Should You Choose Higher Cash Flows Or Higher Appreciation For Toronto Real Estate Investments?
Let’s say you are presented with two investment opportunities. The first one has two times better cash flows compared to the second, but half the appreciation rate. Which one should you choose?
Right now, the situation isn’t as extreme as it was before, but many investors are asking us a similar question. Many do believe appreciation will be slower in the suburbs, but feel that cash flows are still slightly better than investments in Toronto. So let’s work out the numbers so that you can learn how to compare investment opportunities more objectively and make better decisions.
Cash Flows As An Investment Return Metric
First off, cash flow is not rental income. How you calculate cash flows is by taking rents minus operating expenses, minus your interest expense, and minus your principal paydown. So what this means is that part of the outgoing cash flow is not actually a cost but goes towards building your equity. This also means that if you choose a shorter amortisation rate from 30 years to 25 years, you might be paying down your principal more quickly, which will reduce your cash flows as well.
The second important thing to note is that cash flows are not property-dependant but might vary from person to person based on your individual financing situation. So, cash flow doesn’t just change with a changing amortisation period, but will also change if your downpayment percentage changes, and will also change depending on whether you go with the best rates from an A lender or higher rents from private lenders.
The third important point is that a lot of people attribute the interest expense solely to your rental income portion, which will bring down your rental income. This is the proper way from an accounting standpoint. But from an investment standpoint, I’d say the cost of borrowing is actually used to generate both rental income and appreciation gains. So, if a property has higher appreciation and lower rental income, then appreciation and cash flow will look much more imbalanced after you deduct the monthly mortgage payments compared to the situation where you see lower appreciation and higher rental income.
Example
I know this last concept is a little bit harder to grasp, so let’s go right ahead and look at the numbers breakdown. Here are our two investment property opportunities, both with a purchase price of $1,000,000. After the same 20% downpayment and closing costs, you’re looking at the same capital requirements of $235,000.
Now let’s look at the rental income. Property A has higher rents, so after deducting expenses and the monthly mortgage payment, it has a positive cash flow of $666 per month. It has higher rents but lower appreciation. In fact, the investor is expecting half the appreciation at 2% compared to what they can get with property B, which is at 4%. This means Property B has double the appreciation but half the cash flows. The rent is lower at $4,000, and then after you take out expenses and the monthly mortgage payment, the net cash flows are only positive at $333 per month. So this is the situation that I talked about right at the start of the video. Which investment opportunity would you choose?
Like I mentioned before, cash flows are not income. Real estate returns actually come from rent plus appreciation, minus operating costs and your interest expense. So instead of looking at cash flows, you can make more objective property-exclusive decisions if we move up one step. Assuming we can get the same financing terms in both situations, essentially, if a property’s returns are better before we look at the mortgage situation, then it also means it would naturally be the better investment after you take into account the mortgage.
So, the simpler way to compare the two investments is to just look at cap rates, which is your annual net rent yield calculated by taking rents minus operating expenses, stacked against your property price, plus your expected appreciation rate.
At property A, we have a 4% cap rate, and if we add that to our expected appreciation rate of 2%, the total return is 6% before financing. Property B’s cap rate is 3.6%, and if we add in 4% appreciation, the total return is 7.6% before financing. So now, things look simpler and we’re able to easily spot the winning investment here. Property B is the one with the higher total returns.
For your information, we can also walk through what the numbers look like post leverage too. Both situations have the same financing terms, so let’s use an interest expense of 1.6% for both properties, and the leverage effect is also the same in both cases. After interest expense and leverage based on a 20% downpayment and a 30-year amortisation period, property A has an ROI of almost 19% and property B has an ROI of 25.5%. So property B is still the one with the higher total returns post-financing. As you can see, if you do want to compare returns while factoring in financing, I would look at the complete return picture instead of comparing strictly cash flows versus appreciation, which doesn’t show a realistic picture of your returns.
Toronto vs. The Suburbs
Applying this concept to investment opportunities for Toronto investors, you might still be wondering if you should choose Toronto or the suburbs. Well, the suburbs were traditionally not a bad choice because, even though they may have had lower appreciation, they had very strong rents and cap rates. But the problem now is that COVID gave the suburbs a huge bump in appreciation, so the potential for more appreciation moving forward looks even slimmer given that their appreciation was weaker to begin with.
At the same time, suburban rent yields no longer look as good as before because rents haven’t gone up whereas their property prices have gone up drastically. So if you have just slightly better cap rates but possibly half the appreciation, it becomes more clear where the better investments are.
What To Choose If Total Returns Are The Same
Now, if two opportunities have the exact same total returns before tax implications, but one has higher appreciation, you can also think about what the returns look like post-tax. Capital gains are subject to half the taxes you’d have to pay compared to rental income, and tax for capital gains is deferred until the time of sale, so it’s very possible that you would be paying less if you chose the opportunity with higher appreciation, but of course, this can vary depending on your personal tax bracket.
Finally, let’s touch on investment strategies, especially if you’re thinking of growing your real estate investment portfolio quickly. Let’s say you have a high personal income and a lot of borrowing capacity for future purposes. In this case, I’d probably choose higher appreciation opportunities so you can get a bigger equity bump and refinance more quickly, so that you have enough money to get into your next property sooner.
If you are tapping out on your mortgage room but capital for future properties is less of an issue, then choose higher cash flows, which will make it easier for you to qualify for bigger future mortgages. Remember, higher cash flows also lower your investment risk and are generally safer for your holding power.
How We Can Help
And if you want to make it really easy to figure out what the best investments in Toronto are for you specifically, we are here to help you out! We can look at your requirements and preferences and then match you up with the best investment property that fits your needs. After we help you buy it, our team also provides renovation guidance, leasing and property management if you need it. Just connect with us if you want to learn more about our services!
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