What is your goal – to build wealth or to create cash flow?
We all want a property that makes a crap load of monthly cash flow AND is in such a desirable area that it jumps in value from the moment you buy it. But, today with so many people discovering the value of real estate investing, and the returns that can be generated from this investment source, finding that “unicorn” is more difficult than ever.
I divide up markets into three categories: primary, secondary and tertiary markets. In Ontario, we will use examples for each.
What is a Primary Real Estate Market?
The Greater Toronto Area, Hamilton and Ottawa are three big one markets. These markets are nearly bulletproof. Property values rise when the demand for an area grows. The more people that want that property, the higher the value will rise. Can you envision a reasonable scenario where Toronto is no longer a desirable place people want to live and we see a mass exodus from the region? Yeah, we can talk about potential doomsday stuff, but nothing reasonable. These markets are about as safe as they can be.
What is a Secondary Real Estate Market?
Secondary markets may include Peterborough, Cobourg, London and Kingston. These markets are somewhat stable, but not the first place you want to invest if you had your choice. Each of these are towns or small cities that have not grown like the primary markets for one reason or another. There might be short-term spurts of growth, but long-term, the population change hasn’t been great.
What is a Tertiary Real Estate Market?
Tertiary markets may include Timmins, Kirkland Lake, Elliot Lake, Chatham, Picton, Sarnia, Hawkesbury. You get the idea. These towns are about the same size or smaller than they were a generation ago. Employment is scarce or scary. I am always nervous when one industry rules a town because if that industry has a downturn, the town becomes a ghost town.
There is little doubt that you can cash flow like crazy in the tertiary market, but expect it to be very difficult to sell that investment. When it is sold, don’t assume the asset will be worth more than when you bought it.
Expect cash flow to be extremely difficult in primary markets. In fact, in some instances, the revenues generated, may not even meet the monthly costs. However, you can expect primary markets to continue their run of demand, especially if you choose the location and style of property within that market carefully.
How do you choose between building wealth and creating cash flow?
What’s the best way to go?
Everyone’s needs will be different depending on their goals.
Let me tell you what we did. I absolutely prefer primary markets. I am still actively adding primary market properties into my portfolio. But I am also looking closer at a couple of secondary markets that I like, and have researched, as well.
Year one investments create cash flow
My theory is to get properties with small cash flow in year one, but located in extremely desirable neighbourhoods in primary markets. As most of you know, I like detached properties with second suites that combine to generate enough cash monthly to cover expenses with a little room to spare. I have now maxed out my available line of credit from my principal residence for down payment money. I think that’s the third time I have done that. However, because they are primary market properties, the ones I purchased 3-5 years ago have enough equity in them now to possibly refinance. I can use those new funds, to buy yet more properties.
Please note that the rents in these primary markets have also been going up. Properties with small cash flow in year one are cash flowing nicely a few years later. Of course, if I do refinance that property, the extra monthly carrying costs means the cash flow does suffer. I got “cash in hand” but less cash flow. This only makes sense to do this if you are buying more quality assets.
Since I remain in acquisition mode, the only way for me to do that is to consistently refinance a property or two every year. This way, the portfolio will grow nicely, but the cash flow does stay down. You might ask, when do you ever pay them off? The answer may be never, as long as you remain in acquisition mode. By choosing a market with steady long-term demand, you can bank on a small appreciation steadily.
Let’s say, the property value increases in the next year just 3%. Let’s keep in mind that the GTA has AVERAGED over a 6% appreciation since the turn of the century. But even at 3%, the numbers still work. Let’s even say you are paying a 4% interest rate on your money, you are still building wealth if you pick the right property. First off, the property generates enough rental income to cover the expenses, including the mortgage. Then, with an 80% loan to value ratio, a 3% growth in property value means a 15% return on your down payment investment, not including the cash flow. With a 4% appreciation, that ROI exceeds 20% annually. If you hit the century’s average growth of 6%, we are now looking at a 30% ROI annually.
Property profits can help you grow your investment portfolio
By recycling your profits into more properties, you can really see how your wealth can grow quickly.
Let’s say your plan is to have really solid cash flow in 10 years. This is “sort of” our plan too. One way to accomplish this, using the acquisition strategy, is to recycle that down payment money over and over again. When you reach the time you want the cash flow, begin selling off some of your less favourite properties, that have solid equity in them. Use the proceeds to pay the mortgage, save some for capital gains and use the rest to pay down the mortgages on the properties you intend to keep. Let’s say you sell 5 of the 10 properties you acquired. Then use the money generated to pay down the mortgages of the remaining 5 properties. If done correctly, you are sitting with a portfolio of 5 free and clear well-located properties in primary markets.
Use real estate portfolio to finance your retirement
If you decide to choose a secondary or tertiary market, my advice is to research it better than anyone else. Understand the market fundamentals better than anyone else. Be aware that in some secondary and tertiary markets, vacancy is also higher. If the units are not fully rented, or the tenants aren’t paying rent, or the building needs added repairs beyond the budget allows, cash flow could be evaporated. Pick the best secondary market you can and pick the best properties and best location within that market. You can win big in that kind of market, but remember the risks of not being in a primary market too. If the tides change, be ready to liquidate. But if you choose wisely, the secondary market can cash flow right away and will build appreciation and wealth in the long-term.