitfalls of overvalued properties. Similarly, if a rental investor considers his potential purchase as a flip, they would likely avoid the pitfall of undesirable properties.
One has to pay income tax on their net rental income, just like their employment income.
Net Rental Income = Rental Income - Rental Expenses
Rental income is all the rent you have received from your tenants. Rental expenses are all costs that you incur in renting your property. Common rental expenses include property taxes, landlord insurance, interest on the mortgage for rented properties and depreciation. The amount of depreciation you can claim each year is known as capital cost allowance.
A real estate investment ends by selling the investment property. You can determine the capital gain you have made by subtracting the adjusted cost base from the proceeds of sale to calculate your capital gain.
Income tax law treats capital gains more favourably than other forms of income. More specifically, capital gains are multiplied by a multiple called capital gains inclusions rate before being included in taxable income. The capital gains inclusion rate has been ½ or 50% over the past couple of decades. But recently, a caveat has been added to this favourable treatment of capital gains for real estate investors.
Taxable Capital Gains = Capital Gains × Capital Gains Inclusions Rate
In 2021 and 2022, Canadian houses became extraordinarily unaffordable, and flippers have got a share of the blame for this unaffordability. Thus, the government changed the rules to consider any capital gains on houses sold less than a year after their purchase as business income. This change makes the inclusion rate for capital gain on homes less than a year after their purchase equal to 100%. This new rule has been in effect since January 1st, 2023.
We might not think of purchasing our residence as a real estate investment because we are not becoming a landlord, nor are we flipping a property. Yet it is still an investment. Many people's nest egg is mainly in their homes. The good news is that your principal residence is exempt from capital gains tax. What is even better is that you might get some financial help from the government to become a homeowner.
For a flip, you can divide the capital gain by the initial investment and multiply by 100 to derive the percentage of profit in operation. In order to compare this profit with other investments, you can annualize the result. For rental investments, you can use the cap rate as a measure of the profitability of your rental investment. Before any investment, projecting all your cashflows and calculating the internal rate of return is very valuable. Repeating this practice after the investment helps you keep the score.