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24 Mar

Why Cash Flow Matters In The World of Rental Properties.

mortgage finance

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In the world of Commercial Rental Properties, there’s a saying; “Cash flow is king”.

Because the Business that owns the property is errr, in business, it follows that things need to be run at a profit. That means that appreciation in value of the property (the asset) doesn’t factor in to the profitability of the business.

The method of calculating profitability is simple really; deduct real and projected expenses from revenue ( i.e. the rent) and the business is left with positive cash flow ( or profit ). If the cash flow is negative, then the business will try to better manage its costs, increase its revenue or dispose of the asset and try again somewhere else.

Because its a business, decisions are largely made based on the numbers – there’s little emotion involved in the decisions because the business owners realize the risks they are taking on and what their tolerance level is for that risk.

For a long time – because stand alone rental properties could be default insured – lenders who gave you and I mortgages on rental properties, considered all your cash flow personal and rental as part of the ‘business’ and made allowances for the individual owner. This was tacitly approving the idea that asset appreciation ( i.e. increase in property value) was part of the goal.

With the rule changes announced late last year, the government indicated it is no longer prepared to insure stand alone investment properties for individuals. The rationale being, I think, that anything but a self supporting rental was too high a level of risk.

Note that I said “Stand Alone”, the government actually enhanced and clarified their support for insuring properties that you occupy that contain additional rental suites.

Financing for Rental or rather “Investment” Properties is certainly still available though lenders providing uninsured (default insurance) Conventional Mortgage financing but, because the financing is deemed riskier to the lender, rates are higher.

More importantly, rental properties are now subject to similar testing to what is completed in the commercial market. In essence, the property needs at least be self sustaining as a stand alone business. Your broker will likely need to complete a Rental Worksheet similar to the one below in order to assess the viability of your rental financing.

Here’s an example scenario with three different down payments:

 

A couple of things to note from this scenario; a) I used a $400,000 value for the property – a not unreasonable amount for the lower mainland and b) the gross rents have been calculated using an amount of $1900 per month, which is perhaps higher than could be expected for all but a downtown rental suite. Both the rental amount and the property purchase price are perhaps, optimistic.

As you can see from this model, rental properties now require more of an equity commitment from you to make them viable. If you want to play around with your own worksheet, one is available here.

So in the current world, if you’re interested in owning and financing a rental property, there are a couple of challenges that also turn out to be opportunities. In the Japanese business world, challenges or complaints like these are known as Golden Nuggets.

Golden Nugget #1 – The rate is higher, BUT you can offset this cost against your tax obligations.

Golden Nugget #2 – Your own investment is higher BUT the property is immediately profitable or at least self sustaining.

 

As always, if you have any questions or need any help please give me a call.

 

JB