Get Bigger Mortgages & Maximize Your Borrowing Capacity
Your first investment property isn’t actually all that hard to qualify for. You probably don’t have a lot of debt besides your principal residence. So if you have a good income and enough capital, everything else is pretty straight-forward.
But what investors don’t realise is that if your long-term goal is to expand your real estate portfolio to multiple investment properties, you will run into issues with qualifying for future mortgages when your debt starts to multiply but your rental income doesn’t multiply at the same rate. So how do real estate investors get three, four, or even five investment properties?
Of course, time does help once your rental income starts to grow. But if you want to build and grow your real estate portfolio more quickly, what you buy and the order in which you buy it become pretty important. In this video, I’ll share a few strategies that can help you build up a bigger real estate portfolio in a shorter period of time.
Total Debt Servicing Ratio
The most basic thing that banks look at to figure out how much money they can lend you is to see how much income you make, and income will consist of your employment income plus a portion of other income streams like existing and projected investment income. Essentially, they just want to make sure you make enough to be able to pay your monthly mortgage payments on time.
As a basic first step, choosing investment properties with better rent yields will increase your total income, which will help you qualify for a bigger mortgage and a bigger investment. Now if you are thinking that you make a good income and a slight bump in rent yields won’t make much of a difference to you, stay with me. What you buy and the order in which you buy them still matter if you’re thinking about maximizing your borrowing capacity and building a bigger portfolio. So, hang tight because I’ll get to that part soon.
Properties With Better Rent Yields
Going back to choosing properties with better rents, what investments should you make?
- The type of property matters. Condos are simpler to manage because the condo management takes care of a lot of building issues. But that also means you are forced to pay condo fees each month, which increases your monthly expenses. Higher expenses lower your rental income, so in other words, condos and condo townhouses will have lower rent yields compared to freeholds.
- The way a property is split up will also matter. For the same sized home, you’ll likely get lower rent if you rent it out as one unit compared to if you were to split the home into two units and rent it out separately. Of course, you can’t really split a condo into multiple units, so again, a freehold will give you even better rent yields compared to a condo when you split it up.
- Rent yields typically get better as you go from a single family home to a duplex, to a triplex, to a fourplex, and so on. Essentially, you are able to get a lower purchase price per square foot, plus expenses also get diluted over more units, so you should get better rent yields as you go bigger.
- Location matters. If you buy a property in a nice neighbourhood, you end up paying a premium for it, but renters don’t care as much about this, so you end up getting lower rent yields. And even within the same neighbourhood, you’ll also find that you can buy properties on main roads for a slight discount. Again, buyers care more about the location and are more willing to pay a premium for it, whereas the location is less of a concern for renters who move around more often. So what you generally find is that you can get similar rents for a property on a main road, but because you bought it for a discount, you end up getting better rent yields.
Understanding The Mortgage Stress Test Formula
I talked about why properties with better rent yields are important when you’re more limited by income, but I also want to highlight that it’s also important even if you have a very good income. At the end of the day, getting new mortgages will get harder for you as you grow your investments quickly, so getting better rental income always helps bump down your debt to income ratios that banks look at when qualifying you. But perhaps a bigger reason why you should choose properties with better rent yields is that these types of properties generally are bigger purchases, and you want to add these bigger purchases to your portfolio sooner rather than later.
When you get a mortgage for a new property, let’s call it property A, banks will test how well you can pay for A’s mortgage using a stress test interest rate, which is generally much higher than the actual rate you’ll be paying. For example, you might be able to get a variable rate at 1.5% right now, but A’s mortgage is stress tested at 5.25%, and this higher rate will increase your debt-to-income ratio.
Then, when you buy your next property, let’s call that property B, here’s how your total debt-to-income ratio is calculated. The banks will now use property A’s actual mortgage debt amount, and the higher stress test rate will only be used for property B’s debt. So, from a stress test standpoint, property A’s debt to income ratio is much lower than property B’s. Let’s keep things simple and ignore your other debt and income for now. When that’s the case, then your total debt to income ratio is basically a variation of a weighted average of A’s debt to income ratio and B’s debt to income ratio, and your goal is to lower this total debt to income ratio so that you can maximize your borrowing capacity.
If you take a closer look, you’ll realize that the order that you make your purchase will make a difference. If you buy the smaller property first for A and a bigger property later for B, then you’ll have more weight against the higher debt-to-income ratio, which increases your total debt to income ratio. But if you swapped it around and buy the bigger property first and the smaller property second, this gives you less weight with the higher debt to income ratio, which lowers your total ratio and will increase your total borrowing capacity.
Once you understand this, it’ll be clearer in terms of how to structure your purchases so that you can build up a bigger real estate portfolio in a shorter period of time. And perhaps we can go through a few examples just to really show you how to apply this concept to a few situations.
Example 1: Let’s say you want to diversify your real estate investments and buy both a house and a condo in Toronto. Is there a better order to purchase these two properties in order to maximize your borrowing capacity? Based on what we just talked about, you’ll be able to get a lower total debt-to-income ratio if you buy a bigger property with better rent yields first. So, look into buying a house first since it’s easier to qualify for when you have less debt.
Then, after you have the bigger purchase with better rent yields, buy the condo next. You are stacking the higher stress test debt to income ratio for a smaller purchase, so that won’t hurt your total debt to income ratio as much. This means you’re more likely to qualify for the second property sooner if your income is on the tighter end, and if you have a good income, you should be able to purchase a bigger condo and maximize your total investment amount.
Example 2: What if you wanted to buy multiple freeholds with similar rent yields? Does it matter what order you buy them in? I’d still go with the bigger purchase first, which helps lower your total debt to income ratio for future purchases. In other words, you’ll have more flexibility to maximize your total investment portfolio when you start with bigger purchases first.
On a separate note, buying bigger properties earlier in life lets you build up equity at a quicker pace. For example, with the same 20% appreciation, you’d gain $300,000 on a $1.5 million home. That 20% appreciation means $200,000 on a $1,000,000 home, so you might be able to grow more quickly from a capital standpoint if you buy the bigger property first.
Example 3: It might even make sense to bump up your downpayment percentage when you’re starting out for the most aggressive investors with lots of capital. It might seem counter-intuitive since you’re using more of your capital and you’re lowering your leverage, but it can be pretty effective to lower your portfolio’s debt to income ratios, which is actually crucial when you’re trying to grow a big portfolio very quickly.
Of course, these are very general examples, and what’s best for your personal situation will vary based on different factors like your income, capital, debt, your lender, interest rates, and just your overall investment objectives. Remember that before you make any investment decisions on your own, you should crunch the numbers for your own situation to check that what you’re doing actually makes sense for you.
How We Can Help
If you need help with making better real estate investing decisions in Toronto and you want an expert to help you out, our team is ready for you! 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!
Want To Get Started With Real Estate Investing In Toronto?
We’d be happy to learn more about your situation and help you find the best investment opportunities for you.