Friday, October 20, 2017

Proven Way to Get into Real Estate Investing: Put 154K in Your Pocket

How to get into real estate investing?

At a Real Estate Investment Group MeetUp earlier this week, the host asked the group how many were new and how many had some deals already.

It turned out the ratio was about 50/50. The presentation was on secondary suites. Lots of discussion and questions followed because both types of attendees found the topic interesting.

Everyone learned something for their first or next deal.

Here's what I learned. Hope it will help you as well! Especially if you are just looking for various strategies on how to get into real estate investing.

Secondary Suite Investment Strategy

Definition

Secondary suite is a self-contained residential apartment with its own kitchen, bathroom, and bedroom(s). 

Secondary suites also go by second units, basement apartments, accessory apartments, granny flats, in-law suites, nanny suites or garden house. Read more at CMHC website.

Legality

Please check your local legislation for second suites legal requirements.

In Ontario, Canada, The Strong Communities through Affordable Housing Act, 2011, amended the Planning Act to require that all municipalities authorize second units in their official plans and zoning by-laws. 

Each municipality has its own rules & restrictions that you should comply with in your investment. There are areas where second suites are not allowed. There are some specific characteristics of a property that make it a good fit for an economical addition of a legal second suite. Verify what these parameters are in your area before you purchase a house.

How The Strategy Works

  1. Confirm second suite and property requirements in your area
  2. Purchase a property that has no legal second suite, but is appropriate for adding one in
  3. Apply for and obtain a permit for adding a second suite
  4. Engage & manage contractors who will do the work
  5. Rent out main suite 
  6. Complete adding a legal second suite
  7. Rent out second suite
  8. Re-finance the property
  9. Repeat.

Benefits of Secondary Suites Investment Strategy

There are numerous ways to invest in real estate. Secondary Suites is one of them. It became very popular around here in GTA, ON Canada. Here are the main reasons:

Demand - Secondary suites strategy is widely supported by the government in many municipalities because it helps to increase supply of rental units where demand exceeds available inventory. Ontario, Canada, for example, made it required that all municipalities allow legal second suites to boost their creation.

Cash Flow - Rental income from the second unit increases cash flow considerably. For example, in Barrie, ON, a 3-bedroom house can be rented for about $2,100 / month. If you rent the second unit, for an additional $900, your gross rental revenue will increase from $25,200 to $36,000 per year (42% increase) and result in better cash flow.

Value of Property - Investment property is a business. The value of this business strictly ties to the income that it produces. Second suite increases the income of the property and, therefore, increases its value.

Flexible Investment Product - Secondary suites work well for many types of renters (young couples, single people, retirees, students,  travelers, etc.). They also allow flexibility on investor side. In many cases, entrepreneurial home owners use a second suite to off-set their own mortgage payment.

Higher tenant quality - Many tenants are interested in living in high density residential areas within great communities with good schools, established infrastructure, and safe neighbourhoods. This allows for highly selective tenant search and qualification process, resulting in higher quality of tenants.

What are the Cons?

Here are some of the cons you should be aware of. 

Size of Initial Investment - In order to pursue this strategy, you will typically need 20% down payment plus 50-70K budget for adding a second suite. 

Project Management - Coordinating the project to add a legal second suite may be a lot of work, especially when you do it for the first time. 

Compliance - Requirement to comply with Ontario Building Code, the Fire Code and municipal property standards by-laws adds complexity. Please conduct thorough research and select all sub-contractors carefully.

How to do it right?

The presenter at the MeetUp specializes in second suite design, communications with municipalities, obtaining, engaging with reliable sub-contractors throughout GTA, and overseeing the project start to finish. His company already completed over 50 units.

Here are some of tips on how to do it right:

  • Ensure accurate documentation 
  • Obtain all required permits
  • Before you purchase, confirm critical legal second suite requirements in your area. For example, 
    • Parking 
    • Ceiling height
    • Square footage
    • Windows/exists 
  • As you design and build the unit, plan for most optimal layout, some important aspects are:
    • Acoustics - it often helps to mirror top unit 
    • Heating & cooling
    • Plumbing
    • Dry living space.
  • Like with any investment, do thorough due diligence and validate all numbers.

Step 1 - Increase Property Value 

Suppose you purchase a property for 500K.

Now, let's assume:

  • Initially: rental income = $25,200 and Expenses = $8,500
  • With second suite: rental income = $36,000 and Expenses = $14,875
  • Market remains unchanged with Cap Rate = 3.3%

Then, the value of the property with the second unit, is $21K / 3.3% = 632K.

The property now is worth ~25% more, compared to the original purchase price.


Example: Increase property value from 500K to 632K by adding a second suite



Step 2 - Refinance the Property to Pay Build Costs

Let's assume, total costs so far are as follows:

  • Closing costs were = 10K
  • Second suite cost = 50K
  • Interest on short-term construction loan = 10K
  • Refinancing cost = 3K
  • Total = 73K.

If you re-finance the property to 80% of the new value of $632.5K (see Example 1 above), you will receive 33K back (632.5K * 80% - 400K original loan - 73K).

To continue this sample scenario, I assume that we do not pull the remaining cash out. Instead, we use it to decrease our mortgage to 473K (632.5 * 80% - 33K extra cash).

Refinance property and pay off the cost of adding the secondary suite



Step 3 - Put 154K in Your Pocket 

Five-Year Cash Flow Projection

Let's assume, during the next 5 years: 

  • Rents increase by 2% every year
  • Costs increase by 2% every year
  • You hold a 3% fixed interest mortgage with 30 year amortization
  • Property is doing fine and you spend about 25K on any cap-ex expenses, vacancy and small fixes
  • Real estate appreciates at 5% rate in the area.
Unfortunately, my dummy example leads to negative operating cash flow and you invest another 9.4K into your rental.

This is because principal re-payment doesn't go straight into your pocket until you sell or re-finance the house at the end of the 5-year term. 

Notice that at the end of the term, the investment results into a positive outcome:

154K goes into your pocket.



Return on Investment (ROI)


In our sample secondary suite project, initial investment was 100K down payment plus 33K to reduce mortgage after the first refinance, total of 133K.

Therefore, ROI =154K / 133K = 116% over five year period; or

ROI = 23% annually on average.

THANK YOU & PLEASE LEAVE ME A COMMENT

Thanks for reading my blog. I hope you find the example helpful.

If you have any questions or notice anything that I should add or adjust, please let me know in the comments below.

Please also let me know what posts will be helpful for you to see in the future. I will really appreciate all your feedback!

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