We’ve all seen the real estate market go through its up and down cycles. A big part of building financial independence involves owning an asset that generates returns without additional effort.
Unlike larger investment firms, most of us don’t go through a rigorous process to assess potential investments - leaving us susceptible to the scenario of limited/no financial return on our investments.
As someone who’s deeply interested and vested in this space, I’m going to share the things I have learned while making personal real estate investments.
I will be using the format of an investment thesis to share my learning. An investment thesis is a document that justifies whether you should make an investment into a particular business/asset. It is commonly done at investment firms and is a practice that I’d recommend to hold yourself accountable to your initial prediction.
Identifying Your Objective
The first step toward building your investment thesis is to understand the objective of your investment. Are you looking to purchase an income property or looking to make a quick profit (short-term capital gain)? This will inform your approach toward making the investment.
Doing Your Research
The next step is to assess your investment based on the factors below. This list is geared toward people who are looking to buy a detached house as an income property - as that’s where my interests/expertise lie.
The larger the lot of land the better - however there are some key factors that you should pay attention to. Depending on where you live, it is more beneficial to have a land lot frontage (width) of 50 feet as in the long term you can split the land into two pieces and build two houses. You should also aim to avoid houses with irregular lots and houses with any municipal easements as the value for those houses aren’t as high.
A lot of ‘arbitrage’ deals come from unique circumstances related to the seller. It is important to understand the time that has passed since the house was first listed and whether the seller is looking for a clean cut deal (e.g. no conditions on your offer). Most good deals either go really quickly (less than a week) or has been up for a long period of time (leaving room for negotiation). I’d also consider the time of year when assessing the seller’s mindset as well. Most people put up their houses for sale during the spring/summer as that is when the supply of houses are generally the highest. This means that houses that go up for sale during the off-season (e.g. December) tend to be sold at a lower price.
As an investor, your objective is to find the highest quality tenants that pay the highest rent possible. It is important to find a location that can reduce the cost of living for your future tenants as much as possible. The first factor to look into is the proximity to local transit - the closer you are to local bus/subway routes, the easier it is to rent out your property. The second factor would be looking at the availability and proximity to schools as it will make it easier to rent out to families who are aiming to stay long term.
On a separate note, I’d also pay attention to developments happening in the area (e.g. new transit options, condo/housing developments and etc). Any kind of change in your surrounding area has the potential to change the value of your investment.
Structure of the House
While you can renovate and update the ‘look and feel’ of the house, it’s much harder to change the core structure of the house (especially the upstairs unit). Some of the things you should check for include converting excess living space into a bedroom, having a separate entrance to the basement unit and making sure that the basement’s ceiling and number of windows is adequate
Costing Out Renovations
Renovations for houses can probably be it’s post - however here are my high level thoughts. A lot of people fall into the trap of making improvements while keeping themselves in mind. You should constantly ask yourself whether your future tenant will pay more in rent, stay longer or reduce the cost of maintenance as a result of your renovation. I’d recommend that you work with a contractor to get a high level estimate before you buy the house. This will help you avoid surprises in the future.
Ability to Rent
Even if you have the perfect property, your ability to rent it out is largely dependent on the market conditions. You can easily assess this by checking the number of available listings and calculating your expected rent based on current listings. The best spots to check listings are MLS and Kijiji (for those of you based out of Toronto).
Valuing Your Property
The research phase allows you to understand whether it’s worth taking a deeper look into a specific property and the level of competition you’ll likely face. Valuation methods are generally consistent across asset class and involve looking at comparable/precedent transactions and expected cash flows.
This is fairly straightforward - take a look at properties that are currently for sale and were recently sold in the area. It is important that you adjust the sale value for the factors above (even if its arbitrary). The HouseSigma app (for those based out of Ontario) is a useful tool to quickly do this work.
Expected Cash Flows
This is where you take your expected rent (net of utilities and property taxes), renovation costs, and borrowing costs and understand the monthly cash flow you expect to gain. This method will also help you understand your borrowing capacity. I’d recommend that you go through a sensitivity analysis to check whether you can withstand a 10-15% drop in price and/or 2-3 months of no rental income.
Making a Decision
By now, you should have enough information to appropriately value the property and make a purchase decision. Please keep in mind that this entire exercise changes if you plan on living in the house yourself. Some of the things you can do to make your offer more attractive (without increasing the price) include having a mortgage pre-approval, increasing the deposit on your offer and eliminating any purchase conditions. Please make these choices wisely as they all come with its own risk.
Buying an investment property involves committing most of your personal net worth. I’d encourage you to go through this exercise for several ‘hypothetical’ deals so that you’re ready to quickly pull the trigger when the right house comes along.
Please let me know if there are any other factors that you’d add to this post. In future posts, I’ll be providing a similar breakdown on building an investment thesis for other asset classes (e.g. stocks, cryptocurrency, venture capital and SMB businesses).