Does It Make Sense To Buy An Investment Property Or Build A Laneway House or Garden Suite In Toronto?
Introduction
In another video, I talked about investing in a laneway suite or garden suite, which typically costs somewhere between $300,000 and $400,000. You might think, doesn’t it make more sense to use that money to buy another investment instead? Well, maybe.
The thing is, deciding what to invest in is not a one-size-fits-all answer, and managing a build is definitely not for everyone. But even from a financial standpoint, the risk and returns are pretty different, so dig into what might make more sense for you.
Capital & Mortgage Requirements
Here’s our scenario: You own a home where you can refinance and pull out $300,000 to reinvest. With this $300,000, you can build a 1,000-square-foot laneway suite at $300 per square foot.
Or you can take the same amount and use it towards the down payment, closing costs, and potential renovations on another property. With $300,000, you can actually buy up to a $1.5 million turnkey investment, but realistically, it’s going to be pretty hard to qualify for that these days. So let’s look at a more likely case where you would buy a $1 million property and put in renovations instead. As you can see, the amount of debt you are borrowing is different right off the bat.
With a laneway suite, you are borrowing $300,000 from the bank, and at 5.5%, you’re paying back around $1,700 each month. It’s not that hard to qualify for an extra $300,000 of debt to do the laneway suite build, but it does get harder if you’re buying a new property. With a new purchase, you’ll need to be able to qualify for $1.1 million of new debt, and if and only if you do, you’ll still have to pay back $6,200 per month.
Cash Flows
The good news is that rent does help pay for some of it. You might get $6,300 in market rent from the new purchase if you have three separate units combined. And after operating expenses and the mortgage, you would be cash flow negative for over $600 per month because you have a loan to value ratio of 100%.
The laneway suite generates less rent at $3,200. But with lower operating expenses and a much smaller mortgage, you actually get $1,400 of extra cash flow per month.
So if you have the choice, it comes down to your investing goals. If you’re looking for large cash flows, say to subsidize your lifestyle, investing $300,000 in a laneway suite build is a much better option.
Appreciation, Value-Add, Total Returns
On the other hand, a new purchase can give you better long-term appreciation. Let’s assume we see 3% in annual market appreciation. That’s $30,000 per year on a new $1 million purchase, but only $9,000 on a laneway suite if it’s valued at cost.
So if you add up your rental income and appreciation together, you still make more money investing in a new property. Obviously, this changes when we use different appreciation assumptions. If we go with a 7% annual appreciation, which is the average for Toronto over the past 10 years, then the difference is even bigger.
I think it’s important for me to talk about the downside risk for a new purchase which is also higher if prices fall. Assuming a 7% depreciation, your position on the laneway suite won’t changed significantly, but your mark-to-market loss on the new purchase would have increased quite a lot.
Finally I’ll go over value addition just briefly. Realistically, this can vary quite a lot, and there aren’t many sales comps for laneway suite builds because they’re still very new.
But if we use cap rates to price it, you’ll see that the backyard house does have much better value-add potential. Of course, you’re trading in sweat equity to build equity more quickly, but the big benefit here is that it can help you pull out enough cash to reinvest with faster, if that’s something in your plans. The build also helps with future financing because the debt-to-income ratios are much better on the laneway suite.
If you’re running into roadblocks with financing new purchases, then you might need to pivot and build a backyard house to boost your mortgage ratios, which can then help you buy your next property.
How We Can Help
So simply put, the investment returns between a backyard house and a new purchase are different because the financing risk and work involved are also different.
If you want the best return potential and are willing to take on more risk because you are in a growth stage in life, a new purchase is preferable as long as you qualify. If you’re in another stage of life where you just want good, stable cash flows to fund your lifestyle, then the build might be better for you.
And if you can’t figure out what might make sense for you, just reach out to us!
We’re a real estate sales brokerage that focuses on investing in houses and multifamily homes in Toronto. When you work with us, we take the time to understand your needs, teach you the ropes, show you these deals, crunch all the numbers, and eventually help you buy the best one for you. But that’s not all. Our team also provides renovation guidance, leasing, and property management if you need it. So, just connect with us if you want to learn more about our services!
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